The 8
Application: Costs of
Application:
Taxation
Taxation
PRINCIPLES OF
MICROECONOMICS
FOURTH CANADIAN EDITION
N. G R E G O R Y M A N K I W
R O N A L D D. K N E E B O N E
K E N N E T H J. M c K ENZIE
NICHOLAS ROWE
2008 Nelson Education Ltd.
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 deadweight loss?
How does tax revenue depend on the size of the tax?
2008 Nelson Education Ltd.
2
FromChapter6
A tax is a wedge between the price buyers pay and
the price sellers receive.
A tax raises the price buyers pay and lowers the price
sellers receive.
A tax reduces the quantity bought & sold.
These effects are the same whether the tax is
imposed on buyers or sellers, so we do not make this
distinction in this chapter.
2008 Nelson Education Ltd.
3
TheEffectsofaTax
P
With no tax,
eqm price is PE and
quantity is QE .
Govt imposes a
tax of $T per unit.
The price buyers
pay is PB ,
Size of tax = $T
S
PB
PE
PS
D
the price sellers
receive is PS ,
and quantity is QT .
QT
2008 Nelson Education Ltd.
QE
Q
4
TheEffectsofaTax
P
The tax generates
revenue equal to
$T x QT .
Size of tax = $T
S
PB
PE
PS
D
QT
2008 Nelson Education Ltd.
QE
Q
5
TheEffectsofaTax
Next, we use the tools of welfare economics to measure
the gains and losses from a tax.
We will determine consumer surplus (CS), producer
surplus (PS), tax revenue, and total surplus with and
without the tax.
Tax revenue is included in total surplus, because tax
revenue can be used to provide services such as roads,
police, public education, etc.
2008 Nelson Education Ltd.
6
TheEffectsofaTax
P
Without a tax,
CS = A + B + C
PS = D + E + F
A
S
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
B
PE
D
C
E
D
F
QT
2008 Nelson Education Ltd.
23
Q
7
TheEffectsofaTax
P
With the tax,
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
A
PB
S
B
D
C
E
PS
D
F
The tax causes
total surplus to
fall by C + E
QT
2008 Nelson Education Ltd.
QE
Q
8
TheEffectsofaTax
P
C + E is called the
deadweight loss (DWL)
of the tax, the fall in total
surplus that
PB
results from a market
distortion, such as a tax.
The losses to buyers
and sellers exceed the
revenue raised by
government.
A
S
B
D
C
E
PS
D
F
QT
2008 Nelson Education Ltd.
QE
Q
9
AbouttheDeadweightLoss
P
Because of the tax,
the units between
QT and QE are not
sold.
The value of these
units to buyers is
greater than the cost
of producing them,
so the tax has
prevented some
mutually beneficial
trades.
PB
S
PS
D
2008 Nelson Education Ltd.
QT
QE
Q
10
ACTIVELEARNING1:
Analysisoftax
A. Compute
CS, PS, and
total surplus
without a tax.
B. If $100 tax
per ticket,
compute
CS, PS,
tax revenue,
total surplus, and
DWL.
P
The market for
airplane tickets
$ 400
350
300
S
250
200
150
D
100
50
0
Q
0
25
50
75 100 125
11
ACTIVELEARNING1:
AnswerstoA
P
$ 400
CS
= x $200 x 100
= $10,000
PS
= x $200 x 100
= $10,000
The market for
airplane tickets
350
300
S
250
P = 200
total surplus
= $10,000 + $10,000
= $20,000
150
D
100
50
0
Q
0
25
50
75 100 125
12
ACTIVELEARNING1:
AnswerstoB
CS
= x $150 x 75
= $5,625
P
A $100 tax on
airplane tickets
$ 400
350
300
PS = $5,625
PB = 250
tax revenue
= $100 x 75
= $7,500
S
200
total surplus
= $18,750
DWL = $1,250
PS = 150
D
100
50
0
Q
0
25
50
75 100 125
13
WhatDeterminestheSizeoftheDWL?
The govt needs tax revenue to finance roads, schools,
police, etc., so it must tax some goods and services.
Which ones? One answer is that govt should tax the
goods or services with the smallest DWL.
So when is the DWL small vs. large? Turns out it
depends on the elasticities of supply and demand.
Recall: The price elasticity of demand (or supply)
measures how much quantity demanded
(or supplied) changes when the price changes.
2008 Nelson Education Ltd.
14
DWLandtheElasticityofSupply
When supply
is inelastic,
the DWL of a tax
is small.
P
S
Size
of tax
D
Q
2008 Nelson Education Ltd.
15
DWLandtheElasticityofSupply
P
The more elastic
is supply,
the larger is
the DWL.
S
Size
of tax
D
Q
2008 Nelson Education Ltd.
16
DWLandtheElasticityofSupply
When demand
is inelastic,
the DWL of a tax
is small.
P
S
Size
of tax
D
Q
2008 Nelson Education Ltd.
17
DWLandtheElasticityofSupply
P
S
The more elastic
is demand,
the larger is
the DWL.
Size
of tax
D
Q
2008 Nelson Education Ltd.
18
WhyElasticityAffectstheSizeofDWL
A tax distorts the market outcome:
consumers buy less and producers sell less,
so eqm Q is below the surplus-maximizing quantity.
