Soojae Moon Fall 2009 <Oct. 6>

Transcription

1 <Oct. 6> Chapter 8: Application: The Costs of Taxation 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 deadweight loss? How does tax revenue depend on the size of the tax? Review from Chapter 6: - levied on buyers (buyers physically pay the tax) - levied on sellers (buyers physically pay the tax) Effects are the same whether the tax is imposed on buyers or sellers. : the manner in which the burden of a tax is shared among participants in an economy The Effects of a Tax We apply welfare economics to measure the gains and losses from a tax. We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. The per unit tax: - drives a wedge between the price consumers (buyers) pay the price sellers (producers) receive and - reduces the quantity traded, it causes the market for the good to shrink What happens to the economic well-being of consumers and producers? The government collects tax revenue and uses the revenue for roads, police, courts, education, transfer payments, subsidies, etc What is the overall effect of a per unit tax on total surplus? Total surplus = Consumer Surplus + Producer Surplus + Government Tax Revenue If total surplus falls as a result of the tax, then that lost surplus is called a In general, a is the fall in total surplus from a market distortion (such as a tax, price ceiling, or a price floor) Example of taxes & consumer & producer surplus. 1

2 The deadweight loss occurs because the tax causes the market to shrink. Incentives become distorted - buyers pay more, and producers receive less The more the market shrinks as a result of the tax, the greater the deadweight loss The less the market shrinks as a result of the tax, the smaller the deadweight loss Taxes and Elasticities 1) emand is relatively inelastic P P B a S P * c b P S d t Q t Q * Q Now you can see that the consumer pays a much larger portion of the tax burden. 2) Supply is relatively inelastic The producers will pay a greater share of the tax. An example here would be the luxury tax on yachts. The demand for luxury goods is very elastic, so it is the producers of the yachts that bear the bulk of the tax burden. The tax hits yacht builders, and not the wealthy consumer it is supposedly aimed at. Tax Revenue and WL We will compare a market with relatively elastic supply and demand to a market with relatively inelastic supply and demand. 2

3 1) Elastic Supply and emand 2) Inelastic Supply and emand P S t P S t S P B S P* P S Q t Q* Q t Q* Q Notice that the original equilibrium prices are the same and the amount of the tax is the same in both markets (both absolutely and as a percentage of the price). In the market with relatively elastic supply and demand, the tax creates less government revenue and more inefficiency. The Effects of Changing the Size of the Tax Policymakers often change taxes, raising some and lowering others. What happens to WL and tax revenue when taxes change? Initially, the tax is T per unit. oubling the tax, and then tripling the tax. Implication: When tax rates are low, raising them doesn t cause much harm, and lowering them doesn t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial. 3

4 (a) eadweight Loss eadweight Loss 0 Tax Size (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size 4

5 How deadweight loss and tax revenue vary with the size of a tax. Panel (a) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (b) shows that tax revenue first rises, then falls. This relationship is sometimes called the Laffer curve. One day in 1974, economist Arthur Laffer sat in a Washington restaurant with some prominent journalists and politicians. He took out a napkin and drew a figure on it to show how tax rates affect tax revenue. It looked much like (b). Laffer then suggested that the U.S. was on the downward-sloping side of this curve. Tax rates were so high, he argued, that reducing them would actually raise tax revenue. Laffer curve captured the imagination of Ronald Reagan. When Reagan ran for president in 1980, he made cutting taxes part of his platform. Reagan argued that taxes were so high that they were discouraging hard work. The views of Laffer and Regan became known as supply-side economics. Suggested problems: Problems and Applications- 1, 3 5