The Impact of a Tax
When a $1,000 tax is imposed statutorily on the sellers of used cars, the supply curve shifts vertically upward by the amount of the tax. The price of used cars to buyers rises from $7,000 to $7,400, resulting in buyers bearing $400 of the burden of this tax. The price received by a seller falls from $7,000 to $6,400 ($7,400minus the $1,000 tax), resulting in sellers bearing $600 of the burden.
of the new supply curve including the tax, and the demand curve). Thus, despite the tax being statutorily imposed on sellers, the higher price shifts some of the tax burden to buyers. Buyers will now pay $400 more for used cars. Sellers now receive $7,400 from the sale of their used cars. However, after sending $1,000in taxes to the government, they retain only $6,400. This is exactly $600 less than the seller would have received had the tax not been imposed. Because the distance between the supply curves is exactly $1,000, this net price can be found in Exhibit 5 by following the vertical line down from the new equilibrium (point B) to the original supply curve (point C) and over to the price axis. In this case, each $1,000 of tax revenue transferred to the government imposes a burden of $400 on buyers (in the form of higher used-car prices) and a $600 burden on sellers (in the form of lower net receipts from a car sale)-even though sellers are responsible for actually sending the $1,000tax payment to the government.
The tax revenue derived from a tax is equal to the tax base (in this case, the number of used cars exchanged) multiplied by the tax rate. After the tax is imposed, the quantity exchanged will fall to 500,000 cars per month because some buyers will choose not to purchase at the $7,400 price, and some sellers will decide not to sell when they are able to net only $6,400. Given the after-tax quantity sold, the monthly revenue derived from the tax will be $500 million (500,000 cars multiplied by $1,000tax per car).
As Exhibit 5 shows, a $1,000 tax on used cars causes the number of units exchanged to fall from 750,000 to 500,000. It reduces the quantity of units exchanged by 250,000 units. Remember, trade results in mutual gains for both buyers and sellers. The loss of the mutual benefits that would have been derived from these additional 250,000 units also imposes a cost on buyers and sellers. But this cost—the loss of the gains from trade eliminated by the tax—does not generate any revenue for the government. Economists call this the deadweight loss of taxation. In Exhibit 5, the size of the triangle ABC measures the deadweight loss. The deadweight loss is a burden imposed on buyers and sellers over
The level or quantity of an economic activity that is taxed. Higher tax rates reduce the level of the tax base because they make the activity less attractive.
The per-unit amount of the tax or the percentage rate at which the economic activity is taxed.
Deadweight loss The loss of gains from trade to buyers and sellers that occurs when a tax is imposed. The deadweight loss imposes a burden on both buyers and sellers over and above the actual payment of the tax.
and above the cost of the revenue transferred to the government. Sometimes it is referred to as the excess burden of taxation. It is composed of losses to both buyers (the lost consumer surplus consisting of the upper part of the triangle ABC) and sellers (the lost producer surplus consisting of the lower part of the triangle ABC).
The deadweight loss to sellers includes an indirect cost imposed on the people who supply resources to that industry (such as its suppliers and employees). The 1990luxury-boat tax provides a good example. Supporters of the luxury-boat tax assumed the tax burden would fall primarily on wealthy yacht buyers. The actual effects were quite different, though. Because of the tax, luxury-boat sales fell sharply and thousands of workers lost their jobs in the yacht-manufacturing industry. The deadweight loss triangle might seem like an abstract concept, but it wasn't so abstract to the employees in the yacht industry who lost their jobs! Their losses are part of what is reflected in the triangular area. Moreover, because luxury-boat sales declined so sharply, the tax generated only a meager amount of revenue. The large deadweight loss (or excess burden) combined with meager revenue for the government eventually led to the repeal of the tax.
Economic analysis indicates that the actual burden of a tax—or more precisely, the split of the burden between buyers and sellers—does not depend on whether the tax is statutorily placed on the buyer or the seller. To see this, we must first look at how the market responds to a tax statutorily placed on the buyer. Continuing with the auto tax example, let's suppose that the government places the $1,000tax on the buyer of the car, rather than the seller. After making a used-car purchase, the buyer must send a check to the government for $1,000. Imposing a tax on buyers will shift the demand curve downward by the amount of the tax, as shown in Exhibit 6. This is because the height of the demand curve represents the maximum price a buyer is willing to pay for the car. If a particular buyer is willing and able to pay only $5,000 for a car, the $1,000 tax would mean that the most the
When a $1,000 tax is imposed statutorily on the buyers of used cars, the demand curve shifts vertically downward by the amount of the tax. The price of used cars falls from $7,000 to $6,400, resulting in sellers bearing $600 of the burden. The buyer's total cost of purchasing the car rises from $7,000 to $7,400 ($6,400 plus the $1,000 tax), resulting in buyers bearing $400 of the burden of this tax. The incidence of this tax on used cars is the same regardless of whether it is statutorily imposed on buyers or sellers.
Excess burden of taxation Another term for deadweight loss. It reflects losses that occur when beneficial activities are forgone because they are taxed.
Was this article helpful?