6: cost of taxation

Question 1

WHICH GOODS OR SERVICES SHOULD GOVT TAX
TO RAISE THE REVENUE IT NEEDS?

Answer 1

THOSE WITH THE SMALLEST DWL.

Question 2

WHEN IS THE DWL SMALL VS. LARGE?

Answer 2

TURNS OUT IT DEPENDS ON THE PRICE ELASTICITIES
OF SUPPLY AND DEMAND.

Question 3

WHAT DETERMINES THE SIZE OF THE DWL?

Answer 3

THE PRICE ELASTICITY OF DEMAND (OR SUPPLY) MEASURES HOW MUCH QD (OR QS) CHANGES
WHEN P CHANGES.

Question 4

WHEN SUPPLY
IS INELASTIC,

Answer 4

IT’S HARDER FOR FIRMS
TO LEAVE THE MARKET
WHEN THE TAX REDUCES
PS

SO, THE TAX ONLY
REDUCES Q A LITTLE,
AND DWL IS SMALL.

Question 5

The more elastic is supply,

Answer 5

the easier for firms
to leave the market when
the tax reduces PS

the greater Q falls below the
surplus-maximizing quantity,
the greater the DWL.

Question 6

When demand
is inelastic,

Answer 6

it’s harder for consumers to
leave the market when the tax
raises PB

So, the tax only reduces Q a
little, and DWL is small.

Question 7

The more elastic is demand,

Answer 7

the easier for buyers to leave the
market when the tax increases
PB

the more Q falls below the
surplus-maximizing quantity,
and the greater the DWL.

Question 8

A BIGGER GOVERNMENT PROVIDES MORE SERVICES,
BUT REQUIRES HIGHER TAXES, WHICH CAUSE DWLS.

Question 9

THE LARGER THE DWL FROM TAXATION,
THE GREATER THE ARGUMENT FOR SMALLER GOVERNMENT.

Question 10

THE TAX ON LABOR INCOME IS ESPECIALLY IMPORTANT; IT’S THE BIGGEST SOURCE
OF GOVT REVENUE.

Question 11

MARGINAL TAX RATE

Answer 11

(THE TAX ON THE LAST DOLLAR OF EARNINGS) IS ABOUT 40%.

Question 12

HOW BIG IS THE DWL FROM THIS TAX?

Answer 12

IT DEPENDS ON ELASTICITY….

Question 13

IF LABOR SUPPLY IS INELASTIC, THEN THIS DWL IS SMALL.

Question 14

Welfare without a tax

Answer 14

the equilibrium price and quantity are found at the intersection of the
supply and demand curves.

Question 15

Welfare without a tax

Answer 15

• The demand curve reflects buyers’ willingness to pay, consumer surplus is the area between
  the demand curve and the price, A + B + C
• The supply curve reflects sellers’ costs, producer surplus is the area between the supply
  curve and the price, D + E + F

Question 16

Welfare with a tax

Answer 16

welfare after the tax is enacted.

Question 17

Welfare with a tax

Answer 17

• The price paid by buyers rises from P1 to PB, so consumer surplus now equals only area a.
• The price received by sellers falls from P1 to PS, so producer surplus now equals only area f.
• To compute total surplus with the tax, we add consumer surplus, producer surplus, and tax
  revenue. Thus, we find that total surplus is area A + B + D + F

Question 18

CHANGES IN WELFARE

Answer 18

• THE CHANGE IN TOTAL WELFARE INCLUDES THE CHANGE IN CONSUMER
  SURPLUS (WHICH IS NEGATIVE), THE CHANGE IN PRODUCER SURPLUS
  (WHICH IS ALSO NEGATIVE), AND THE CHANGE IN TAX REVENUE (WHICH IS
  POSITIVE)
• THE LOSSES TO BUYERS AND SELLERS FROM A TAX EXCEED THE REVENUE
  RAISED BY THE GOVERNMENT

Question 19

• A TAX ON A GOOD REDUCES THE WELFARE OF BUYERS AND SELLERS. THIS WELFARE
  LOSS USUALLY EXCEEDS THE REVENUE THE TAX RAISES FOR THE GOVT.

Question 20

• THE FALL IN TOTAL SURPLUS (CONSUMER SURPLUS, PRODUCER SURPLUS, AND TAX
  REVENUE) IS CALLED THE DEADWEIGHT LOSS (DWL) OF THE TAX.

Question 21

• A TAX HAS A DWL BECAUSE IT CAUSES CONSUMERS TO BUY LESS AND PRODUCERS
  TO SELL LESS, THUS SHRINKING THE MARKET BELOW THE LEVEL THAT MAXIMIZES
  TOTAL SURPLUS.

Question 22

• THE PRICE ELASTICITIES OF DEMAND AND SUPPLY MEASURE HOW MUCH BUYERS
  AND SELLERS RESPOND TO PRICE CHANGES. THEREFORE, HIGHER ELASTICITIES
  IMPLY HIGHER DWLS.

Question 23

• AN INCREASE IN THE SIZE OF A TAX CAUSES THE DWL TO RISE EVEN MORE.

Question 24

• AN INCREASE IN THE SIZE OF A TAX CAUSES REVENUE TO RISE AT FIRST, BUT
  EVENTUALLY REVENUE FALLS BECAUSE THE TAX REDUCES THE SIZE OF THE MARKET.

Question 25

how tax affects welfare
consumer surplus

Answer 25

*w/o tax
- A+B+C
*w/ tax
A
*change
-(B+C)

Question 26

how tax affects welfare
producer surplus

Answer 26

*w/o tax
- D+E+F
*w/ tax
F
*change
-(D+E)

Question 27

how tax affects welfare
tax revenue

Answer 27

*w/o tax
none
*w/ tax
B+D
*change
-(B+D)

Question 28

how tax affects welfare
total surplus

Answer 28

*w/o tax
A+B+C+D+E+F
*w/ tax
B+D
*change
-(C+E)

Question 29

consumer surplus

Answer 29

• the diff between what consumers are willing to pay for a product and what they actually pay
• imposed tax, the price paid by consumer increases

Question 30

producer surplus

Answer 30

• the diff between what producers are willing to accept for a product and what they actually receive
• imposed tax, price received by producers decreases

Question 31

total surplus

Answer 31

• the combination of consumer and producer surplus in a market
• tax imposed, relative changes in consumer and producer surplus