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The Costs of Taxation

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The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE Size of tax = $T
PB S
Eq’m with
tax = $T per unit: PE
Buyers pay PB PS D
Sellers receive PS
Quantity = QT
Q
QT QE

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Effects of a Tax
P

Revenue from tax:


$T x QT Size of tax = $T
PB S

PE

PS D

Q
QT QE

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The Effects of a Tax
 Next, we apply welfare economics to measure
the gains and losses from a tax.
 We determine consumer surplus (CS),
producer surplus (PS), tax revenue,
and total surplus with and without the tax.
 Tax revenue can fund beneficial services
(e.g., education, roads, police),
so we include it in total surplus.

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The Effects of a Tax
Without a tax, P

CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
= CS + PS D E
=A+B+C D
F
+D+E+F

Q
QT QE

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Effects of a Tax
With the tax, P
CS = A
PS = F
A
Tax revenue PB S
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax reduces
total surplus by Q
C+E QT QE

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Effects of a Tax
P
C + E is called the
deadweight loss
(DWL) of the tax, A
PB S
the fall in total
B C
surplus that
results from a D E
market distortion, PS D
such as a tax. F

Q
QT QE

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About the Deadweight Loss
P
Because of the tax,
the units between
QT and QE are not
sold. S
PB
The value of these
units to buyers is
greater than the cost PS D
of producing them,
so the tax prevents
some mutually
Q
beneficial trades. QT QE

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Analysis of tax The market for
P airplane tickets
A. Compute $ 400
CS, PS, and
350
total surplus
without a tax. 300
S
250
B. If $100 tax
per ticket, 200
compute 150
D
CS, PS, 100
tax revenue,
50
total surplus,
and DWL. 0 Q
0 25
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50 75 100 125
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Answers to A The market for
P airplane tickets
CS $ 400
= ½ x $200 x 100 350
= $10,000 300
S
PS 250
= ½ x $200 x 100 P = 200
= $10,000 150
D
Total surplus 100
= $10,000 + $10,000 50
= $20,000 0 Q
0 25
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50 75 100 125
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Answers to B A $100 tax on
P airplane tickets
CS $ 400
= ½ x $150 x 75 350
= $5,625
300
PS = $5,625 S
PB = 250
Tax revenue 200
= $100 x 75 PS = 150
= $7,500 D
100
Total surplus 50
= $18,750
0 Q
DWL = $1,250
0 25
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What Determines the Size of the DWL?
 Which goods or services should govt tax
to raise the revenue it needs?
 One answer: those with the smallest DWL.
 When is the DWL small vs. large?
Turns out it depends on the price elasticities
of supply and demand.
 Recall:
The price elasticity of demand (or supply)
measures how much QD (or QS) changes
when P changes.

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DWL and the Elasticity of Supply

When supply P
is inelastic,
S
it’s harder for firms
to leave the market
when the tax
reduces PS.
Size
So, the tax only of tax
reduces Q a little,
and DWL is small. D
Q

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
DWL and the Elasticity of Supply
The more elastic is
P
supply,
the easier for firms
to leave the market
S
when the tax
reduces PS, Size
of tax
the greater Q falls
below the surplus-
maximizing quantity, D
the greater the DWL. Q

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
DWL and the Elasticity of Demand
When demand
P
is inelastic,
S it’s harder for
consumers to
Size
leave the market
of tax
when the tax
raises PB.
So, the tax only
D reduces Q a little,
Q and DWL is small.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
DWL and the Elasticity of Demand
The more elastic is
P demand,
S the easier for buyers
to leave the market
when the tax
Size increases PB,
of tax
the more Q falls
D
below the surplus-
maximizing quantity,
and the greater the
Q
DWL.

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Elasticity and the DWL of a tax

Would the DWL of a tax be larger if the


tax were on:
Groceries or meals at fancy restaurants?

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Answer

Groceries or meals at fancy restaurants


Groceries are more of a necessity and therefore
less price-elastic than meals at
fancy restaurants.
So, a tax on restaurant meals would cause a
larger DWL than a tax on groceries.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Effects of Changing the Size of the Tax

 Policymakers often change taxes, raising some


and lowering others.
 What happens to DWL and tax revenue when
taxes change? We explore this next….

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
DWL and the Size of the Tax
P
Initially, the tax is
new
T per unit. DWL
Doubling the tax S
causes the DWL
to more than 2T T
double. D
initial
DWL

Q
Q2 Q1

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
DWL and the Size of the Tax
P
Initially, the tax is new
T per unit. DWL

Tripling the tax S


causes the DWL
to more than 3T T
triple. D
initial
DWL

Q
Q3 Q1

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DWL and the Size of the Tax
Summary
When a tax increases,
DWL rises even more.
DWL

Tax size

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Revenue and the Size of the Tax
When the P
tax is small,
increasing it
causes tax PB
S
revenue to rise. PB
2T T
PS D
PS

Q
Q2 Q1

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Revenue and the Size of the Tax
P

PB
PB
S

When the 3T 2T
tax is larger,
increasing it D
causes tax PS
revenue to fall. PS
Q
Q3 Q2

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Revenue and the Size of the Tax

The Laffer curve


The Laffer curve
shows the Tax
relationship revenue
between
the size of the tax
and tax revenue.

Tax size

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