Chapter 8 notes. Figure 1 The Effects of a Tax Size of tax Quantity 0 Price Price buyers pay Price...

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Transcript of Chapter 8 notes. Figure 1 The Effects of a Tax Size of tax Quantity 0 Price Price buyers pay Price...

  • Slide 1
  • Chapter 8 notes
  • Slide 2
  • Figure 1 The Effects of a Tax Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax The price paid by consumers is higher The price received by firms is lower. And the quantity declines. Who benefits?
  • Slide 3
  • Tax Revenue T = the size of the tax Q = the quantity of the good sold T Q = the governments tax revenue
  • Slide 4
  • Figure 2 Tax Revenue Tax revenue (T Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive
  • Slide 5
  • Welfare, Taxes and Total Surplus Without tax market is at equilibrium; total surplus is area between the S and D curves up to EQ With tax total surplus = new consumer surplus + tax revenue + new producer surplus
  • Slide 6
  • Deadweight Loss When taxes are enacted, buyers and sellers are worse off and govt is better off Total surplus falls Deadweight Loss = the fall in total surplus b/c of a distortion such as a tax Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade
  • Slide 7
  • Figure 3 How a Tax Effects Welfare A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax
  • Slide 8
  • Change in total welfare The change in total welfare includes: The change in consumer surplus, The change in producer surplus, and The change in tax revenue. The losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss.
  • Slide 9
  • Figure 4 The Deadweight Loss Cost to sellers Value to buyers Size of tax Quantity 0 Price Demand Supply Lost gains from trade Reduction in quantity due to the tax Price without tax Q1Q1 PBPB Q2Q2 PSPS
  • Slide 10
  • Determinants of Deadweight Loss What determines whether the deadweight loss from a tax is large or small? The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. That, in turn, depends on the price elasticities of supply and demand.
  • Slide 11
  • Figure 5 Tax Distortions and Elasticities (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.
  • Slide 12
  • Figure 5 Tax Distortions and Elasticities (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.
  • Slide 13
  • Figure 5 Tax Distortions and Elasticities Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.
  • Slide 14
  • Figure 5 Tax Distortions and Elasticities (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.
  • Slide 15
  • Size of DWL The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and, the greater the deadweight loss of a tax.
  • Slide 16
  • The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. 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)
  • Slide 17
  • DWL and Tax Revenue With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax. For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.
  • Slide 18
  • Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS
  • Slide 19
  • Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss
  • Slide 20
  • Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of the Tax Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss
  • Slide 21
  • 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 market shrinks so much that tax revenue starts to fall.
  • Slide 22
  • Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a) Deadweight Loss Deadweight Loss 0 Tax Size
  • Slide 23
  • 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 views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.
  • Slide 24
  • Figure 6 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size