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The cost of taxes
Lecture 7 – academic year 2014/15
Introduction to EconomicsFabio Landini
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The cost of taxes
• Past classes: a tax on a good affects its price and quantity exchanged.
• Moreover: buyers and sellers share in the tax burden in different ways.
• The objective of this lecture is to answer the following question: what are the effects of a tax on the welfare of market participants?
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Market equilibrium and allocative efficiency
• A free market produces the quantity of goods that maximizes the total welfare(= consumer surplus + producer surplus).
• When an allocation of resources maximizes the total welfare, we say that such allocation is economically efficient.
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The costs of imposing taxes
• When the government imposes a tax on a particular good, the equilibrium quantity of that good diminishes and its price increases.
• The size of the market for that particular good decreases.
• Therefore: in a perfectly competitive market, taxes have a cost in terms of diminished welfare experienced by individuals.
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Market equilibrium in presence of a tax
Tax levyTax levy((T x QT x Q))
Q.ty with the tax
Demand
Supply
Q.ty withoutthe tax Quantity0
Price
Value ofthe tax
(T)Consumer Price
Quantity sold (Q)
Producer price
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• The tax introduces a mark-up between the price paid by the consumer and the price earned by the producer.
• The cost of the tax for consumers and producers exceeds the tax levy (earned by the government), generating a net loss.
• The net loss is the reduction in total welfare caused by the introduction of a tax.
The costs of imposing taxes
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A
F
B
D
C
E
Demand
Supply
Q1
Price without tax = P1
Q2
Price paid by consumer = PB
Price earned by producer = PS
0 Quantity
Price
Consumer surplus: from A+B+C to A
Producer surplus: from D+E+F to F
Tax levy: from none to B+D
Total surplus (social welfare): from
A+B+C+D+E+F to A+B+D+F
Net loss of social welfare: C+E
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Net loss: an example
• At the current price of 0.50 € per unit, the quantity sold is 1.000 units.
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Quantity0
Price
demand
Supply
1000
0.50
Net loss: an example
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• The government introduces a tax of 0.20 € on the production of each unit of the good. The producers “collect” the tax and then they pay it back to the government.
• Let’s assume the tax burden is shared equally – Consumers and producers pay 0.10 € each.– Remember: taxes are not necessarily
paid only by those who are supposed to pay the government (previous lessons).
• The higher price for consumers and the smaller price for producers translates into a smaller quantity that is exchanged in the market.
Net loss: an example
11Quantity0
Price
Demand
Supply
0.50
1000800
0.40
0.60
Net loss: an example
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• The tax impair both consumers and producers, so that the quantity exchanged diminishes of 200 units(= 1.000 - 800).
• The area of the triangle included between the demand curve and the supply curve and delimited by the quantity exchanged is a measure of the net loss.
• Example: = (0.10 x 200)/2 + (0.10 x 200)/2 = 20 €.
• Tax levy= (0.60 - 0.40) x 800 = 160
Net loss: an example
13Quantity0
Price
Demand
Supply
0.50
1000
0.40
0.60
800
Tax levy = 160
Decrease in quantity = 200
Net loss of social Net loss of social welfare = 20welfare = 20
Net loss: an example
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Effects of taxes• Taxes -> loss of welfare
– They induce the market participants (producers and consumers) to change their behaviour.
• Prices (PD, PS) change makes some some exchanges not profitable any more.– Higher price induces consumers to purchase
less.– Lower price induces producers to produce less.
• The size of the market reduces and becomes smaller than the optimal level.
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Price without tax
Q1
Demand
Supply
PB
Q2
PS
Value for consumer
Cost of supplier
Value of the tax
Loss of exchange benefits
Decrease in quantity due to the tax
Quantity0
Price
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Why the net loss?
• Even if the tax levy is redistributed entirely to producers and consumers, the fiscal revenue is not sufficient to compensate for the reduction in the volume of exchange due to the tax.
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How big is the net loss? Theory
• The size of the net loss depends on Q* caused by T.
• At the same time: Q* depends on the price elasticity of demand and supply.– If price elasticity, then net loss.– If price elasticity, then net loss.
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Effects of taxes and elasticity of supply
(a) Inelastic supply (b) Elastic supplyPrice
0 Quantity
Price
0 Quantity
Demand Demand
Supply
SupplyIf the supply is inelastic, the netloss is small.
