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Unformatted text preview: Chapter 8 Application: The Costs of Taxation "Taxes are what we pay for civilized society." To understand more fully how taxes affect economic well-being, we must compare the reduced welfare of buyers and sellers to the amount of revenue the government raises. The tools of consumer and producer surplus allow us to make this comparison. The analysis will show that the cost of taxes to buyers and sellers exceeds the revenue raised by the government. The Deadweight Loss of Taxation The outcome is the same whether a tax on a good is levied on buyers or sellers of the good. When a tax is levied on buyers, the demand curve shifts downward by the size of the tax; when it is levied on sellers, the supply curve shifts upward by that amount. In either case, when the tax is enacted, the price paid by buyers rises, and the price received by sellers falls. In the end, the elasticities of supply and demand determine how the tax burden is distributed between producers and consumers. This distribution is the same regardless of how it is levied. Figure 1 shows these effects. To simplify our discussion, this figure does not show a shift in either the supply or demand curve, although one curve must shift. Which curve shifts depends on whether the tax is levied on sellers (the supply curve shifts) or buyers (the demand curve shifts). In this chapter, we can keep the analysis general and simplify the graphs by not bothering to show the shift. The key result for our purposes here is that the tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. In other words, a tax on a good causes the size of the market for the good to shrink. Figure 1. The Effects of a Tax A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. How a Tax Affects Market Participants The benefit received by buyers in a market is measured by consumer surplusthe amount buyers are willing to pay for the good minus the amount they actually pay for it. The benefit received by sellers in a market is measured by producer surplusthe amount sellers receive for the good minus their costs. If T is the size of the tax and Q is the quantity of the good sold, then the government gets total tax revenue of T Q . It can use this tax revenue to provide services, such as roads, police, and public education, or to help the needy. Therefore, to analyze how taxes affect economic well-being, we use the government's tax revenue to measure the public benefit from the tax. Keep in mind, however, that this benefit actually accrues not to government but to those on whom the revenue is spent. Figure 2 shows that the government's tax revenue is represented by the rectangle between the supply and demand curves. The height of this rectangle is the size of the tax, T , and the width of the rectangle is the quantity of the good sold,...
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- Spring '07