CHAPTER 8

APPLICATION:
THE COSTS OF TAXATION
PRINCIPLES OF ECONOMICS By N. Gregory
Mankiw

Microeconomics
ANSWERS TO THESE QUESTIONS:
 How does a tax affect consumer surplus, producer surplus, and total surplus?
 What is the deadweight loss of a tax?
 What factors determine the size of this deadweight loss?
 How does tax revenue depend on the size of the tax?

2
 REVIEW FROM CHAPTER 6
 A tax
 drives a wedge between the price buyers pay and the price sellers
receive.
 raises the price buyers pay and lowers the price sellers receive.
 reduces the quantity bought & sold.
 These effects are the same whether the tax is imposed on
buyers or sellers, so we do not make this distinction in this
chapter.
APPLICATION: THE COSTS OF TAXATION 3
 THE EFFECTS OF A TAXP
Eq’m with no tax:
Price = PE
Quantity = QE Size of tax = $T
PB S
Eq’m with
tax = $T per unit: PE
Buyers pay PB PS D
Sellers receive PS
Quantity = QT
Q
QT QE

APPLICATION: THE COSTS OF TAXATION 4

 THE EFFECTS OF A TAXP
Revenue from tax: $T x QT
Size of tax = $T
PB S

PE

PS D

Q
QT QE

APPLICATION: THE COSTS OF TAXATION 5

 THE EFFECTS OF A TAX
 Next, we apply welfare economics to measure the
gains and losses from a tax.
 We determine consumer surplus (CS), producer
surplus (PS), tax revenue, and total surplus with and
without the tax.
 Tax revenue can fund beneficial services (e.g.,
education, roads, police) so we include it in total
surplus.
APPLICATION: THE COSTS OF TAXATION 6
THE EFFECTS OF A TAX P

Without a tax,
CS = A + B + C A
S
PS = D + E + F B C
Tax revenue = 0 PE
D E
Total surplus D
F
= CS + PS
=A+B+C Q
QT QE
+D+E+F
APPLICATION: THE COSTS OF TAXATION 7
 THE EFFECTS OF A
P
TAX
With the tax,
CS = A
PS = F A
S
Tax revenue= B + D PB
B C
Total surplus D E
PS D
=A+B +D+F F

The tax reduces total Q

QT QE
surplus by C + E
APPLICATION: THE COSTS OF TAXATION 8
 THE EFFECTS OF A
P
TAX
C + E is called the
deadweight loss A
S
(DWL) of the tax, the PB
B C
fall in total surplus E
D
that results from a PS D
F
market distortion,
such as a tax.
Q
QT QE

APPLICATION: THE COSTS OF TAXATION 9

 ABOUT THE DEADWEIGHT
P
LOSS

Because of the tax, the

units between
S
QT and QE are not sold. PB

The value of these units

to buyers is greater than PS D
the cost of producing
them, so the tax prevents
some mutually beneficial QT QE
Q
trades.
APPLICATION: THE COSTS OF TAXATION 10
ACTIVE LEARNING 1 The market for airplane
P tickets
ANALYSIS OF TAX
$400
A. Compute
350
CS, PS, and total
surplus without a tax. 300
S
250
B. If $100 tax
per ticket, 200
compute 150
D
CS, PS, 100
tax revenue, total
50
surplus, and DWL.
0 Q
0 25 50 75 100 125 11
ACTIVE LEARNING 1 The market for airplane
ANSWERS TO A P tickets
$400
CS
350
= ½ x $200 x 100
= $10,000 300
S
PS 250
= ½ x $200 x 100 P = 200
= $10,000 150
D
Total surplus 100
= $10,000 + $10,000 50
= $20,000 0 Q
0 25 50 75 100 125 12
ACTIVE LEARNING 1 A $100 tax on airplane
ANSWERS TO B P tickets
$400
CS
= ½ x $150 x 75 350
= $5,625 300
PS = $5,625 S
PB = 250
Tax revenue 200
= $100 x 75 PS = 150
= $7,500 D
100
Total surplus
50
= $18,750
0 Q
DWL = $1,250
0 25 50 75 100 125 13
 WHAT DETERMINES THE SIZE OF THE DWL?
 Which goods or services should govt tax to raise the
revenue it needs?
 One answer: those with the smallest DWL.
 When is the DWL small vs. large? Turns out it depends
on the price elasticities of supply and demand.
 Recall:
The price elasticity of demand (or supply) measures how
much QD (or QS) changes when P changes.

APPLICATION: THE COSTS OF TAXATION 14

 DWL AND THE ELASTICITY OF SUPPLY
P
When supply is inelastic,
S
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.
Size
of tax

D
Q

APPLICATION: THE COSTS OF TAXATION 15

 DWL AND THE ELASTICITY OF SUPPLY
The more elastic is supply,
P
the easier for firms
to leave the market when
the tax reduces PS,
S
the greater Q falls below the
Size
surplus-maximizing quantity, of tax
the greater the DWL.

