Chapter

8
Application: The
Costs of
Taxation
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
TENTH EDITION Eastern Illinois University
Mankiw, Principles of Economics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part. 1
 IN THIS CHAPTER
• 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?

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 Review

J.B. HANDELSMAN/THE NEW YORKER COLLECTION/THE CARTOON BANK

• A tax
– Drives a wedge between the price
buyers pay and the price sellers
receive
– Raises the price buyers pay
– Lowers the price sellers receive
– Reduces the quantity bought and
“ You know, the idea
sold of taxation with
representation
These effects are the same whether doesn’t appeal to
the tax is imposed on buyers or me very much,
either.”
sellers.
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Figure 1 The Effects of a Tax

A tax on a good places

a wedge between
the price that buyers
pay
And
the price that sellers
receive.
The quantity of the
good sold declines.
Figure 2 Tax Revenue

The tax revenue that

the government
collects equals T × Q,
the size of the tax, T,
times the quantity
sold, Q. Thus, tax
revenue equals the
area of the rectangle
between the supply
and demand curves.
 REVIEW: The effects of a tax
Equilibrium with P
Revenue from tax: $T x QT
no tax:
Price = PE Size of tax = $T
S
Quantity = QE PB

PE
Equilibrium with
tax = $T per unit: PS D
Buyers pay PB
Sellers receive PS
Q
Quantity = QT QT QE

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 How a Tax Affects Market Participants
• Total surplus = Consumer surplus + Producer surplus
– Maximized at equilibrium
• With a per-unit tax of $T:
– CS decreases (higher PB, lower QT)
– PS decreases (lower PS, lower QT)
– Government gains tax revenue ($T × QT)
– What happens to total surplus?

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EXAMPLE 1: The effects of a tax – 1
Welfare without a tax P
(PE, QE),
CS = A + B + C A
PS = D + E + F S
B C
Tax revenue = 0 PE
D E
D
Total surplus F
= CS + PS
=A+B+C
Q
+D+E+F QT QE

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EXAMPLE 1: The effects of a tax – 2
With the tax (PB, PS, QT), C + E is called the deadweight
P loss (DWL) of the tax, the fall in
• CS = A total surplus that results from a
• PS = F market distortion, such as a tax.

• Tax revenue = B + D A
Total surplus PB S
= CS + PS + tax B C
revenue D E
=A+B+D+F PS D
F
The tax reduces total
surplus by C + E
QE – QT = units not sold Q
QT QE
because of the tax
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Figure 3 How a Tax Affects Welfare
A tax on a good reduces consumer surplus (by the area B + C) and producer
surplus (by the area D + E). Because the fall in producer and consumer surplus
exceeds the tax revenue (area B + D), the tax is said to impose a deadweight loss
(area C + E).
Without Tax With Tax Change
Consumer A+B+C A ̶ (B + C)
Surplus
Producer D+E+F F ̶ (D + E)
Surplus
Tax None B+D + (B + D)
Revenue
Total A+B+C+D+E A+B+D+ ̶ (C + E)
Surplus +F F

The area C + E shows the fall in total surplus

and is the deadweight loss of the tax.
Figure 4 The Source of a Deadweight Loss

When the government

imposes a tax on a
good, the quantity sold
falls from Q1 to Q2.
At every quantity
between Q1 and Q2, the
potential gains from
trade among buyers and
sellers are not realized.
These lost gains from
trade make up the
deadweight loss.
EXAMPLE 2: DWL and the gains from trade
Zaria is taking her laundry to Ethan’s dry cleaning and laundry
services business. For this arrangement, each month, Zaria is
willing to pay $165, and Ethan’s cost is $140. They agree on a
price of $150 per month.
A. Calculate CS, PS, and TS.
B. The government imposes a $35 tax on all laundry service
providers. What happens to CS, PS, and TS?

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Active Learning 1: Analysis of a tax
P
A. Compute CS, PS, 400
$
and total surplus
350
without a tax.
300
S
250
B. If a $200 tax per 200
unit is imposed,
150
compute CS, PS, D
100
tax revenue, total
50
surplus, and
DWL. 0
0 25 50 Q
75 100 125
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 The Determinants of the Deadweight Loss
• Price elasticities of supply and demand
– For a given demand, the more elastic the supply curve,
the larger the DWL
– For a given supply, the more elastic the demand curve,
the larger the DWL
• The greater the elasticities of supply and demand
– The greater the deadweight loss of a tax

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EXAMPLE 3: DWL and elasticity of supply – 1
When supply is
inelastic, P
• A change in price S
leads to a small
change in quantity
supplied.
Size
of tax
• DWL is small. D
Q

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EXAMPLE 3: DWL and the elasticity of supply – 2

The more elastic is

the supply, P
• The greater the
change in quantity
S
supplied due to a
Size
change in price... of tax
• The greater the
DWL.
D
Q

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EXAMPLE 4: DWL and elasticity of demand – 1

When demand is
P inelastic,
S • A change in price
Size
leads to a small
of tax change in quantity
demanded.
• DWL is small.
D

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EXAMPLE 4: DWL and the elasticity of demand – 2
The more elastic is
P demand,
S
• The greater the
change in quantity
demanded due to
Size a change in
of tax price…
D

• and the greater the

Q DWL.