If the supply is elastic, the net loss is large
Value of the tax
Value of the tax
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Demand
Supply
(c) Inelastic demand(d) Elastic demand
0 Quantity 0 Quantity
Value of the tax
Demand
Supply
If the demand is elastic, the net loss is large
If the demand is inelastic, the netloss is small
Price
Value of the tax
Price
Effects of taxes and elasticity of supply
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How big is the net loss? Discussion
• While it is easy to compute the value of taxes, it is not that easy to evaluate the net loss caused by the taxes.
• Example: tax on labour:
• For some workers the supply of labour is inelastic:– 40 years-old head of household wants to
work full time, independently of the wage.
– In this case, a tax on labour causes a relatively small net loss
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• For other types of workers the supply is elastic.– Women, elderly people, students: react
positively to monetary incentives. – In these cases, a tax on labour causes a
relatively large net loss (smaller productivity, illegal work, early retirement).
• In general: there are different opinions on the elasticity of labour supply.
How big is the net loss? Discussion
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State and the economyThe debate on the net loss is not (only) an
academic discussion.
Different opinions on the elasticity and its effects often derive from different visions concerning the role of the State in the economy
The tax on labour represent a large part of the tax levy in advanced countries. When people talk bout reducing such taxes, the question is:
– Do we want to reduce taxes and public services?
– Or do we want higher taxes and more public services?
The answer depend on how we think the role of the State in the allocation of resources.
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Net loss and fiscal revenue
Following an increase in taxes, the fiscal revenue rapidly increases up to a maximum and, then, it diminishes.
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PB
QuantityQ20
Price
Q1
Demand
Supply
Net loss
Fiscal revenuePS
Small tax
Net loss and fiscal revenue
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Demand
Supply
Fiscal revenue
PB
QuantityQ20
Price
Q1
Net loss
PS
Medium tax
Net loss and fiscal revenue
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Fis
cal re
ven
ue
PB
QuantityQ20
Price
Q1
Demand
Supply
Large tax
Net loss
PS
Net loss and fiscal revenue
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(a) Net loss
Net loss
0Value of the tax
(b) Revenue (Laffer’s curve)
Fiscal revenue
0Value ofthe tax
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The theory of Laffer’s curve …
Main idea: when taxes are too high they discourage production.
• In the case of labour: if the tax on income is too high, it discourage the supply of work.
• Smaller taxes create incentives to work more, increasing social welfare and fiscal revenue.
Hence: it is better to reduce taxes!
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…and the empirical evidence
In the 1980 , Reagan (USA president) implemented a policy aimed at reducing taxes. However, the fiscal revenue decreased rather than increasing
In the period 1980-84, disposable income: +4%, fiscal revenue: -9%
Fiscal deficit.
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What does this result tell us?
• The idea of Laffer can be correct if applied to tax payers subject to high tax rates.In the period 1980-84 the fiscal revenue produced
by high income tax payers increased (more work, smaller evasion…)
• The idea of Laffer can be correct if applied to countries with high tax rates.In Sweden during the 1980s the tax rate on high
incomes was about the 80%, while in the USA was much smaller .
…and the empirical evidence
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The debate…
But then why there are countries with high tax rates and countries with low tax rates?
It depends on how one evaluates the elasticity of some economic curves.
In reality it is really complex to determine the real value of elasticity, and this creates a lack of consensus on this issues.
Much depends on the preferences of citizens/voters…
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In some countries (northern Europe), high tax rates are accepted because they create more resources to be redistributed through public services. This, in their view, compensate parts of the net loss.
In other countries (USA), low tax rates and little redistribution are preferred because it is generally believed that poverty is not the result of unlucky events but rather the consequence of individual actions. Therefore the social expenditure is unfair (beyond a certain limit) and it does not compensate the net loss.
The debate…
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Conclusion
• The reduction in the consumer surplus and producer surplus caused by taxes exceeds the the increase in fiscal revenue obtained by the public administration. Therefore, taxes produce a net loss.
• The higher the tax rate, the higher the net loss.
• The fiscal revenue first increase with the value of the tax; then, as the tax rate increases, the fiscal revenue starts to diminish following the reduction in the size of the market.
• When the tax rate is very high, this can justify a tax cut so as to reduce the net loss.
