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Unformatted text preview: C H A P T E R 19 Distortionary Taxes and Subsidies This chapter, the second in a series of three that focuses on implications of price distortions on the first welfare theorem, revisits the topics of distortionary taxes and subsidies, topics that had previously been treated solely within the consumer model and, to some extent (in end-of-chapter exercises) in the producer model. In these previous treatments, we simply assumed that a tax raised the price on con- sumers or the marginal costs of producers, or a subsidy lowered these. In the utility maximization framework, we were able to demonstrate that the deadweight losses from such price distortions could be measured on marginal willingness to pay (or compensated) curves or, in the special case of quasilinear tastes, they could me measured on (uncompensated) demand curves. We return to these issues now be- cause we now have the tools to illustrate how such taxes and subsidies affect con- sumer and producer prices in equilibrium and how the work we previously did fits into this equilibrium framework. Building on our work with price elasticities in Chapter 18, we can furthermore differentiate these impacts based on relative price elasticities of demand and supply. And we can show how the pictures that you probably saw in previous economics courses apply for the case of quasilinear tastes but also how such pictures can be deeply misleading when the quasilinearity assumption is not appropriate. Chapter Highlights The main points of the chapter are: 1. The statutory incidence of taxes and subsidies bears no relation to the eco- nomic incidence of taxes and subsidies, with the latter arising from the price elasticities of demand and supply. The more price inelastic part of the mar- ket will end up bearing the greater burden of a tax because the tax can more easily be passed onto that side of the market regardless of how the tax law is written. 2. The size of tax revenues one can expect from a given tax rate is similarly de- pendent on the price elasticities of supply and demand, with revenues higher Distortionary Taxes and Subsidies 448 the more price inelastic at least one side of the market is. For most taxes, we can derive a Laffer curve that illustrates tax revenues as initially increasing with the tax rate but eventually decreasing. As a rough rule of thumb, dead- weight losses increase by t 2 for any t-fold increase in tax rates leading to the conventional wisdom that it is more efficient to tax a large base at a low rate rather than a small base at a high rate . 3. When underlying tastes are quasilinear , deadweight losses can be measured as areas beneath the demand and above the supply curves with dead- weight losses on the consumer side arising from substitution effects as pre- viously discussed in earlier chapters....
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This note was uploaded on 11/17/2010 for the course ECON 100A taught by Professor Woroch during the Fall '08 term at University of California, Berkeley.
- Fall '08