LECTURE #7: MICROECONOMICS CHAPTER 8

1. LECTURE #7: MICROECONOMICSCHAPTER 8 Economic Costs of Taxation Deadweight Loss and Social Policy

2. The Deadweight Loss of Taxation • Taxes (Sales, Use or Excise) • Levied on buyers • Demand curve shifts downward by the size of tax • Levied on sellers • Supply curve shifts upward by the size of tax • Same outcome: price wedge • Price paid by buyers – rises • Price received by sellers – falls • Lower quantity sold 2

3. The Effects of a Tax Price Size of tax Price buyers pay Price without tax Price sellers receive Quantity with tax Quantity without tax Supply 0 Quantity Demand Figure 1: A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. 3

4. The Deadweight Loss of Taxation • Tax Burden • Distributed between producers and consumers • Determined by elasticities of S & D • Market for the good – smaller • Taxes and Deadweight Losses • Welfare losses to buyers and sellers exceed tax revenues to government • Deadweight Loss = fall in total surplus • Taxes prevent buyers and seller from realizing gains from trade 4

5. Economic Costs of Taxation • Tax Revenue = Amount of tax (T) times Quantity (Q) (See Fig 2) • Recall: Taxes raise the price paid and reduce the prices received. • Taxes effectively reduce consumption. • Reduced consumption = reduced standard of living • Reduced consumption leads to increased in unemployment • Some proportion of the producer/consumer surpluses discussed in Chapter 7 effectively expropriated via taxes. Compare Figure 7, Ch 7 and Figure 3, Ch 8

6. Tax Revenue Price Size of tax (T) Quantity sold (Q) Price buyers pay Price sellers receive Tax revenue T ˣ Q Quantity with tax Quantity without tax Supply 0 Quantity Demand Figure 2: The tax revenue that the government collects equals T × Q, the size of the tax T times the quantity sold Q. 6

7. Taxes and Deadweight LossesFigure 3 A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). Price A =PB B Price buyers pay C Price without tax =P1 Price sellers receive E D F =PS Q2 Q1 Supply The area C + E shows the deadweight loss resulting from the tax 0 Quantity Demand 7

8. Determinants of the Deadweight Loss • Price Elasticities of Supply and Demand • If PED or SED more elastic – deadweight losses are larger • If either is inelastic, deadweight losses are smaller

9. Tax Distortions and Elasticities of Supply Price Price (a) Inelastic supply (b) Elastic supply When supply is relatively inelastic, the deadweight loss of a tax is small When supply is relatively elastic, the deadweight loss of a tax is large Size of tax Size of tax Supply 0 0 Quantity Quantity Supply Demand Demand Figure 5: In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. The more elastic the supply curve, the larger the deadweight loss of the tax. 9

10. Tax Distortions and Elasticities of Demand Price Price (c) Inelastic demand (d) Elastic demand When demand is relatively inelastic, the deadweight loss of a tax is small When demand is relatively elastic, the deadweight loss of a tax is large Size of tax Size of tax Supply Supply 0 0 Quantity Quantity Demand Figure 5: In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. The more elastic the demand curve, the larger the deadweight loss of the tax. Demand 10

11. Break Time

12. Deadweight Loss and Social Policy • The larger the deadweight loss, the more expensive social programs • The greater the elasticity of supply and demand, the greater the deadweight loss • The Economic Argument: The impact of labor taxes • If the labor supply is relatively inelastic – then the deadweight losses are smaller. • If the labor supply is relatively elastic – then the deadweight losses are larger. • Regardless: the larger the tax, the greater the deadweight losses (See Fig 6)

13. Deadweight Loss and Social Policy • Arguments for Elastic Labor Supply • Over-time premiums • Second or third income net take-home pay • Incentives for part time work • Incentives to work "under the table" • Laffer Curve and Supply-Side Economics • Reducing taxes eventually causes revenues to rise • High tax rates discourage working, consumption, and investing • Lowering tax rates encouraged consumption and employment

14. Deadweight Loss, Magnitude of Tax and Tax RevenueFigure 6 (b) Medium tax (a) Small tax (c) Large tax Price Price Price PB PB PB Deadweight loss Deadweight loss Deadweight loss Tax revenue Tax revenue Tax revenue PS PS PS Q2 Q2 Q2 Q1 Q1 Q1 0 0 0 Panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. Panel (b), a larger tax has a larger deadweight loss and raises a larger amount of revenue. Panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue. Demand Demand Demand Quantity Quantity Quantity Supply Supply Supply 14

15. Deadweight Loss, Magnitude of Tax and Tax Revenue Deadweight loss Tax Revenue (d) From panel (a) to panel (c), deadweight loss continually increases (e) From panel (a) to panel (c), tax revenue first increases, then decreases Laffer curve 0 0 Tax size Tax size Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve. 15

16. Reagan Revolution • Supply Side Economics (Arthur Laffer) • High marginal tax rates discourage working • High marginal tax rates discourage investment • Result is decrease in tax revenues → deficits • Reaganomics • Reduce Marginal Tax Rates • Encourage working • Encourage investment • Increase in incomes → increase in tax revenues • Empirical data suggests the greater the marginal rate, the less people work (See “In The News”, page 170)

17. In The News: On The Way to FranceWSJ, Oct 20,2003

18. Homework • Questions for Review: 1, 2, 4 • Problems and Applications: 6, 12 (a, b, c, e)

19. Problems & Applications • #12. Suppose that a market is described by the following supply and demand equations: • QS = 2P • QD = 300 – P • Solve for the Equilibrium Price and Quantity • Recall that at Equilibrium QS = QD, therefore • 2P = 300 – P • 3P = 300 • P = $100 → QS = 200 and QD = 200 (units)

20. Problem #12 Continued • b. Suppose that a tax of T is placed on buyers. The new demand equation is: • QD = 300 – (P + T) • What is the new Equilibrium? • QS = 2P • 2P = 300 – (P + T) • P = 100 – T/3 (price received by seller) • P = 100 - T/3 + T = 100 + 2T/3 (price paid by buyer)

21. Problem #12 Continued • b.1. Suppose Tax = $15 • Producer Receives (PT) = $100 – 5 = $95 • Quantity Supplied = 2 (95) = 190 • Consumer Pays = P + T = $95 + $15 = $110 • New QD = 300 – (S + T) = 300 – 110 = 190 • New QS = 2S = 2 * 95 = 190 • c. Deadweight Loss = T * Q = $15 * 190 = $2,850 • Revenue [Expense] @ϵ = 200 * 100 = 20,000 • New Producer Revenue = 190 * 95 = $18,050 • New Consumer Expenditure = 110 * 190 = 20,900 • Difference = $20,900 – 18,050 = $2,850 (QED)

22. Problem #12 Continued