Elasticity measures how much buyers and sellers
respond to changes in price,
and therefore determines how much the
tax distorts the market outcome.
2008 Nelson Education Ltd.
19
ACTIVELEARNING2:
ElasticityandDWLofatax
Would DWL the of a tax be larger if the
tax were on
A. Rice Krispies or sunscreen?
B. Hotel rooms in the short run or hotel rooms in the long
run?
C. Groceries or meals at fancy restaurants?
20
ACTIVELEARNING2:
Answers
A. Rice Krispies or sunscreen
From Chapter 5:
Rice Krispies has many more close substitutes than
sunscreen, so demand for Rice Krispies is more priceelastic than demand for sunscreen.
So, a tax on Rice Krispies would cause a larger DWL
than a tax on sunscreen.
21
ACTIVELEARNING2:
Answers
B. Hotel rooms in the short run or long run
From Chapter 5:
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger DWL in
the long run than in the short run.
22
ACTIVELEARNING2:
Answers
C. Groceries or meals at fancy restaurants
From Chapter 5:
Groceries are more of a necessity and therefore less
price-elastic than meals at fancy restaurants.
So, a tax on restaurant meals would cause a larger
DWL than a tax on groceries.
23
ACTIVELEARNING3:
Discussionquestion
The government must raise tax revenue to pay for
schools, police, etc. To do this, it can either tax
groceries or meals at fancy restaurants.
Which should it tax?
24
HowBigShouldtheGovernmentBe?
A bigger government provides more services,
but requires higher taxes, which cause DWL.
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 many workers, the marginal tax rate (the tax on the
last dollar of earnings) is almost 50%.
How big is the DWL from this tax?
It depends on elasticity.
2008 Nelson Education Ltd.
25
HowBigShouldtheGovernmentBe?
If labour supply is inelastic, then this DWL is small.
Some economists believe labour supply is inelastic,
arguing that most workers work
full time regardless of the wage.
2008 Nelson Education Ltd.
26
HowBigShouldtheGovernmentBe?
Other economists believe labour taxes are highly distorting
because some groups of workers have elastic supply and
can respond to incentives:
Many workers can adjust their hours,
e.g. by working overtime.
Many families have a 2nd earner with discretion over
whether and how much to work.
Many elderly choose when to retire based on the wage
they earn.
Some people work in the underground economy to
evade high taxes.
2008 Nelson Education Ltd.
27
TheEffectsofChangingtheSizeoftheTax
Policymakers often change taxes, raising some and
lowering others.
What happens to DWL and tax revenue when taxes
change? We explore this next.
2008 Nelson Education Ltd.
28
DWLandtheSizeoftheTax
Initially, the tax is T
per unit.
P
new
DWL
Doubling the tax
causes the DWL
to more than
double.
S
T
2T
initial
DWL
Q2
2008 Nelson Education Ltd.
Q1
D
Q
29
DWLandtheSizeoftheTax
Initially, the tax is T
per unit.
P
new
DWL
Tripling the tax
causes the DWL
to more than
triple.
S
T
3T
initial
DWL
Q3
2008 Nelson Education Ltd.
Q1
D
Q
30
DWLandtheSizeoftheTax
Summary
Implication
When tax rates are low,
raising them doesnt
cause much harm, and
lowering them doesnt
bring much benefit.
DWL
When a tax increases,
DWL increases at an
increasing rate.
When tax rates are
high, raising them is
very harmful, and
cutting them is very
beneficial.
2008 Nelson Education Ltd.
Tax
size
31
0
RevenueandtheSizeoftheTax
P
When the
tax is small,
increasing it
causes tax
revenue to rise.
B
S
PB
P
2T
PS
T
D
S
P
Q2
2008 Nelson Education Ltd.
Q1
Q
32
0
RevenueandtheSizeoftheTax
P
P
B
B
S
When the
tax is larger,
increasing it
causes tax
revenue to fall.
P
3T
2T
D
S
P
P
S
Q3
Q2
2008 Nelson Education Ltd.
Q
33
RevenueandtheSizeoftheTax
The Laffer curve
shows the
relationship
between
the size of the tax
and tax revenue.
Tax
revenue
0
The Laffer curve
Tax
size
2008 Nelson Education Ltd.
34
CHAPTER SUMMARY
A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the revenue
the tax raises for the govt.
The fall in total surplus (consumer surplus, producer
surplus, and tax revenue) is called the deadweight loss
(DWL) of the tax.
A tax has a DWL because it causes consumers to buy
less and producers to sell less, thus shrinking the market
below the level that maximizes total surplus.
2008 Nelson Education Ltd.
35
CHAPTER SUMMARY
The price elasticities of demand and supply measure
how much buyers and sellers respond to price changes.
Therefore, higher elasticities imply higher DWLs.
An increase in the size of a tax causes the DWL to rise
even more.
An increase in the size of a tax causes revenue to rise at
first, but eventually revenue falls because the tax
reduces the size of the market.
2008 Nelson Education Ltd.
36
End: Chapter 8
2008 Nelson Education Ltd.
37