Deadweight Loss and Taxes

Governments have many powers to affect welfare but each power involves choices about who wins and who looses as a result.

Taxes tend to spread the losses across society in general through the “social climate”.

Prescriptions have direct effects on specific sectors and as such deal with the “business climate”.

Taxes are a distortion

• Taxes and subsidies distort the market and produce what is called deadweight loss because it removes from the market economic surplus that would otherwise benefit consumers and employ resources for production.

• The deadweight loss depends on the elasticities of supply and demand and therefore as to whether or consumers or producers “win” or “loose”.

• However Suppliers also win or loose and it is the relative impact on suppliers that may have the most profound economic impact.

Deadweight Loss• Deadweight Loss is calculated as Surplus Before less Surplus After for Producers and for Consumers in total. This is economic

surplus that cannot be recovered after the tax. Suppliers also loose but it is assumed that they are able to find markets in other sectors and are not part of the deadweight loss.

Price

Quantity

Supply

Demand

Consumer Surplus After

ConsumerSurplus BeforePrice with tax

Price before tax

Quantity with tax Quantity without tax

Producer Surplus After

Producer Surplus Before

Supplier Surplus BeforeSupplier

Surplus After

Elasticities Determine “winners” and “losers”. As demand becomes more inelastic CS falls and taxes are ineffective because consumers

substitute out of the market and suppliers follow. As supply becomes more elastic PS rises and taxes are ineffective because producers cannot

change production and suppliers are cut out of the market. Only when demand and supply are measurably elastic will there be a long term deadweight loss.

Perfectly Inelastic Demand

Perfectly Inelastic Supply

Measurably Elastic Supply

Measurably Elastic Demand

Price

Quantity

Perfectly Elastic Supply

Perfectly Elastic Demand

Governments Perspective on Deadweight Losses

• Tax revenue may “capture” the deadweight loss and the government can then redistribute the wealth in a socially responsible way which the market would not.

• Deadweight losses are dependent on elasticities and the government may be able to change the elasticity of demand by:– Education and public awareness making demand

more inelastic.– Research and development efforts making supply

more inelastic.– Using prescriptions to “block out” a market.

Making Demand Inelastic• When demand is relatively inelastic the deadweight loss of a tax is relatively small.• When demand is relatively elastic the deadweight loss of a tax is relatively Large.

Deadweight LossIs relatively small

Deadweight LossIs relatively large

Inelastic Demand Elastic Demand

SupplySupply

DemandDemand

Making Supply Inelastic• When supply is relatively inelastic the deadweight loss of a tax is relatively small.• When supply is relatively elastic the deadweight loss of a tax is relatively Large.

Deadweight LossIs relatively small

Deadweight LossIs relatively large

Inelastic SupplyElastic Supply

Supply

Demand

Supply

Demand

Blocking Out a Market • When Demand and Supply are inelastic the market is blocked out, as would be done by a benevolent social

planner so taxes would not be needed and Total Revenue is fixed for all markets including supply markets

Inelastic Supply

Inlastic Demand

Total Revenue is fixed.

The Public Policy Debate• Taxes force consumers to prioritize expenditure and in the long run this may lead to abandoning a market

entirely. As tax rates increase the deadweight loss increases at an increasing arte. As the tax rate increases though the revenue increases and then decreases. There is a tax rate and level of welfare loss beyond which deadweight losses are not recoverable.

Tax RevenueDeadweight Loss$

Tax Size Percentage

Deadweight Loss

Tax Revenue

Tax Burden Rate

Redistribution Level

Tax Limits

• There are limits to taxation that will preserve a market. Governments generally view this as the level above which they cannot redistribute welfare losses caused by taxation.

• The business climate in a free market economy with democratic freedoms allow for information to be widely understood by all members of society.

• Even though surpluses may be manipulated they are never eliminated and when taxes are removed or government prescriptions are relaxed the surpluses are re-instated.