the cost of taxes lecture 7 – academic year 2014/15 introduction to economics fabio landini

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.