8 Application: The Costs of Taxation. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of...
33
8 Application: The Costs of Taxation
-
Upload
elijah-lucas -
Category
Documents
-
view
252 -
download
3
Transcript of 8 Application: The Costs of Taxation. CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 2 The Effects of...
8
Application: The Costs of Taxation
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
2
The Effects of Taxation• We saw in Chapter 6 how taxes
– reduce the equilibrium quantity, – increase the price paid by buyers, and – decrease the price received by sellers.
• We also saw that– It does not matter whether a tax is placed on the
buyers or the sellers; • the outcome is the same in either case
• But how do taxes affect the economic well-being of market participants?
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
3
Welfare Economics
• Welfare economicsWelfare economics is the study of how the allocation of resources affects economic well-being.
• We saw in Chapter 7 that– Buyers benefit from buying (consumer surplus),
and – Sellers benefit from selling (producer surplus)– The equilibrium outcome in a perfectly competitive
market maximizes the total surplus of society.
Applying welfare economics to study the effects of taxation
• In this chapter we will combine what we learned in Chapters 6 and 7 to compare the costs and the benefits of a tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION4
Figure1 The Effects of a Tax
Size of tax
Quantity0
Buyers’ PriceSellers’ price
Price buyers pay
Price sellersreceive
Demand
Supply
Pricewithout tax
Quantitywithout tax
Quantitywith tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
6
How a Tax Affects Market Participants
• A tax places a wedge between the price buyers pay and the price sellers receive.
• Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax.– See Chapter 6 for details
• This fall in output is the cost of the tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
7
How a Tax Affects Market Participants
• Governments earn revenue from taxes• This revenue is the benefit of the tax• Tax Revenue
– T = the size of the tax– Q = the quantity of the good sold
TT QQ = the government’s tax revenue = the government’s tax revenue
Figure 2 Tax Revenue
Taxrevenue (T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
Figure 3 How a Tax Affects Welfare
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellers
receive
= P1
Q1
Pricewithout tax
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
13
Deadweight Losses and the Gains from Trade
• The cost of a tax exceeds the benefit of a tax• The decrease in total surplus that is caused by
a tax is the deadweight loss of the tax• Taxes cause deadweight losses because they
prevent buyers and sellers from realizing some of the gains from trade.
Figure 4 The Deadweight Loss
Cost tosellersValue to
buyers
Size of tax
Quantity0
Price
Demand
SupplyLost gainsfrom trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
15
DETERMINANTS OF THE DEADWEIGHT LOSS
• What determines whether the deadweight loss from a tax is large or small?– The size of the deadweight loss depends on how
much the quantity supplied and quantity demanded respond to changes in the price.
– In other words, the size of a tax’s deadweight loss depends on the price elasticitiesprice elasticities of supply and demand.
Figure 5 Tax Distortions and Elasticities
(a) Inelastic Supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply isrelatively inelastic,the deadweight lossof a tax is small.
Figure 5 Tax Distortions and Elasticities
(b) Elastic Supply
Price
0 Quantity
Demand
SupplySizeoftax
When supply is relativelyelastic, the deadweightloss of a tax is large.
Figure 5 Tax Distortions and Elasticities
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.
Figure 5 Tax Distortions and Elasticities
(d) Elastic Demand
Price
0 Quantity
Sizeoftax Demand
Supply
When demand is relativelyelastic, the deadweightloss of a tax is large.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
20
DETERMINANTS OF THE DEADWEIGHT LOSS
• The greater the elasticities of demand and supply:– the larger the decline in equilibrium quantity and,– the greater the deadweight loss of a tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
21
The Deadweight Loss Debate
• Some economists argue that taxes on labor income are highly distorting—that is, taxes on labor income have high deadweight losses—because they believe that labor supply is elastic.– Here are some examples of workers who may respond more
to incentives:• Workers who can adjust the number of hours they work• Families with second earners• Elderly who can choose when to retire• Workers in the underground economy (i.e., those engaging in illegal
activity)
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
22
DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
• With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax revenue
Demand
Supply
Quantity0
Price
Q1
(a) Small Tax
Deadweightloss
PB
Q2
PS
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Tax revenue
Quantity0
Price
(b) Medium Tax
Supply
Demand
PB
Q2
PS
Deadweightloss When the tax
rate doubles, the deadweight loss quadruples
Q1
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Tax
rev
enue
Demand
Supply
Quantity0
Price
Q1
(c) Large Tax
PB
Q2
PS
Deadweightloss
Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
(d) deadweight loss continually increases
DeadweightLoss
0 Tax Size
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
27
DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
• As the size of a tax increases, its deadweight loss quickly gets larger.
• By contrast, tax revenue first rises with the size of a tax, but then, as the tax gets larger, the quantity bought and sold shrinks so much that tax revenues start to fall.
28
DEADWEIGHT LOSS AND TAX REVENUE AS TAXES VARY
• Tax revenue = tax rate × quantity bought and sold– TR = T × Q
• T↑ causes Q↓• Therefore, the effect of T↑ on TR is ambiguous• T↑ causes TR↑ when the tax rate (T) is low• T↑ causes TR↓ when the tax rate (T) is high• This gives us the Laffer Curve
Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
(e) Tax revenue first increases, then decreases (the Laffer curve)
TaxRevenue
0 Tax SizeT1
Note that it makes no sense at all to make the tax size bigger than T1.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
30
CASE STUDY: The Laffer Curve and Supply-Side Economics
• The Laffer curve depicts the relationship between tax rates and tax revenue.
• Supply-side economics refers to the view that a tax cut– would induce more people to work, and thereby – have the potential to increase tax revenues.
• Large tax cuts were adopted during the Reagan administration
• The results do not settle the debate on the validity of supply-side economics
CASE STUDY: The Laffer Curve and Supply-Side Economics
• Between the early 1970s and mid 1990s, the French tax rate rose to 59 percent from 49 percent, while the U.S. tax rate held at 40 percent
• The average French person of working age logged 24.4 hours a week in the early 1970s, one hour more than an American. By the mid 1990s, the French workweek had shrunk to 17.5 hours, while the U.S. workweek had grown to 25.9 hours– Data from research by Edward Prescott
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
31
CASE STUDY: The Laffer Curve and Supply-side Economics
Country Tax Rate Workweek
Italy 64% 16.5 hours
France 59 17.5
Germany 59 19.3
Canada 52 22.8
UK 44 22.9
USA 40 25.9
Japan 37 27.0
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
32
Data from research by Edward Prescott
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
33
The Price of a Civilized Society• This chapter has focused on the negative
effects of taxes on buyers and sellers in a market
• However, without taxes we would not have a functioning government
• As Oliver Wendell Holmes, Jr., Supreme Court Justice, once said, “Taxes are the price we pay for a civilized society."
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
34
Summary• A tax on a good reduces the welfare of buyers
and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government.
• The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue — is called the deadweight loss of the tax.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
35
Summary• Taxes have a deadweight loss because they
cause buyers to consume less and sellers to produce less.
• This change in behavior shrinks the size of the market below the level that maximizes total surplus.
CHAPTER 8 APPLICATION: THE COSTS OF TAXATION
36
Summary• As a tax grows larger, it distorts incentives
more, and its deadweight loss grows larger.• Tax revenue first rises with the size of a tax.• Eventually, however, a larger tax reduces tax
revenue because it reduces the size of the market.
