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Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Chapter 8
The Costs of Taxation
Copyright (c) 1999 Harcourt Brace & Company, Canada, Ltd. All rights reserved.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Market Efficiency: Three observations
Free markets allocate the supply of goods to the buyers who value them most highly.
Free markets allocate the demand for goods to the sellers who can produce them at least cost.
Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
The Costs of Taxation
A tax places a wedge between the price buyers pay and the price sellers receive.
Tax!
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
The Costs of Taxation
A tax places a wedge between the price buyers pay and the price sellers receive.
A tax results in a Deadweight Loss to society and the economy
Tax! Loss!
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
$.20 tax imposed
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation: Example
The twenty cent tax results in new prices to consumers and producers:– Consumers pay $0.60
– Sellers receive $0.40 The Tax Revenue from the imposed tax
is = $160 i.e. [($0.60-$0.40) x 800]
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
Tax Revenue
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation
The tax places a wedge between the price buyers pay and the price sellers receive. The higher price to buyers and the lower price to sellers results in a lower quantity demanded and quantity supplied.
The loss in quantity demanded and the quantity supplied is 200 units (1000 - 800).
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation: Graphical
$.50
1000
Demand
Supply
$.60
$.40
800
DeadweightLoss = $20
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss of Taxation, example
The deadweight loss of 200 units do no one any good– The value of the loss to society due to
the twenty cent tax is = $20 ($500 - $480)
Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Determinants of Deadweight Loss
The magnitude of the Deadweight Loss depends upon how large a decline in market exchange occurs as a result of the tax.
The size in the decline in market exchange depends upon how sensitive consumers and producers are to changes in prices: Elasticity Concept.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Determinants of Deadweight Loss
The more elastic demand and supply are, the greater will be the
decline in equilibrium quantity and the greater the
Deadweight Loss.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
More Elastic Demand and Supply
S0
D0
QE
PE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
More Elastic Demand and Supply
S0
D0
QE
PE
S2
Amount of Tax
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
More Elastic Demand and Supply
S0
D0
QE
PE
S2
Amount of Tax
Q2
P2
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
More Elastic Demand and Supply
S0
D0
QE
PE
S2
Amount of Tax
Q2
P2
DeadweightLoss!
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Determinants of Deadweight Loss
A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.– Higher prices cause buyers to buy less.
– Lower prices received causes sellers to offer less.
The size of the market shrinks below the optimum.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Less Elastic Demand and Supply
S0
D0
QE
PE
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Less Elastic Demand and Supply
S0
D0
QE
PE
S2
P2
Q2
Amount of Tax
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Less Elastic Demand and Supply
S0
D0
QE
PE
S2
P2
Q2
Amount of Tax
DeadweightLoss!
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
Deadweight Loss and Tax Revenue The deadweight loss of a tax rises
even more rapidly than the size of the tax. – It is related to the area of a triangle. If we
double the tax, the size of the triangle increases four times.
With each increase in the tax rate, tax revenues will rise slowly, reach a maximum, and decline.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
The Costs of Taxation: Conclusion
When a tax is imposed on a good, the tax reduces consumer and producer surplus by an amount that is greater than the tax revenue generated.
The difference between the decrease in total consumer and producer surplus and the tax revenue generated is referred to as the Deadweight Loss of a tax.
Principles of Microeconomics & Principles of Macroeconomics: Ch.8 First Canadian Edition
The Costs of Taxation: Conclusion
As the tax gets larger, the deadweight loss increases more than proportionate to the tax increase.
With the increase in the tax rate, the percentage decrease in market equilibrium quantity becomes greater. Tax revenues begin to decrease.