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Figure 5 Tax Distortions and Elasticities
In panels (a) and (b), the demand
curve and the size of the tax are
the same, but the price elasticity
of supply is different. Notice that
the more elastic the supply curve,
the larger the deadweight loss of
the tax.

In panels (c) and (d), the supply

curve and the size of the tax are
the same, but the price elasticity
of demand is different. The more
elastic the demand curve, the
larger the deadweight loss of the
tax.
Active Learning 2: Elasticity and the DWL
In each situation, explain if the DWL of a tax would be larger if
the tax were imposed on:
A. Only Mountain Dew or soda in general?
B. Airfare in the short run or airfare in the long run?
C. Groceries or meals at fancy restaurants?

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 How Big Should the Government Be? – 1
• If taxes result in large DWL
– The DWL = strong argument for a leaner government (does less
and taxes less)
• If taxes impose small DWL
– Government programs are less costly than they otherwise might
be
– Argument for a more expansive government.
• Marginal tax rate on labor income = 40%
– Social Security tax, Medicare tax, federal income tax, state
income taxes
– Biggest source of government revenue
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 How Big Should the Government Be? – 2
40% marginal tax rate on labor income – how big is the
DWL?
– Depends on the elasticity of labor supply
• Some economists: labor supply is fairly inelastic
– Almost vertical: most people would work full-time regardless of
wage
• Workers in their prime working years and main breadwinners
of their families
– Tax on labor leads to a small DWL

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 How Big Should the Government Be? – 3
Other economists: labor supply is more elastic
– Labor taxes are highly distortionary
– Many groups of workers have elastic supply and respond more to
incentives
• Many workers can adjust their hours
• Many families have 2nd earners; some discretion over whether
and how much to work
• Many people can choose when to retire; incentive to work part-
time
• Some work in the “underground economy” to evade taxes

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 The Laffer Curve – 1

“A cut in federal income tax rates in the United States

right now [2012] would lead to higher national
income within five years than without the tax cut.”

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 DWL and Tax Revenue as Taxes Vary
• As the tax increases
– Deadweight loss increases
• Even more rapidly than the size of the tax
– Tax revenue
• Increases initially
• Then decreases
• The higher tax: drastically reduces the size of the market

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EXAMPLE 5: DWL and the size of the tax – 1
Initially, the tax is T P
per unit. new
DWL
S
• Increasing the tax
to 2T per unit… 2T T

D
initial
• causes the DWL DWL
to more than
double. Q
Q2 Q1

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EXAMPLE 5: DWL and the size of the tax – 2
Initially, the tax is T P
new
per unit. DWL

S
• Increasing the tax
even more, to 3T 3T T
per unit… D
initial
DWL
• causes the DWL
to more than Q
Q3 Q1
triple.
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EXAMPLE 6: Revenue and the size of the tax
When the tax is P
small, increasing
PB3
it causes tax
PB2
revenue to rise. S
PB1
3T 2T T
When the tax is PS1 D
larger, increasing PS2
it causes tax PS3
revenue to fall. Q
Q3 Q2 Q1

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 DWL and tax revenue as taxes vary
DWL Tax revenue

The Laffer curve

Tax size Tax size

When a tax increases, When a tax increases, tax

DWL rises even more. revenue initially increases,
then decreases.
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Figure 6 How Deadweight Loss and
Tax Revenue Vary with the Size of a Tax
The deadweight loss is the reduction in total
surplus resulting from the tax. Tax revenue is
the size of the tax multiplied by the amount of
the good sold. In panel (a), a small tax has a
small deadweight loss and raises a small
amount of revenue. In panel (b), a somewhat
larger tax has a larger deadweight loss and
raises more revenue. In panel (c), a very large
tax has a very large deadweight loss, but
because it reduces the size of the market so
much, the tax raises only a small amount of
revenue. Panels (d) and (e) summarize these
conclusions. Panel (d) shows that as the size
of a tax grows larger, the deadweight loss
grows larger. Panel (e) shows that tax revenue
first rises and then falls. This relationship is
called the Laffer curve.
 The Laffer Curve – 2

“A cut in federal income tax rates in the United States

right now [2012] would raise taxable income enough
so that the annual total tax revenue would be higher
within five years than without the tax cut.”

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 CHAPTER IN A NUTSHELL
• A tax on a good reduces the welfare of buyers and sellers,
and the reduction in CS and PS usually exceeds the
revenue raised by the government.
– The fall in total surplus is DWL of a tax.
• Taxes have deadweight losses (DWL).
– Buyers consume less and pay a higher P.
– Sellers produce less and receive a lower P.

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 CHAPTER IN A NUTSHELL
• Large S and D elasticities: larger DWL
• As a tax grows larger
– Distorts incentives more
– Its DWL grows larger
– Tax revenue first rises with the size of a tax, but if the tax
gets large enough, tax revenue starts to fall.

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