1 Analyzing the Economic Impact of Taxes Module 7.

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Analyzing the Economic Impact of Taxes

Analyzing the Economic Impact of Taxes

Module 7Module 7

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Use demand and supply graphs to analyze the economic impact of taxes.

Compare the pre-tax market outcomes and the post-tax market outcomes.

What happens to consumer surplus following the tax?

What happens to producer surplus when a tax

is imposed on a good?

Identify the deadweight loss created by a tax.

Determine if a tax is efficient.

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ObjectivesObjectives

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A tax can be levied on a buyer or a seller. This means that the government collects the tax directly from the buyer or the seller.

Tax “burden” or “incidence”, on the other hand, refers to who actually bears the tax.

Whether a tax is levied on consumers or producers does not affect the tax incidence.

Some TerminologySome Terminology

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The end results of a tax are:The end results of a tax are:

Consumers typically pay a higher price for the product and there will be a loss of consumer surplus.

The net pricenet price received by producers falls and there will be a loss of producer surplus. The net price means the price after paying the tax. Another way of describing “net price” is the revenue net of tax for each unit sold.

There is a deadweight lossdeadweight loss because of the tax. This deadweight loss is also called the excess burden of the tax.

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Who actually bears the tax?Who actually bears the tax?

The tax burden varies depending on how responsive producers and consumers are to the price change caused by the tax.

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Suppose the tax is levied on the seller of a product. This simply means that the government collects the tax directly from the seller.

Graphically, levying a tax on the seller is shown by a vertical or upward shift of the supply curve by the full amount of the tax.

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The price paid by consumers has gone up from $12 to Pc

but it has not gone up by the full amount of the tax. It has gone up by less than $4.

In order to determine how the burden of the tax is shared, we need to trace its effects as it works through the market.

Let’s see what happens when we add a demand curve to the graph.

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Example: Example: Suppose the government imposes a unit tax Of $4 in the market for wines.

Let S0 = supply curve before the imposition of the tax.

Before Tax

Price paid by the consumer $12

Price received by the seller $12

Quantity sold 480 units

Objective: Compare the pre-tax market outcomes Objective: Compare the pre-tax market outcomes and the post-tax market outcomesand the post-tax market outcomesObjective: Compare the pre-tax market outcomes Objective: Compare the pre-tax market outcomes and the post-tax market outcomesand the post-tax market outcomes

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And now a $4 unit tax is levied on the seller. This is shown by an upwards shift of the supply curve.


The supply curve shifts up by the full amount of the tax. The distance ef = cs= $4

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Before tax After tax

Price paid by the consumer $12 $14Net price received by the seller for every unit sold $12 $14 − $4 = $10

Quantity sold 480 units 360 units

Consumer’s burden of the tax -- $14 $12 = $2

Producer’s burden of the tax -- $1 $10=$2

Benefit to government -- $4 x 360 = $1,440


The price increase to the buyer as a result of the tax

The fall in revenue received by the seller for each unit sold.

The total tax revenue collected by the government.

Tax revenue =unit tax quantity sold

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Following the imposition of the tax,

The supply curvesupply curve shifts up by the full amount of the tax.

The price paid by consumersconsumers has increased.

The net price received by producersproducers has decreased.

The quantity tradedquantity traded has decreased.

The governmentgovernment collects tax revenue (a benefit).

The effects of a tax: a summaryThe effects of a tax: a summaryThe effects of a tax: a summaryThe effects of a tax: a summary

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What happens to consumer surplus when a unit What happens to consumer surplus when a unit tax is imposed on a good?tax is imposed on a good?What happens to consumer surplus when a unit What happens to consumer surplus when a unit tax is imposed on a good?tax is imposed on a good?

