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Lecture PowerPoint Slidesto accompany

Prepared by

Marc PrudHomme, University of Ottawa 1

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Chapter 8

Application: the Costs ofTaxation

2Copyright 2011 Nelson Education Limited

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In this chapter,look for the answers to these questions:

How does a tax affect consumer surplus, producer surplus, and total surplus?

What is the deadweight loss of a tax?

What factors determine the size of this deadweightloss?

How does tax revenue depend on the size of thetax?


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Review from Chapter 6 A tax

drives a wedge between the price buyers payand the price sellers receive.raises the price buyers pay and lowers the price

sellers receive.reduces the quantity bought & sold.

These effects are the same whether the tax isimposed on buyers or sellers, so we do not makethis distinction in this chapter.


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Q T

The Effects of a TaxP

Q

D

S

Eqm with no tax:Price = P E Quantity = Q E

P S

P B

P E

Q E

Eqm withtax = $ T per unit:

Sellers receive P S Quantity = Q T

Buyers pay P B

Size of tax = $ T


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The Effects of a TaxNext, we apply welfare economics to measurethe 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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Q

D

S

Without a tax,

P E

Q E Q T

A

B CD E

F

CS = A + B + CPS = D + E + FTax revenue = 0

Total surplus= CS + PS= A + B + C

+ D + E + F


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Q

D

S

P S

P B

Q E Q T

A

B CD E

F

CS = APS = FTax revenue

= B + DTotal surplus

= A + B+ D + F

With the tax,

The tax reducestotal surplus by

C + E


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Q

D

S

P S

P B

Q E Q T

A

B CD E

F

C + E is called thedeadweight loss(DWL) of the tax,the fall in totalsurplus thatresults from amarket distortion,such as a tax.


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About the Deadweight LossP

Q

D

S

P S

P B

Q E Q T

Because of the tax,

the units betweenQ T and Q E are notsold.

The value of theseunits to buyers isgreater than the costof producing them,

so the tax preventssome mutuallybeneficial trades.


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A C T I V E L E A R N I N G 1 Analysis of taxA. Compute

CS, PS, andtotal surpluswithout a tax.

B. If $100 taxper ticket,compute

CS, PS,tax revenue,total surplus,and DWL.

D

S

0

50

100

150

200250

300

350

400

0 25 50 75 100 125

P

Q

$

The market for

airplane tickets


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A C T I V E L E A R N I N G 1 Answers to A

D

S

CS= x $200 x 100= $10,000

0

50

100

150

200

250

300

350

400

0 25 50 75 100 125

P

Q

$

Total surplus= $10,000 + $10,000= $20,000

PS= x $200 x 100= $10,000

P =

The market for airplane tickets


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A C T I V E L E A R N I N G 1 Answers to B

D

S

CS= x $150 x 75= $5,625

0

50

100

150

200

250

300

350

400

0 25 50 75 100 125

P

Q

$

Total surplus= $18,750

PS = $5,625Tax revenue= $100 x 75

= $7,500

DWL = $1,250

P S =

P B =

A $100 tax onairplane tickets


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What Determines the Size of the DWL?Which goods or services should govt taxto 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 elasticitiesof supply and demand.

Recall:The price elasticity of demand (or supply)measures how much Q D (or Q S ) changeswhen P changes.


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When supplyis inelastic,

its harder for firmsto leave the marketwhen the taxreduces P S .

So, the tax onlyreduces Q a little,

and DWL is small.

DWL and the Elasticity of Supply

P

Q

D

S

Sizeof tax


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DWL and the Elasticity of Supply

P

Q

D

S

Sizeof tax

The more elastic issupply,

the easier for firmsto leave the marketwhen the taxreduces P S ,

the greater Q fallsbelow the surplus-maximizing quantity,

the greater the DWL.


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DWL and the Elasticity of Demand

P

Q

D

S

Sizeof tax

When demandis inelastic,

its harder for consumers toleave the marketwhen the taxraises P B .

So, the tax onlyreduces Q a little,

and DWL is small.


