Taxes and Subsidies Part 4: Tax Revenue and Economic Welfare

Taxes and Subsidies Part 4: Tax Revenue and Economic Welfare


– So now let’s look
at what revenue the tax will produce
and what effect the tax will have on overall
economic welfare. And, of course, buyers are going
to be made worse off by the tax because the effective price
they’re paying is going up, so they have lower
consumer surplus. Sellers are receiving,
net of tax, a lower price and so they’re going
to have lower producer surplus. But then again, the government gains
some tax revenue and total tax revenue is going
to equal the size of the tax per unit times
the quantity transacted. And remember, of course,
that the tax is going to reduce the quantity transacted
somewhat. Graphically we can see that tax revenue is
going to be this box here, where the width
of the box is equal to the quantity transacted
with the tax. And the height
of the box is equal to the tax per transaction. Here’s a little review question that you can go ahead
and assess yourself on. And then notice
that when we do this, when we start to metal– model overall economic welfare, I think it’s not
very controversial to measure taxes as a cost. Most people don’t like taxes although they may accept
that taxes are necessary to fund government services
and spending. But then the question arises
how to actually value that government spending. And, of course, people get to have very
different opinions on this. Some people will
think that money spent to increase the capabilities
the U.S. military is well-spent and some people will
think that it’s really, you know, very,
very badly spent. Likewise, if money is spent to
help people who are unemployed, some people might think,
well, you know, that’s money well-spent. Other people might think,
you know, we shouldn’t be
encouraging people to, you know, not go out
and search really hard for jobs. So because of
all that we’re going to go ahead and basically just
punt on this idea of value in government spending. And instead just notice that $1 of tax revenue funds $1
of spending. And no matter what,
pretty much, that $1 of spending is income for someone and they
would value it at $1. So we’re going
to treat each dollar of tax revenue
as giving $1 of benefit. That said,
what can we say about how a tax affects
economic welfare? Without the tax, of course, the equilibrium price
would be here at P1, consumer surplus
would be everything above P1
and below the demand curve. So consumer surplus would be
A + B + C. Producer surplus without the tax
would be everything below the price and above
the supply curve. So producer surplus would be
D + E + F. When we have the tax, buyers pay an effective price up here
of P sub B. So once we have the tax in place consumer surplus is
this smaller triangle A, which is above P sub B
and below the demand curve. Producer surplus is everything below P sub S
and above the supply curve. B and D are equal
to the amount of the tax times the number of transactions. So B + D is overall
government revenue. And then C and E, very much like our price
ceilings and price floors, C and E is our deadweight loss. Because what happens here is
transactions have been reduced from Q1 to Q2
and these transactions between Q1 and Q2
were mutually beneficial. But they weren’t mutually
beneficial enough to justify going through with
them once the tax was in place. ‘Cause, remember,
the mutual benefit from a transaction is equal to willingness to pay
minus seller cost. So all these transactions
between Q2 and Q1 generated less gains from trade
than the amount of the tax. And therefore, people
don’t find it worthwhile to go through with them after
the tax has been established. If we draw up a little ledger
here of the economic welfare, we can track the changes. And once we go through with all
that we can see that although B and C are lost
from consumer surplus, B at least shows up as
tax revenue whereas C does not. So C is deadweight loss,
a change in total surplus. A negative change in total
surplus is deadweight loss. D and E are lost
from producer surplus but at least D shows up
as tax revenue, while E is part
of deadweight loss. And this brings up
a somewhat subtle, perhaps even
counterintuitive point. The taxes that you actually
pay are the good part of taxes because the purpose
of taxes is to raise revenue. The really bad part
of taxes is the deadweight loss, is the transactions that were
discouraged by the taxation and the decrease
in economic efficiency that occurred
because of the taxation.

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