Loss in Consumer Surplus = U + V + W - U

= V + W

Before taxBefore tax After taxAfter tax

Price paid by the consumer $12 $14

Consumer Surplus (area) U + V + W U

Consumer Surplus ($) ½ x 480 x 8 = $1,920

½ x 360 x 6 = $1,080

Consumer’s burden of the tax -- $14-$12 = $2

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The consumer surplus loss when a unit tax is The consumer surplus loss when a unit tax is imposedimposedThe consumer surplus loss when a unit tax is The consumer surplus loss when a unit tax is imposedimposed

Loss in Consumer SurplusLoss in Consumer Surplus = V + W = $1,920 - $1,080 = $840

OR calculate the loss in consumer surplus by adding the area of the rectanglerectangle VV and the area of the triangle Wtriangle WArea of rectanglerectangle VV = 2 x 360 = $720 Area of triangle Wtriangle W = ½ x 120 x 2 =$120Therefore, loss in Consumer Surplusloss in Consumer Surplus = $840


Consumer Surplus (area) U + V + W U

Consumer Surplus ($) ½ x 480 x 8 = $1,920

½ x 360 x 6 = $1,080

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Loss in Producer Loss in Producer Surplus = X + Y +Z – Z Surplus = X + Y +Z – Z = X + Y= X + Y

What happens to producer surplus when a unit What happens to producer surplus when a unit tax is imposed on a good?tax is imposed on a good?What happens to producer surplus when a unit What happens to producer surplus when a unit tax is imposed on a good?tax is imposed on a good?


Price received by the producer $12 $10

Producer Surplus (area) X + Y + Z Z

Producer Surplus ($) ½ x 480 x 8 = $1,920

½ x 360 x 6 = $1,080

Producer’s burden of the tax -- $12-$10 = $2

This is the net price to the seller. The buyer pays $14 but the seller cannot keep this entire amount. $4 must be given to the government

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Producer Surplus (area) X + Y + Z Z

Producer Surplus ($) ½ x 480 x 8

= $1,920½ x 360 x 6

= $1,080

Loss in Producer SurplusLoss in Producer Surplus = X + Y = $1,920 - $1,080 = $840

OR calculate the loss in producer surplus by adding the area of the rectanglerectangle XX and the area of the triangle Ytriangle YArea of rectanglerectangle XX = 2 360 = $720 Area of triangle Ytriangle Y = ½ 120 2 =$120Therefore, loss in Producer Surplusloss in Producer Surplus = $840

The producer surplus loss when a unit tax is The producer surplus loss when a unit tax is imposedimposedThe producer surplus loss when a unit tax is The producer surplus loss when a unit tax is imposedimposed

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The deadweight loss of a taxThe deadweight loss of a taxThe deadweight loss of a taxThe deadweight loss of a tax

The deadweight lossdeadweight loss to society is a measure of the inefficiency of a tax. It arises because::

1. the tax drives up the price of the good and lowers the quantity sold (360 units instead of 480 units).

2. For the last unit sold, the marginal benefit ($14) the marginal cost ($10).

Marginal cost of the last unit sold

Marginal benefit of the last unit sold

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Before TaxBefore Tax After TaxAfter Tax

Consumer Surplus U +V + W U Loss = V + W

Producer Surplus X + Y + Z Z Loss = X + Y

Benefit to Government 0 V + X Gain = V + X

Economic Surplus U + V + W + X + Y + Z U + V + X + Z Deadweight loss = W + Y

Part of the consumer surplus loss and producer surplus loss goes to the government in the form of tax tax revenuerevenue (area V + X).

What about the area W+Y? No one gets this. This is a deadweight lossdeadweight loss.

Determining the deadweight loss of a taxDetermining the deadweight loss of a taxDetermining the deadweight loss of a taxDetermining the deadweight loss of a tax

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Identifying the deadweight loss on a graphIdentifying the deadweight loss on a graphIdentifying the deadweight loss on a graphIdentifying the deadweight loss on a graph

Consumer surplus transferred to government

Producer surplus transferred to government

Deadweight loss

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Since a tax creates a deadweight loss, does this mean that it is never a good idea for a government to raise revenues by taxing products?

No, not necessarily. In fact, a tax is considered efficient if the deadweight loss is small relative to the tax revenue raised.

In our example, the deadweight loss = W + Y = $240 and the tax revenue = V + X = $1,440. The deadweight loss is relatively small and therefore this tax is considered efficient.

Should the government impose a tax despite the Should the government impose a tax despite the deadweight loss created? deadweight loss created?

Should the government impose a tax despite the Should the government impose a tax despite the deadweight loss created? deadweight loss created?

1 Analyzing the Economic Impact of Taxes Module 7.

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