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DWL and the Elasticity of Demand

P

Q

D

S

Sizeof tax

The more elastic isdemand,

the easier for buyersto leave the market

when the taxincreases P B ,

the more Q fallsbelow the surplus-

maximizing quantity,and the greater theDWL.


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Would the DWL of a tax be larger if thetax were on:

A. Breakfast cereal or sunscreen?

B. Hotel rooms in the short run or hotel rooms in the long run?

C. Groceries or meals at fancy restaurants?

A C T I V E L E A R N I N G 2 Elasticity and the DWL of a tax


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C. Groceries or meals at fancy restaurants

From Chapter 5:Groceries are more of a necessity and

therefore less price-elastic than meals atfancy restaurants.

So, a tax on restaurant meals would cause a

larger DWL than a tax on groceries.

A C T I V E L E A R N I N G 2 Answers


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The government must raise tax revenue to payfor schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.

Which should it tax?

A C T I V E L E A R N I N G 3 Discussion question


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How Big Should the Government Be? A bigger government provides more services,

but requires higher taxes, which cause DWLs.The larger the DWL from taxation,the greater the argument for smaller government.

The tax on labour income is especially important;its the biggest source of govt revenue.

For the typical worker, the m arginal tax r a te

(the tax on the last dollar of earnings) is about 40%.How big is the DWL from this tax?It depends on elasticity.


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How Big Should the Government Be?If labour supply is inelastic, then this DWL issmall.

Some economists believe labour supply isinelastic, arguing that most workers workfull-time regardless of the wage.


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How Big Should the Government Be?Other economists believe labour taxes are highly

distorting because some groups of workers haveelastic supply and can respond to incentives:

Many workers can adjust their hours,e.g. , by working overtime.Many families have a 2 nd earner with discretionover whether and how much to work.Many elderly choose when to retire based on thewage they earn.Some people work in the underground economyto evade high taxes.


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The Effects of Changing the Size of theTax

Policymakers often change taxes, raising someand lowering others.

What happens to DWL and tax revenue whentaxes change? We explore this next.


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Q 2 Q 1

DWL and the Size of the TaxP

Q

D

S

causes the DWLto more thandouble.

Doubling the tax

2T T

Initially, the tax isT per unit.

initial

DWL

newDWL


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Q 3

DWL and the Size of the TaxP

Q

D

S

Q 1

3T T causes the DWLto more thantriple.

Tripling the tax

Initially, the tax isT per unit.

initial

DWL

newDWL


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DWL and the Size of the Tax

DWL

Tax size

Summary

When a tax in creases ,DWL r ises even m ore.

Implication

When tax rates arelow, raising themdoesnt cause muchharm, and lowering them doesnt bring much benefit.

When tax rates are

high, raising them isvery harmful, and cutting them is very beneficial.


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Q 2

Revenue and the Size of the TaxP

Q

D

S

Q 1

P B

P S

P B

P S

2T T

When thetax is small,increasing itcauses taxrevenue to rise.


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Q 3

Revenue and the Size of the TaxP

Q

D

S

Q 2

P B

P S

P B

P S

3T 2T When thetax is larger,increasing itcauses taxrevenue to fall.


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The Laffer curve shows therelationshipbetween

the size of the taxand tax revenue.

Revenue and the Size of the Tax

Tax size

Taxrevenue

The Laffer curve


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CHAPTER SUMMARY


A tax on a good reduces the welfare of buyers andsellers. This welfare loss usually exceeds therevenue the tax raises for the govt.

The fall in total surplus (consumer surplus,producer surplus, and tax revenue) is called thedeadweight loss (DWL) of the tax.

A tax has a DWL because it causes consumers tobuy less and producers to sell less, thus shrinkingthe market below the level that maximizes totalsurplus.

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CHAPTER SUMMARY

34C ight 2011 N l Ed ti Li it d

The price elasticities of demand and supplymeasure how much buyers and sellers respond toprice changes. Therefore, higher elasticities implyhigher DWLs.

An increase in the size of a tax causes the DWL torise even more.

An increase in the size of a tax causes revenue torise at first, but eventually revenue falls becausethe tax reduces the size of the market.

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