135
Chapter 8
of Taxation
WHAT’S NEW IN THE EIGHTH EDITION:
A new
Ask the Experts
feature on “The Laffer 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.
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 affects
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 affects economic well-being. Chapter 8
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.
8
APPLICATION: THE COSTS OF
TAXATION
136 ❖ Chapter 8 /Application: The Costs of Taxation
• 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.
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.
C. How a Tax Affects Market Participants
1. We can measure the effects of a tax on consumers by examining the change in consumer
surplus. Similarly, we can measure the effects of the tax on producers by looking at the
change in producer surplus.
If you spent enough time covering consumer and producer surplus in Chapter 7,
students should have an easy time with this concept.
Figure 1
Chapter 8 /Application: The Costs of Taxation ❖ 137
3. Welfare without a Tax
a. Consumer surplus is equal to: A + B + C.
b. Producer surplus is equal to: D + E + F.
c. Total surplus is equal to: A + B + C + D + E + F.
4. Welfare with a Tax
a. Consumer surplus is equal to: A.
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).
Figure 2
Figure 3
138 ❖ Chapter 8 /Application: The Costs of Taxation
D. Deadweight Losses and the Gains from Trade
1. Taxes cause deadweight losses because they prevent buyers and sellers from benefiting from
trade.
2. This occurs because the quantity of output declines; trades that would be beneficial 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
II. The Determinants of the Deadweight Loss
Figure 4
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 benefits for anyone.
Chapter 8 /Application: The Costs of Taxation ❖ 139
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.
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 firm pays and the wage that workers receive.
Figure 5
140 ❖ Chapter 8 /Application: The Costs of Taxation
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.
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.
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.
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 effects of taxation on labor
supply. This in-class exercise gives them the opportunity to consider the effects 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%,
… (up to 100%).
Points for Discussion
Many students have no idea that current marginal tax rates are greater than 30% for many
taxpayers.
Students will likely say that a tax rate of zero would be best, but remind them that there
would be no roads, libraries, parks, or national defense without at least some revenue raised
by the government.
Figure 6
Chapter 8 /Application: The Costs of Taxation ❖ 141
C. As the tax increases, the level of tax revenue will eventually fall.
D.
Case Study: The Laffer Curve and Supply-Side Economics
1. The relationship between the size of a tax and the level of tax revenues is called a Laffer
curve.
3. Economists continue to debate Laffer’s argument.
a. Many believe that the 1980s refuted Laffer’s theory.
E.
Ask the Experts:
The Laffer Curve
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 five 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 five years.
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.
142 ❖ Chapter 8 /Application: The Costs of Taxation
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
Instructions
Tell the class, “The state has decided to increase funding for public education. They are
considering four alternative taxes to finance 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 of each of
these taxes?
1. A sales tax on food: At the margin, some consumers will purchase less food. Overall
2. A tax on families with school-age children: No families would put their children up for
adoption to avoid taxes. A large tax could have implications for family planning; couples
may choose not to have children, or to have fewer children, over time. A more realistic
concern would be relocation to other states by mobile families to avoid the tax.
3. A property tax on vacation homes: This tax would be concentrated on fewer
4. A sales tax on jewelry: This tax would also be relatively concentrated. People would buy
less jewelry, or they would buy jewelry in other states with lower taxes.
B. Rank these taxes from smallest deadweight loss to largest deadweight loss.
Lowest deadweight loss – tax on children, very inelastic
Chapter 8 /Application: The Costs of Taxation ❖ 143
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Figure 1 shows the supply and demand curves for cookies, with equilibrium quantity
Q
1 and
2. The deadweight loss of a tax is greater the greater is the elasticity of demand. Therefore, a
3. If the government doubles the tax on gasoline, the revenue from the gasoline tax could rise
or fall depending on whether the size of the tax is on the upward or downward sloping
C. Is deadweight loss the only thing to consider when designing a tax system?
No. This can generate a lively discussion. There are a variety of equity or fairness
concerns. The taxes on children and on food would be regressive. Each of the taxes
would tax certain households at much higher rates than other households with similar
incomes.
144 ❖ Chapter 8 /Application: The Costs of Taxation
Chapter Quick Quiz
1. a
Questions for Review
1. When the sale of a good is taxed, both consumer surplus and producer surplus decline. The
2. Figure 2 illustrates the deadweight loss and tax revenue from a tax on the sale of a good.
Figure 2
3. The greater the elasticities of demand and supply, the greater the deadweight loss of a tax.
4. Experts disagree about whether labor taxes have small or large deadweight losses because
they have different views about the elasticity of labor supply. Some believe that labor supply
Chapter 8 /Application: The Costs of Taxation ❖ 145
Problems and Applications
1. a. Figure 3 illustrates the market for pizza. The equilibrium price is
P
1, the equilibrium
quantity is
Q
1, consumer surplus is area A + B + C, and producer surplus is area D + E +
Figure 3
b. With a $1 tax on each pizza sold, the price paid by buyers,
P
B, is now higher than the
price received by sellers,
P
S, where
P
B =
P
S + $1. The quantity declines to
Q
2, consumer
surplus is area A, producer surplus is area F, government revenue is area B + D, and
c. If the tax were removed and consumers and producers voluntarily transferred B + D to
the government to make up for the lost tax revenue, then everyone would be better off
than without the tax. The equilibrium quantity would be
Q
1, as in the case without the
146 ❖ Chapter 8 /Application: The Costs of Taxation
2. a. The statement, “A tax that has no deadweight loss cannot raise any revenue for the
government,” is incorrect. An example is the case of a tax when either supply or demand
b. The statement, “A tax that raises no revenue for the government cannot have any
deadweight loss,” is incorrect. An example is the case of a 100% tax imposed on sellers.
3. a. With very elastic supply and very inelastic demand, the burden of the tax on rubber
Figure 4 Figure 5
b. With very inelastic supply and very elastic demand, the burden of the tax on rubber
bands will be borne largely by sellers. As Figure 5 shows, consumer surplus does not
4. a. The deadweight loss from a tax on heating oil is likely to be greater in the fifth year after
b. The tax revenue is likely to be higher in the first year after it is imposed than in the fifth
Chapter 8 /Application: The Costs of Taxation ❖ 147
5. Because the demand for food is inelastic, a tax on food is a good way to raise revenue
6. a. This tax has such a high rate that it is not likely to raise much revenue. Because of the
7. a. Figure 6 illustrates the market for socks and the effects of the tax. Without a tax, the
equilibrium quantity would be
Q
1, the equilibrium price would be
P
1, total spending by
consumers equals total revenue for producers, which is
P
1 x
Q
1, which equals area B + C
b. Unless supply is perfectly elastic or demand is perfectly inelastic, the price received by
producers falls because of the tax. Total receipts for producers fall, because producers
lose revenue equal to area B + E + F.
Figure 6
c. The price paid by consumers rises, unless demand is perfectly elastic or supply is
perfectly inelastic. Whether total spending by consumers rises or falls depends on the
price elasticity of demand. If demand is elastic, the percentage decline in quantity
148 ❖ Chapter 8 /Application: The Costs of Taxation
Before
Subsidy
After Subsidy
Change
Chapter 8 /Application: The Costs of Taxation ❖ 149
is represented by areas C + D, which are equal to (0.5)($10)(100) = $500.
Figure 8 Figure 9
When the tax is doubled, the tax revenue rises by less than double, while the deadweight
loss rises by more than double. The higher tax creates a greater distortion to the market.
150 ❖ Chapter 8 /Application: The Costs of Taxation
d. As Figure 11 shows, the area of the triangle (laid on its side) that represents the