What are the dead weightloss from various types of tax plans? How would you change the tax system to promote equality, efficiency, and/or economic growth?

You may want to look at revising our current system, or you may want to look at alternative systems such as the VAT in Europe.

section 8-1

The Deadweight Loss of Taxation

We begin by recalling a lesson from Chapter 6: The ultimate impact of a tax on a market outcome is the same whether the tax is levied on buyers or sellers of a good. A tax levied on buyers shifts the demand curve downward by the size of the tax; a tax levied on sellers shifts the supply curve upward by that amount. In either case, the tax raises the price paid by buyers and reduces the price received by sellers. As a result, how the tax burden is distributed between producers and consumers depends not on how the tax is levied but on the elasticities of supply and demand.

How a Tax Affects Market Participants

Let's now use the tools of welfare economics to measure the gains and losses from a tax on a good. To do this, we must take into account how the tax affects buyers, sellers, and the government. The benefit received by buyers in a market is measured by consumer surplusthe amount buyers are willing to pay for the good minus the amount they actually pay for it. The benefit received by sellers in a market is measured by producer surplusthe amount sellers receive for the good minus their costs of producing it. These are the measures of economic welfare we used in Chapter 7.

What about the third interested party, the government? If is the size of the tax and is the quantity of the good sold, then the government gets total tax revenue of . It can use this tax revenue to fund government services, such as roads, police, and public education, or to help the needy. Therefore, to analyze how taxes affect economic well-being, we use the government's tax revenue to measure the public benefit from the tax. This benefit, however, actually accrues not to the government but to those on whom the revenue is spent.

8-1bDeadweight Losses and the Gains from Trade

To better understand why taxes cause deadweight losses, consider an example. Imagine that Malik cleans Mei's house each week for . The opportunity cost of Malik's time is , and the value of a clean house to Mei is . Thus, Malik and Mei each receive a benefit from their deal. The total surplus of measures the gains from trade in this particular transaction.

Now suppose that the government levies a tax on the providers of cleaning services. There is now no price that Mei can pay Malik that will leave both of them better off. The most Mei would be willing to pay is , but then Malik would be left with only after paying the tax, which is less than his opportunity cost. Conversely, for Malik to cover his opportunity cost of , Mei would need to pay , which is above the value she places on a clean house. As a result, Mei and Malik cancel their arrangement. Malik loses the income, and Mei lives in a dirtier house.

The tax has made Malik and Mei worse off by a total of because they have each lost of surplus. But note that the government collects no revenue from Malik and Mei because they cancel their arrangement. The is pure deadweight loss: It is a loss to buyers and sellers in a market that is not offset by an increase in government revenue. From this example, we can see the ultimate source of deadweight losses: Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

The area of the triangle between the supply and demand curves created by the tax wedge (area in Figure 3) measures these losses. This conclusion can be seen more easily in Figure 4 by recalling that the demand curve reflects the value of the good to consumers and that the supply curve reflects the costs of producers. When the tax raises the price buyers pay to and lowers the price sellers receive to , the marginal buyers and sellers leave the market, so the quantity sold falls from to . Yet as the figure shows, the value of the good to these buyers still exceeds the cost to these sellers. At every quantity between and , the situation is the same as in our example with Malik and Mei. The gains from tradethe difference between buyers' value and sellers' costare less than the tax. As a result, these trades are not made once the tax is imposed. The deadweight loss is the surplus that is lost because the tax discourages these mutually advantageous trades.

8-2The Determinants of the Deadweight Loss

What determines whether the deadweight loss from a tax is large or small? The answer is the price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price.

Let's consider first how the elasticity of supply affects the size of the deadweight loss. In the top two panels of Figure 5, the demand curve and the size of the tax are the same. The only difference in these figures is the elasticity of the supply curve. In panel (a), the supply curve is relatively inelastic: Quantity supplied responds only slightly to changes in the price. In panel (b), the supply curve is relatively elastic: Quantity supplied responds substantially to changes in the price. Notice that the deadweight loss, the area of the triangle between the supply and demand curves, is larger when the supply curve is more elastic.

8-3Deadweight Loss and Tax Revenue as Taxes Vary

Taxes rarely stay the same for long periods of time. Policymakers in local, state, and federal governments are always considering raising one tax or lowering another. Here we consider what happens to the deadweight loss and tax revenue when the size of a tax changes.

Figure 6 shows the effects of a small, medium, and large tax, holding constant the market's supply and demand curves. The deadweight lossthe reduction in total surplus that results when the tax reduces the size of a market below the optimumequals the area of the triangle between the supply and demand curves. For the small tax in panel (a), the area of the deadweight loss triangle is quite small. But as the size of the tax rises in panels (b) and (c), the deadweight loss grows larger and larger.

8-3Deadweight Loss and Tax Revenue as Taxes Vary

Taxes rarely stay the same for long periods of time. Policymakers in local, state, and federal governments are always considering raising one tax or lowering another. Here we consider what happens to the deadweight loss and tax revenue when the size of a tax changes.

Figure 6 shows the effects of a small, medium, and large tax, holding constant the market's supply and demand curves. The deadweight lossthe reduction in total surplus that results when the tax reduces the size of a market below the optimumequals the area of the triangle between the supply and demand curves. For the small tax in panel (a), the area of the deadweight loss triangle is quite small. But as the size of the tax rises in panels (b) and (c), the deadweight loss grows larger and larger.