Cost and Inefficiency of Taxes/Subsidies

1. Cost and Inefficiency of Taxes/Subsidies

2. Taxes and Deadweight Loss • Outcome of Tax • Buyers pay higher price • Sellers get lower price • “Tax Wedge” • Lower quantity sold • Burden of Tax • Split between buyer and seller • Depends on elasticities

3. Buyer Post Tax Price Pre Tax Price Size of Tax Seller Post Tax Price Post Tax Quantity Pre Tax Quantity

4. Winners and Losers • Losers • Buyers: Pay higher price so lower consumer surplus • Sellers: Get lower price so lower producer surplus • Winners • Gov’t (other tax payers): gain revenue from taxes raised = [New Quantity x Tax]

5. Losers Lost Consumer Surplus Buyer Post Tax Price Pre Tax Price Seller Post Tax Price Lost Producer Surplus Post Tax Quantity Pre Tax Quantity

6. Winners Taxes Raised: Q x T Buyer Post Tax Price Pre Tax Price Seller Post Tax Price Post Tax Quantity Pre Tax Quantity

7. Welfare Before Tax • Consumer Surplus • Producer Surplus • Tax Revenue = 0 • Welfare After Tax • Smaller Consumer Surplus • Smaller Producer Surplus • Positive Tax Revenue • Smaller overall Welfare

8. Deadweight Loss: CS and PS lost but not gained back by tax revenue Buyer Post Tax Price Pre Tax Price Seller Post Tax Price Post Tax Quantity Pre Tax Quantity

9. A Buyer Post Tax Price B C Pre Tax Price E D Seller Post Tax Price F Post Tax Quantity Pre Tax Quantity

10. Consumer surplus goes down • Some gained by tax revenue • Some lost • Producer surplus goes down • Some gained by tax revenue • Some lost • Overall surplus (welfare) goes down because of lower quantity in market • Market is smaller, so some product/service are not made even though market value is higher than cost, ie Inefficient

11. The fact that Gov’t gets some revenue that once was consumer/producer surplus is not where loss of welfare comes from Buyer Post Tax Price Value to buyers (height of demand curve) higher than cost to producers (height of supply curve), so should produce at these levels, but not because of tax – this is why welfare is lost, or surplus goes down. Pre Tax Price Seller Post Tax Price Post Tax Quantity Pre Tax Quantity

12. Size of tax distortion/DWL • Greater the elasticity of supply/demand the greater the shrinkage of the market and greater deadweight loss • B/C markets are reacting more (elastic) to the change in price due to the tax • So market shrinks more and more welfare loss because more potential trades that would have led to gains are loss

13. Inelastic Markets – Low Distortion and DWL Elastic Markets – High Distortion and DWL DWL Tax Wedge DWL Tax Wedge Q2 Q1 Q2 Q1

14. Tax Revenue and Tax Size • At first as you increase the size of a tax you increase Revenue (Q x T) • But at some point increasing size of tax decreases revenue because the effect shrinks the market so much there’s not much to tax

15. Low Tax – Low Revenue Med Tax – High Revenue High Tax – Low Revenue Tax Revenue Tax Revenue Tax Revenue

16. Laffer Curve • Idea is based on previous thought • Says that by decreasing tax (normally income tax) could increase government revenue • Popular Idea in the 80’s that still persists but with less support – Why? • Supply of labor fairly inelastic • Actual income tax rate is not that high • No big black market

17. Laffer Curve Tax Revenue But at what rate is the peak? ? Size of Tax

18. Example • Say $10 trillion economy with tax rate 30% • Revenue is $3 trillion • Then lower rate to 25% and get an extra $1 trillion in activity (big increase in activity) • New revenue is $2.75 trillion • In this case would need a 20% increase in activity to break even, not very likely • Though to be fair it is still debated, perhaps

19. Federal Income Tax Rate Ranges Iowa State Income Tax rate ranges from 0.36% - 8.98%

20. Inefficiency due to Subsidy • Subsidy Increases the market size beyond the market equilibrium • This means the supply curve is above the demand curve at the new quantity • This means those last products produced cost more to produce than they are actually valued in the market • This is inefficient

21. New Producer Surplus Nobody Gains/Values New Seller Price Subsidy Wedge Initial Price Government Pays for all 3 regions but the one region is lost, ie inefficient New Buyer Price New Consumer Surplus