Chapter 8
of Taxation
WHAT’S NEW IN THE EIGHTH EDITION:
A new Ask the Experts feature on “The Laer Curve” has been added.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
how taxes reduce consumer and producer surplus.
the meaning and causes of the deadweight loss from a tax.
why some taxes have larger deadweight losses than others.
how tax revenue and deadweight loss vary with the size of a tax.
135
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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8
APPLICATION: THE COSTS OF
TAXATION
136 ❖ Chapter 8 /Application: The Costs of Taxation
CONTEXT AND PURPOSE:
Chapter 8 is the second chapter in a three-chapter sequence dealing with welfare
economics. In the previous section on supply and demand, Chapter 6 introduced taxes and
demonstrated how a tax aects the price and quantity sold in a market. Chapter 6 also
described the factors that determine how the burden of the tax is divided between the
buyers and sellers in a market. Chapter 7 developed welfare economics—the study of how
the allocation of resources aects economic well-being. Chapter 8 combines the lessons
learned in Chapters 6 and 7 and addresses the eects of taxation on welfare. Chapter 9 will
address the eects of trade restrictions on welfare.
The purpose of Chapter 8 is to apply the lessons learned about welfare economics in
Chapter 7 to the issue of taxation from Chapter 6. Students will learn that the cost of a tax
to buyers and sellers in a market exceeds the revenue collected by the government.
Students will also learn about the factors that determine the degree by which the cost of a
tax exceeds the revenue collected by the government.
KEY POINTS:
A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction
in consumer and producer surplus usually exceeds the revenue raised by the
government. The fall in total surplus—the sum of consumer surplus, producer surplus,
and tax revenue—is called the deadweight loss of the tax.
Taxes have deadweight losses because they cause buyers to consume less and sellers to
produce less, and these changes in behavior shrink the size of the market below the
level that maximizes total surplus. Because the elasticities of supply and demand
measure how much market participants respond to market conditions, larger elasticities
imply larger deadweight losses.
As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger.
Because a tax reduces the size of a market, however, tax revenue does not continually
increase. It @rst rises with the size of a tax, but if the tax gets large enough, tax revenue
starts to fall.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Chapter 8 /Application: The Costs of Taxation ❖ 137
CHAPTER OUTLINE:
I. The Deadweight Loss of Taxation
A. Remember that it does not matter who a tax is levied on; buyers and sellers will likely
share in the burden of the tax.
B. If there is a tax on a product, the price that a buyer pays will be greater than the
price the seller receives. Thus, there is a tax wedge between the two prices and the
quantity sold will be smaller if there was no tax.
C. How a Tax Aects Market Participants
1. We can measure the eects of a tax on consumers by examining the change in
consumer surplus. Similarly, we can measure the eects of the tax on producers
by looking at the change in producer surplus.
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Figure 1
138 ❖ Chapter 8 /Application: The Costs of Taxation
2. However, there is a third party that is aected by the tax—the government, which
gets total tax revenue of T × Q. If the tax revenue is used to provide goods and
services to the public, then the bene@t from the tax revenue must not be ignored.
3. Welfare without a Tax
a. Consumer surplus is equal to: A + B + C.
b. Producer surplus is equal to: D + E + F.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 2
If you spent enough time covering consumer and producer surplus in
Chapter 7, students should have an easy time with this concept.
Figure 3
Chapter 8 /Application: The Costs of Taxation ❖ 139
c. Total surplus is equal to: A + B + C + D + E + F.
4. Welfare with a Tax
a. Consumer surplus is equal to: A.
b. Producer surplus is equal to: F.
c. Tax revenue is equal to: B + D.
d. Total surplus is equal to: A + B + D + F.
5. Changes in Welfare
a. Consumer surplus changes by: –(B + C).
b. Producer surplus changes by: –(D + E).
c. Tax revenue changes by: +(B + D).
d. Total surplus changes by: –(C + E).
6. De@nition of deadweight loss: the fall in total surplus that results from a
market distortion, such as a tax.
D. Deadweight Losses and the Gains from Trade
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Figure 4
140 ❖ Chapter 8 /Application: The Costs of Taxation
1. Taxes cause deadweight losses because they prevent buyers and sellers from
bene@ting from trade.
2. This occurs because the quantity of output declines; trades that would be
bene@cial to both the buyer and seller will not take place because of the tax.
3. The deadweight loss is equal to areas C and E (the drop in total surplus).
4. Note that output levels between the equilibrium quantity without the tax and the
quantity with the tax will not be produced, yet the value of these units to
consumers (represented by the demand curve) is larger than the cost of these
units to producers (represented by the supply curve).
II. The Determinants of the Deadweight Loss
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Show the students that the nature of this deadweight loss stems from the
reduction in the quantity of the output exchanged. Stress the idea that
goods that are not produced, consumed, or taxed do not generate
Chapter 8 /Application: The Costs of Taxation ❖ 141
A. The price elasticities of supply and demand will determine the size of the deadweight
loss that occurs from a tax.
