Application: the Cost of Taxation

Chapter 8 Application: The Cost of Taxation

Introduction . We are going to employ the concepts of consumer surplus and producer surplus to evaluate the impact on society’s welfare of imposing a tax. . We already know how to calculate the tax incidence on buyers and sellers, but now we will see how inefficient (in terms of reducing total social welfare) some taxes are. . Most taxes generate a deadweight loss in welfare that nobody benefits from.

The Deadweight Loss of Taxation . Recall that when a tax is imposed a wedge appears between the price paid by buyers and the price received by sellers: - The price that buyers pay, higher than the initial equilibrium price, would naturally reduce the consumer surplus from A+B+C to simply A. - The price that sellers receive, lower than the initial equilibrium price, would naturally reduce the producer surplus from D+E+F to simply F. - The difference between buyers and sellers’ prices (i.e.: the tax wedge) will represent the per unit revenue collected by the government so that total tax revenue is B+D.

. The good news is that the government is redistributing economic welfare by taking a part of this market’s consumer and producer surpluses and making it available to other people. . The bad news is that something is lost in the process. Nobody picks up the C+E surplus. This is a deadweight loss in total surplus.

. Why does this happen? Because there is a distortion to the normal free trade. Taxes force people to buy and sell a certain quantity of the good at a certain price which they would otherwise choose not to. Taxes negatively impact the efficiency of markets.

The Determinants of the Deadweight Loss . It is very easy to see that the relative elasticity of supply and demand will determine the size of the deadweight loss: - Taxes on goods or services with low elasticity of demand or supply will create the smaller deadweight losses. Note that these taxes are the most revenue-generating ones. - Taxes on goods or services with high elasticity of demand or supply will create the larger deadweight losses. Note that these taxes are the least revenue-generating ones.

. As we already know, the more elastic the demand (supply), the larger the impact on quantity demanded (supplied) from a change in price. . Therefore, the larger the distortion to normal free trade a tax will represent –and so the loss.

. Based on this information, what type of goods should be taxed so that the deadweight loss is minimized? Basic necessities that everybody consumes or luxuries available only to the rich? . What about taxing labor to pay for social security? Is this an inelastic good?

Deadweight Loss and Tax Revenue as Taxes Vary . Determining the optimal size of a tax is no small problem because as a tax increases in size (ceteris paribus) the deadweight loss grows faster than the revenue collected from the tax: - Small taxes generate little revenue and create a small deadweight loss. - Large taxes also generate little revenue but with a much larger deadweight loss. - The optimal amount of tax will maximize revenue without inflating the deadweight loss.

. If we plot in a graph the relationship between the size of the tax and the size of the deadweight loss we come up with a curve that has an exponentially-growing positive slope. . Similarly, if we plot in a graph the relationship between the size of the tax and the volume of revenue collected we obtain an inverted U line, sometimes referred to as the Laffer curve.

. As you can imagine this concept of the Laffer curve was very attractive for conservative politicians and in fact it was made a major point in the political platform of Reagan in 1980. . If true, lowering taxes would increase tax revenue (helping the rich actually helps the poor.) Nonetheless taxes must be extremely high to begin with for this relationship to hold. . Reagan’s economic experiment in the 1980s was a failure in this front.