Week 6 Flashcards
Consider the market illustrated in the figure on the right, where demand is perfectly inelastic. If the government levies a tax on consumers, what will be the tax incidence?
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Tax incidence refers to how the burden of taxation is distributed across various agents in the economy. The tax will shift the demand curve downward by an amount equal to the size of the tax, but the market price and quantity will not change (because demand is perfectly inelastic). After adding the tax to be paid by consumers to the market price, the total amount paid by consumers will have increased by an amount equal to the size of the tax, so the entire tax burden (100 percent) falls on consumers (and none on producers).
Question 5
Which of the following is a cost associated with government intervention in an economic system?
Unemployment.
Bureaucracies.
Externalities.
Inequality.
The government will sometimes make mistakes, the bureaucracy can be inefficient and slow, and some politicians may be corrupt, seeking to use the process of decision making for their own benefit or their own ideological ends. Government failures also include the costs of bureaucracies. Bureaucrats who are employed by the government could be working in other productive sectors of the economy. This is an important opportunity cost of government work.
Given that there are costs involved with government intervention in an economy, governments still choose to intervene in markets to
Governments frequently intervene in markets to achieve social objectives and to correct market failures.
Paternalism
Paternalism is the view that consumers do not always know what is best for them, and the government should encourage or induce them to change their actions. This approach gives the government an active hand in helping individuals make the right decisions and in designing choices so that people make the right decisions when they are unlikely to do so by themselves.
As the Evidence-Based Economics describes, economic analysis cannot make the value judgments needed to determine the optimal size of government. However, economic analysis is able to evaluate the costs and benefits of government interventions and to identify ways of designing more efficient and equitable government policies.
Economic analysis tells us when government policy requires raising revenue, it should tax activities where market supply is:
The primary social cost of a tax is the deadweight loss associated with the reduced activity in response to the tax. Taxing activities with inelastic supply means that there is relatively little reduction in the activity and therefore relatively lower deadweight loss.
Economic analysis also suggests that when considering whether government should raise an extra tax dollar, it should compare the marginal increase in the deadweight loss to the:
In considering the optimal size of government, economic analysis advises that when the marginal social benefit of a government intervention exceeds the marginal social cost, the policy will result in improvement.
Government failure
Happens when government intervention fails to correct or exacerbates market failure.
Some causes of government failure
the cost of intervention may exceed the benefit
government information failure (unable to conduct proper cost-benefit analysis)
non-public (vested) interest
regulatory capture
perceptions of paternalism
We look at two particular cases of government failure
costs of taxation and international trade restrictions
Costs of taxation
Tax discourages market activist
Administrative burden
Tax discourages market activist
It reduces the quantity that is traded;
Both buyers and sellers are worse off; a tax raises the price buyers pay and lowers the price sellers receive.
Administrative burden
Moreover, there is an administrative burden associated with taxes, in the form of costs incurred to comply with tax laws.
Yet some level of taxation is necessary to help fund government expenditure.
To understand how taxes affect economic wellbeing
To understand how taxes affect economic wellbeing, we must compare the reduced welfare of buyers and sellers with the amount of revenue the government raises.
Deadweight loss
The reduction in total surplus that results from a market distortion, such as tax or trade restriction. The concept of deadweight loss is used to measure the welfare consequences of government policies.
Welfare without taxation
Without tax, the market equilibrium is the intersection of demand and supply.
Consumer surplus is the area below the demand curve and above the equilibrium price.
Producer surplus is the area below the equilibrium price and above the supply curve.
Total surplus is maximised (i.e. economic welfare maximised)
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Welfare effects of taxation (1)
The tax creates a wedge between the price paid by buyers, and the price received by sellers.
The price buyers pay rises, and the price sellers receive falls.
The quantity traded is lower than in the equilibrium without tax.
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Welfare effects of taxation (2)
The tax reduces the welfare of both buyers and sellers:
Tax revenue
Welfare effects of taxation (2)
The tax reduces the welfare of both buyers and sellers:
Consumer surplus is reduced because buyers purchase a lower quantity at a higher price.
Producer surplus is reduced because sellers sell a lower quantity at a lower price.
Welfare effects of taxation (2)
Tax revenue
The government raises revenue from the tax. Tax revenue is equal to the size of tax times the quantity traded.
Tax revenue measures the benefit that the government derives from the tax.
Because tax revenue funds the provision of goods and services, households are the ultimate beneficiaries of taxation.
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Deadweight loss of taxation
The deadweight loss of taxation is the area of the triangle between demand, supply and the quantity with tax.
The deadweight loss triangle was part of the total surplus without tax, but is not part of the total surplus with tax.
The deadweight loss exists because the revenue raised by the tax is less than the loss of consumer and producer surplus due to the tax.
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Deadweight loss of taxation: lost gains from trade
Tax reduces quantity traded from Q1 to Q2.
At every quantity between Q1 and Q2 the value to the marginal buyer exceeds the cost to the marginal seller.
The difference between these values equals the gains from trade that are lost because the transaction does not occur.
The tax prevents any transaction for which the gains from trade are less than the size of the tax.
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. Deadweight loss and elasticity
A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.
The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less.
Hence the equilibrium quantity in the market shrinks below the optimal quantity.
The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks, and the greater the deadweight loss.
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Deadweight loss, size of tax and tax revenue
Small tax
A small tax has a small effect on buyer and seller behaviour (and vice versa).
Because the quantity traded is close to the optimal quantity, the deadweight loss is small. Because the size of the tax is small, tax revenue is small.
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Deadweight loss, size of tax and tax revenue
As the size of the tax rises
As the size of the tax rises, the effect on buyer and seller behaviour also grows.
Tax revenue initially increases because the size of the tax is growing proportionately faster than quantity traded is falling.
The deadweight loss grows faster than tax revenue because the size of the tax, and the difference between the quantity with and without the tax, both increase.
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