1. Given a stable demand curve, the deadweight loss is larger when supply is
relatively elastic.
2. Given a stable supply curve, the deadweight loss is larger when demand is
relatively elastic.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 5
142 ❖ Chapter 8 /Application: The Costs of Taxation
B. Case Study: The Deadweight Loss Debate
1. Social Security tax and federal income tax are taxes on labor earnings. A labor tax
places a tax wedge between the wage the @rm pays and the wage that workers
receive.
2. There is considerable debate among economists concerning the size of the
deadweight loss from this wage tax.
3. The size of the deadweight loss depends on the elasticity of labor supply and
demand, and there is disagreement about the magnitude of the elasticity of
supply.
a. Economists who argue that labor taxes do not greatly distort market outcomes
believe that labor supply is fairly inelastic.
b. Economists who argue that labor taxes lead to large deadweight losses
believe that labor supply is more elastic.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Chapter 8 /Application: The Costs of Taxation ❖ 143
Activity 1—Labor Taxes
Type: In-class discussion
Topics: Deadweight loss, taxation
Materials needed: None
Time: 10 minutes
Class limitations: Works in any size class
Purpose
Most students have not spent a great deal of time considering the eects of
taxation on labor supply. This in-class exercise gives them the opportunity to
consider the eects of proposed tax rates on their own willingness to supply labor.
Instructions
Ask students to assume that they are full-time workers earning $10 per hour, $80
per day, $400 per week, $20,000 per year.
Ask them if they would quit their jobs or keep working if the tax rate was 10%,
20%, 30%,
III. Deadweight Loss and Tax Revenue as Taxes Vary
A. As taxes increase, the deadweight loss from the tax increases.
B. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the
tax.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Figure 6
144 ❖ Chapter 8 /Application: The Costs of Taxation
1. The deadweight loss is the area of a triangle and the area of a triangle depends
on the square of its size.
2. If we double the size of a tax, the base and height of the triangle both double so
the area of the triangle (the deadweight loss) rises by a factor of four.
C. As the tax increases, the level of tax revenue will eventually fall.
D. Case Study: The Laer Curve and Supply-Side Economics
1. The relationship between the size of a tax and the level of tax revenues is called a
Laer curve.
2. Supply-side economists in the 1980s used the Laer curve to support their belief
that a drop in tax rates could lead to an increase in tax revenue for the
government.
3. Economists continue to debate Laer’s argument.
a. Many believe that the 1980s refuted Laer’s theory.
b. Others believe that the events of the 1980s tell a more favorable supply-side
story.
c. Some economists believe that, while an overall cut in taxes normally
decreases revenue, some taxpayers may @nd themselves on the wrong side of
the Laer curve.
E. Ask the Experts: The Laer Curve
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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Chapter 8 /Application: The Costs of Taxation ❖ 145
1. Economic experts were asked whether a cut in the federal income tax rates now
in the U.S. would lead to higher national income in @ve years than without the tax
cut. While 43 percent of the experts agreed, 9 percent disagreed and nearly half,
48 percent, were uncertain.
2. However, 96 percent of the same panel of experts disagreed that cutting the
federal income tax rates now in the U.S. would result in greater tax revenue in
@ve years.
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
ALTERNATIVE CLASSROOM EXAMPLE:
Draw a graph showing the demand and supply of paper clips. (Draw each curve
as a 45-degree line so that buyers and sellers will share any tax equally.) Mark
the equilibrium price as $0.50 (per box) and the equilibrium quantity as 1,000
boxes. Show students the areas of producer and consumer surplus.
Impose a $0.20 tax on each box. Assume that sellers are required to “pay” the
tax to the government. Show students that:
the price buyers pay will rise to $0.60.
the price sellers receive will fall to $0.40.
the quantity of paper clips purchased will fall (assume to 800 units).
146 ❖ Chapter 8 /Application: The Costs of Taxation
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Activity 2—Tax Alternatives
Type: In-class assignment
Topics: Taxes and deadweight loss
Materials needed: None
Time: 20 minutes
Class limitations: Works in any size class
Purpose
The market impact of taxes can be a new concept to many students. This exercise
helps them think about the eects of taxes on dierent goods. Taxes that may be
appealing for equity reasons can be distortionary from a market perspective.
Instructions
Tell the class, “The state has decided to increase funding for public education.
They are considering four alternative taxes to @nance these expenditures. All four
taxes would raise the same amount of revenue.” List these options on the board:
1. A sales tax on food.
2. A tax on families with school-age children.
3. A property tax on vacation homes.
4. A sales tax on jewelry.
Ask the students to answer the following questions. Give them time to write an
answer, and then discuss their answers before moving to the next question:
A. Taxes change incentives. How might individuals change their behavior because
of each of these taxes?
B. Rank these taxes from smallest deadweight loss to largest deadweight loss.
Explain.
C. Is deadweight loss the only thing to consider when designing a tax system?
Common Answers and Points for Discussion
A. Taxes change incentives. How might individuals change their behavior because