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Module 14 krugman 1
Module 14
The Benefits and Costs of Taxation
What’s New in the Fourth Edition?
• Updated Economics in Action example.
Module Objectives
• How do taxes affect supply and demand?
• What factors determine who bears the burden of a tax?
• What are the costs and benefits of a tax, and why is the cost greater than the tax revenue generated?
Teaching Tips
The Economics of Taxes: A Preliminary View
Creating Student Interest
• Ask students about the price of gas. Do they know what the current price of gas is? Have they
observed the price of gas changing over the past months or years? Now ask them if an increase in
the price of gas would change their driving habits.
See if they are aware of the federal and state excise tax on gasoline. Consumers pay both a federal
gas tax (18.4 cents per gallon since 1997—see the website
Presenting the Material
• Use the example of a $20 excise tax on the sale of motorcycles, as illustrated in the graph below.
The tax causes the supply curve to shift to S2 by the amount of the tax. The new equilibrium price is
now $1,010. The effect of the excise tax is to push up the equilibrium price to $1,010 from $1,000.
This means that buyers are paying $10 more than before, and because sellers are paying the
government $20, they are now netting just $990 for each bike sold. Buyers and sellers are bearing
an equal burden of the tax: buyers have to pay $10 more than before and sellers net $10 less than
before.
• Make sure students understand that buyers and sellers will not always share the burden of the tax—
it depends on elasticity. Also, the text demonstrates that if the excise tax is imposed on consumers
instead of on producers, the effects on price and quantity are the same. Taxing producers is
administratively less costly so this explains why producers and not consumers usually pay the excise
tax.
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The Benefits and Costs of Taxation
Creating Student Interest
• Have students consider examples of goods that the government taxes in ways other than through the
sales tax (cigarettes, hotel rooms, alcohol, gasoline). Ask students what characteristics these goods
have that make them more likely to be taxed. Is the government, for example, likely to tax necessary
Presenting the Material
• Have students consider the motorcycle example above by first having them consider a less elastic,
steeper supply curve. They should notice that the tax incidence is higher for the supplier. Have
them do the same with a less elastic, steeper demand curve. On their graphs, have the students
identify what happens to consumer and producer surplus when the excise tax is imposed. Also have
them identify the government revenue and the deadweight loss. Make sure they understand that the
size of the deadweight loss and the amount of revenue collected depend on elasticity.
Module Outline
I. The Economics of Taxes: A Preliminary View
A. The effect of an excise tax on quantities and prices
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1. An excise tax imposed on the seller causes firms to increase the price for which they are
willing to sell the good or service, shifting the supply curve upward. See text Figure 14-
1, shown next.
2. Consumers will end up paying a higher price for the good, and as a result, will choose
to buy a smaller quantity.
Figure 14-1
3. The tax drives a wedge between the price paid by the consumer and the after-tax price
received by the seller.
4. The tax creates missed opportunities for mutually beneficial transactions.
5. Tax incidence is not a function of who actually pays the tax. It does not matter who pays
the government directly, producers or consumers.
B. Price elasticities and tax incidence
1. The incidence of an excise tax depends on the price elasticities of demand and supply.
2. Low price elasticities of demand and high price elasticities of supply lead the tax burden
to fall on consumers.
II. The Benefits and Costs of Taxation
A. The revenue from an excise tax
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1. The revenue collected from an excise tax equals the area of the rectangle, with height =
the tax wedge and width = quantity bought/sold under the tax.
B. Tax rates and revenues
1. An increase in the tax, or tax rate, may increase or decrease tax revenue depending on
what happens to the quantity sold. If supply and demand are relatively inelastic, then
the increase in the tax will reduce quantity by a small amount, and tax revenue should
rise.
III. The costs of taxation
A. Taxes prevent mutually beneficial transactions from happening.
B. Taxes lead to deadweight loss, as illustrated in text Figure 7-9.
C. The lost consumer and producer surplus exceeds the government tax revenue, creating a
deadweight loss.
Figure 14-9
IV. Elasticities and the deadweight loss of a tax
A. The larger the number of prevented transactions, the larger the size of the deadweight loss.
B. When demand and supply are both relatively inelastic, the deadweight loss is relatively small.
C. See text Figure 14-10 on the next page for a summary of the relationship between the size of
the deadweight loss and elasticity.
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Figure 14-10
Case Studies in the Text
Economics in Action
Taxing Tobacco—This EIA looks at cigarette taxes and uses the data from states to show the result of
large increases in tax rates on tax revenues.
Ask students the following questions:
1. What does analysis of the cigarette market tell us about the price elasticity of demand for
2. How is tax revenue affected when the cigarette tax is increased? Explain why. (It increases
Web Resources
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Handout 14-1
Date_________ Name____________________________ Class________ Professor________________
The Impact of Taxes (15–20 minutes)
Find three classmates to work with. In your group decide one student who will play the role of business groups,
one student who will play the role of an environmental group, one who will play the role of government, and the
last who will play the role of U.S. consumers.
The graphs below represent two different taxes: a tax on gasoline and a tax on gas-guzzling cars. Draw the effect
of the tax on the market for each, and then label the effect of the tax on the group you represent.
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Answers:
The tax on gasoline hits consumers harder—the equilibrium price rises more. However, gasoline and gas-
Module 14 krugman 9
Handout 14-2
Date_________ Name____________________________ Class________ Professor________________
Who Pays the Tax?
Think of circumstances in which a seller can pass the full amount of an excise tax onto consumers. Use graphs to
explain your answer where necessary.
Do you think your state excise tax on gasoline is completely passed onto consumers? Why or why not?
Those Pesky Excise Taxes
If these products had an excise tax placed on them, who would wind up paying the tax and why?
• Gasoline
• Super Bowl tickets
• Luxury cars
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Answers:
Who Pays the Tax?
Most students will understand that the more inelastic the demand, the more the tax can be pushed onto
consumers. However, supply elasticity is also relevant here: The more elastic the supply is, the more sellers can
transfer the tax to consumers.
The state excise tax on gasoline would not be completely passed onto customers because the demand for gasoline
is not perfectly inelastic. People will alter their driving habits as a tax increases.
Those Pesky Excise Taxes
If these products had an excise tax placed on them, who would wind up paying the tax and why?