D
Q

APPLICATION: THE COSTS OF TAXATION 16

 DWL AND THE ELASTICITY OF DEMAND
When demand
P
is inelastic,
S it’s harder for consumers
to leave the market when
Size
the tax raises PB.
of tax
So, the tax only reduces
Q a little,
and DWL is small.
D
Q

APPLICATION: THE COSTS OF TAXATION 17

 DWL AND THE ELASTICITY OF DEMAND
The more elastic is
P demand,
S the easier for buyers to
leave the market when the
tax increases PB,
Size the more Q falls below the
of tax
surplus-maximizing
D
quantity,
and the greater the DWL.
Q

APPLICATION: THE COSTS OF TAXATION 18

ACTIVE LEARNING 2
ELASTICITY AND THE DWL OF A TAX
Would the DWL of a tax be larger if the tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or
hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?

19
ACTIVE LEARNING 2
ANSWERS
A.Breakfast cereal or sunscreen
From Chapter 5:
Breakfast cereal has more close substitutes than
sunscreen, so demand for breakfast cereal
is more price-elastic than demand for sunscreen.
So, a tax on breakfast cereal would cause a larger
DWL than a tax on sunscreen.
20
ACTIVE LEARNING 2
ANSWERS
B. Hotel rooms in the short run or long run
From Chapter 5:
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger DWL in the long
run than in the short run.

21
ACTIVE LEARNING 2
ANSWERS
C. Groceries or meals at fancy restaurants
From Chapter 5:
Groceries are more of a necessity and therefore less
price-elastic than meals at
fancy restaurants.
So, a tax on restaurant meals would cause a larger
DWL than a tax on groceries.

22
ACTIVE LEARNING 3
DISCUSSION QUESTION
The government must raise tax revenue to pay for
schools, police, etc. To do this, it can either tax
groceries or meals at fancy restaurants.
Which should it tax?

23
 HOW BIG SHOULD THE GOVERNMENT BE?
 A bigger government provides more services, but requires higher taxes, which
cause DWLs.
 The larger the DWL from taxation, the greater the argument for smaller
government.
 The tax on labor income is especially important; it’s the biggest source of govt
revenue.
 For the typical worker, the marginal tax rate (the tax on the last dollar of
earnings) is about 40%.
 How big is the DWL from this tax?
It depends on elasticity….

APPLICATION: THE COSTS OF TAXATION 24

 HOW BIG SHOULD THE GOVERNMENT BE?
If labor supply is inelastic, then this DWL is
small.
Some economists believe labor supply is
inelastic, arguing that most workers work
full-time regardless of the wage.

APPLICATION: THE COSTS OF TAXATION 25

 HOW BIG SHOULD THE GOVERNMENT BE?
Other economists believe labor taxes are highly distorting
because some groups of workers have elastic supply and can
respond to incentives:
 Many workers can adjust their hours,
e.g., by working overtime.
 Many families have a 2nd earner with discretion over whether and how
much to work.
 Many elderly choose when to retire based on the wage they earn.
 Some people work in the “underground economy” to evade high taxes.

APPLICATION: THE COSTS OF TAXATION 26

 THE EFFECTS OF CHANGING THE SIZE OF THE TAX
 Policymakers often change taxes, raising some and lowering
others.
 What happens to DWL and tax revenue when taxes change?
We explore this next….

APPLICATION: THE COSTS OF TAXATION 27

 DWL AND THE SIZE OF THE TAX
P
new
Initially, the tax is T per unit. DWL
S
Doubling the tax causes the DWL
2T T
to more than double.
D
initial
DWL

Q
Q2 Q1

APPLICATION: THE COSTS OF TAXATION 28

 DWL AND THE SIZE OF THE TAX
P
Initially, the tax is T per unit. new
DWL

Tripling the tax S

causes the DWL to more than
3T T
triple.
D
initial
DWL

Q
Q3 Q1

APPLICATION: THE COSTS OF TAXATION 29

 DWL AND THE SIZE OF THE TAX
Summary
Implication
When a tax increases,
When tax rates are low, DWL rises even more.
raising them doesn’t cause DWL
much harm, and lowering
them doesn’t bring much
benefit.
When tax rates are high,
raising them is very harmful,
and cutting them is very
beneficial.
Tax size

APPLICATION: THE COSTS OF TAXATION 30

 REVENUE AND THE SIZE OF THE TAX
P

When the PB
tax is small, increasing it causes S
PB
tax revenue to rise.
2T T
PS D
PS

Q
Q2 Q1

APPLICATION: THE COSTS OF TAXATION 31

 REVENUE AND THE SIZE OF THE TAX
P

PB
When the
PB
tax is larger, increasing it S
causes tax revenue to fall.
3T 2T

D
PS
PS
Q
Q3 Q2

APPLICATION: THE COSTS OF TAXATION 32

 REVENUE AND THE SIZE OF THE TAX
The Laffer curve shows the
The Laffer curve
relationship between Tax revenue
the size of the tax and tax
revenue.

Tax size

APPLICATION: THE COSTS OF TAXATION 33

CHAPTER SUMMARY
 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.
 The fall in total surplus (consumer surplus, producer surplus, and tax
revenue) is called the deadweight loss (DWL) of the tax.
 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.

34
CHAPTER SUMMARY

 The price elasticities of demand and supply measure how much buyers and
sellers respond to price changes. Therefore, higher elasticities imply higher
DWLs.
 An increase in the size of a tax causes the DWL to rise even more.
 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.

35