Chapter Outline

I. The of Taxation

Figure 1

Price

Price buyers pay

Price sellers receive

Tax Revenue

Supply

Demand

Quantity

C. How a Tax Affects Market Participants

Figure 2

Price

Supply

Price buyers pay

Price without tax

Price sellers receive

Demand

Supply

Price buyers pay

Price without tax

Price sellers receive

Demand

Quantity Quantity with tax without tax

Quantity

1. We can measure the effects of a tax on consumers by examining the change in consumer surplus. Similarly, we can measure the effects of the tax on producers by looking at the change in producer surplus.

. However, there is a third party that is affected by the tax—the government, which gets total tax revenue of T x Q. If the tax revenue is used to provide goods and services to the public, then the benefit from the tax revenue must not be ignored.

3. Welfare without a Tax a. Consumer surplus is equal to: A + B + C.

c. Total surplus is equal to: A + B + C + D + E + F.

4. Welfare with a Tax a. Consumer surplus is equal to: A.

b. Producer surplus is equal to: F.

Figure 3

5. Changes in Welfare a. Consumer surplus changes by: -(B + C).

6. Definition of_: the fall in total surplus that results from a market distortion, such as a tax.

D. Deadweight Losses and the Gains from Trade

1. Taxes cause deadweight losses because they prevent buyers and sellers from benefiting from trade.

2. This occurs because the quantity of output declines; trades that would be beneficial to both the buyer and seller will not take place because of the tax.

3. The deadweight loss is equal to areas C and E (the drop in total surplus).

4. Note that output levels between the equilibrium quantity without the tax and the quantity with the tax will not be produced, yet the value of these units to consumers (represented by the demand curve) is larger than the cost of these units to producers (represented by the supply curve).

II. The Determinants of the Deadweight Loss

Figure 5

Figure 5

A. The price elasticities of supply and demand will determine the size of the deadweight loss that occurs from a tax.

1. Given a stable demand curve, the deadweight loss is larger when supply is relatively elastic.

2. Given a stable supply curve, the deadweight loss is larger when demand is relatively elastic.

B. Case Study: The Deadweight Loss Debate

1. Social Security tax and federal income tax are taxes on labor earnings. A labor tax places a tax wedge between the wage the firm pays and the wage that workers receive.

2. There is considerable debate among economists concerning the size of the deadweight loss from this wage tax.

3. The size of the deadweight loss depends on the elasticity of labor supply and demand, and there is disagreement about the magnitude of the elasticity of supply.

a. Economists who argue that labor taxes do not greatly distort market outcomes believe that labor supply is fairly inelastic.

b. Economists who argue that labor taxes lead to large deadweight losses believe that labor supply is more elastic.

III. Deadweight Loss and Tax Revenue as Taxes Vary

Figure 6

A. As taxes increase, the deadweight loss from the tax increases.

B. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax.

1. The deadweight loss is the area of a triangle and the area of a triangle depends on the square of its size.

2. If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four.

C. As the tax increases, the level of tax revenue will eventually fall.

D. Case Study: The Laffer Curve and Supply-Side Economics

1. The relationship between the size of a tax and the level of tax revenues is called a Laffer curve.

2. Supply-side economists in the 1980s used the Laffer curve to support their belief that a drop in tax rates could lead to an increase in tax revenue for the government.

3. Economists continue to debate Laffer's argument.

a. Many believe that the 1980s refuted Laffer's theory.

b. Others believe that the events of the 1980s tell a more favorable supply-side story.

c. Some economists believe that, while an overall cut in taxes normally decreases revenue, some taxpayers may find themselves on the wrong side of the Laffer curve.

E. In the News: On the Way to France

1. Tax rates affect work effort.

2. This is an article from the WallStreetJournalthat discusses how tax rates and hours worked varies across several countries.

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