UMD ECON 200 - Chapter 8: Application-The Costs of Taxation

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Chapter 8: Application-The Costs of TaxationThe Deadweight Loss of Taxation- Taxes cause the size of the market to shrink- A tax on a good places a wedge between the price that buyers pay and the price that sellers receive; quantity of the good sold falls - The tax revenue that the government collects equals T*Q (T=size of the tax) (Q= quantity sold); tax revenue equals the area of the rectangle between the supply and demand curves- A tax on a good reduces consumer surplus and producer surplus; b/c the fall in producer and consumer surplus exceeds tax revenue, the tax is said to impose a deadweight loss- Deadweight loss: the fall in total surplus that results when a tax distorts a market outcome >> taxes distort incentives & cause markets to allocate resources inefficiently - Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from tradeThe Determinants of the Deadweight Loss- Price elasticities of supply & demand determine whether the deadweight loss from a tax is large or small- Tax raises price paid by buyers so they consume less, tax lowers the price received by sellers so they produce less >> size of market shrinks below optimum- The greater the elasticities of supply & demand, the greater the deadweight loss ofa taxDeadweight Loss and Tax Revenue as Taxes Vary- A small tax has a small deadweight loss and raises a small amount of revenue- A somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue- A very large tax has a very large deadweight loss, but b/c it has reduced the size of the market so much, the tax raises only a small amount of revenue- As the size of a tax grows larger, the deadweight loss grows larger; however tax revenue first rises and then falls >> Laffer curve - Supply-side economics: Reagan’s view; cut in taxes intended to encourage ppl to increase the quantity of labor


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UMD ECON 200 - Chapter 8: Application-The Costs of Taxation

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