Ch 8. The Costs of Taxation

.title[
# Ch 8. The Costs of Taxation
]
.subtitle[
## Microeconomics for Students of Accounting, Finance, and Digital Applications
]
.author[
### Lyuben Ivanov, PhD; Georgi Ganev, PhD
]
.institute[
### Sofia University St. Kliment Ohridski
]
.date[
### Fall Term 2024/2025
]

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<strong>  Introduction</strong>
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# Review of Taxes

Taxes are money transferred from the private sector (either buyers or sellers) to the government. There are many kinds of taxes but they can be divided into two categories: direct and indirect taxes.

A tax

-   Drives a wedge between the price buyers pay and the price sellers receive

-   Raises the price buyers pay and lowers the price sellers receive

-   Reduces the quantity bought and sold

These effects are the same regardless of whether the tax is imposed on buyers or sellers and are easy to see on a demand and supply diagram!

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# Demand and Supply Diagram

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# Taxation: A Key Assumption

Under taxation, what is taken from participants in market transactions goes to the government, which spends it according to its discretion for specific policies.

The government can use the tax revenue to provide public goods and services, redistribute income, and influence market outcomes.

An important starting assumption: the government spends the taxes taken from economic agents efficiently. This assumption is unrealistic, but allows to concentrate on the theoretically important effects of taxation on welfare!

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# Deadweight Loss of Taxation

<table class="none">
  <tr style="background-color: transparent;">
    <td style="text-align: center; vertical-align: top; width: 240px;"><b>deadweight loss</b></td>
    <td> </td>
    <td> </td>
    <td>the fall in total (social) surplus that results from a market distortion</td>
  </tr>
</table>

<table class="none">
  <tr style="background-color: transparent;">
    <td style="text-align: center; vertical-align: top; width: 240px;"><b>deadweight loss of taxation</b></td>
    <td> </td>
    <td> </td>
    <td>the drop in total (social) surplus that results from imposing taxes on a market</td>
  </tr>
</table>

The deadweight loss of taxation is unobservable in the "real world", but we can see it on a supply and demand diagram (if we know where to look!).

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# Deadweight Loss Diagram

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# Quick Test

<div class="container">
    <div class="question">
        <p>Which of the following statements is incorrect?</p>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice1" id="choiceA1" value="A">
        <label class="form-check-label" for="choiceA1">
            A tax on a good reduces the welfare of buyers and sellers.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice1" id="choiceB1" value="B">
        <label class="form-check-label" for="choiceB1">
            The welfare loss of buyers and sellers, measured in monetary terms, exceeds the revenue the tax raises for the government.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice1" id="choiceC1" value="C">
        <label class="form-check-label" for="choiceC1">
            A tax has a deadweight loss because it causes consumers to buy more and producers to sell less
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice1" id="choiceD1" value="D">
        <label class="form-check-label" for="choiceD1">
            A tax has a deadweight loss because it causes shrinking of the market below the level that maximizes total surplus.
        </label>
    </div>
    <br>
    <button class="btn btn-custom mt-3" onclick="checkAnswer('C', 'result1', 'choice1')">Submit</button>
    <div class="result" id="result1"></div>
  </div>

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# Quick Test

<div>
    <p>On the diagram, the maximum willingness to pay of the buyers is equal to 60, the minimum willingness to sell of the sellers is 20, and the tax is 10. The equilibrium price is 25, the price buyers pay is 33.75, the equilbrium quantity is 25, and the quantity traded after tax is 18.75. How much is the deadweight loss of taxation?</p>
</div>

<div style="position: relative; top: 0px">
    <input type="text" id="userAnswer1" placeholder="Answer" class="input-field"><button onclick="checkAnswerO(31.25, 'result1', 'userAnswer1')" class="submit-button">Check</button>
</div>
<div id="result1"></div>
  
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# Quick Test

<div style="position: relative; top: 0px">
    <input type="text" id="userAnswer2" placeholder="Answer" class="input-field"><button onclick="checkAnswerO(187.5, 'result2', 'userAnswer2')" class="submit-button">Check</button>
</div>
<div id="result2"></div>
  
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# Quick Test

<div class="container">
    <div class="question">
        <p>Which of the following statements is correct?</p>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice2" id="choiceA2" value="A">
        <label class="form-check-label" for="choiceA2">
            An increase in the size of a tax causes tax revenue to rise at first, but eventually revenue falls because the tax increases the size of the market.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice2" id="choiceB2" value="B">
        <label class="form-check-label" for="choiceB2">
            An increase in the size of a tax causes tax revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice2" id="choiceC2" value="C">
        <label class="form-check-label" for="choiceC2">
            An increase in the size of a tax causes tax revenue to fall at first, but eventually revenue rises because the tax reduces the size of the market.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice2" id="choiceD2" value="D">
        <label class="form-check-label" for="choiceD2">
            An increase in the size of a tax causes tax revenue to fall at first, but eventually revenue rises because the tax increases the size of the market.
        </label>
    </div>
    <br>
    <button class="btn btn-custom mt-3" onclick="checkAnswer('B', 'result2', 'choice2')">Submit</button>
    <div class="result" id="result2"></div>
  </div>

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# Laffer Curve Diagram

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# Arthur Laffer (1940&mdash;&nbsp;)

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# Quick Test

<div class="container">
    <div class="question">
        <p>An increase in the size of a tax causes the deadweight loss to</p>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice3" id="choiceA3" value="A">
        <label class="form-check-label" for="choiceA3">
            fall.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice3" id="choiceB3" value="B">
        <label class="form-check-label" for="choiceB3">
            rise.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice3" id="choiceC3" value="C">
        <label class="form-check-label" for="choiceC3">
            fall exponentially.
        </label>
    </div>
    <div class="form-check">
        <input class="form-check-input" type="radio" name="choice3" id="choiceD3" value="D">
        <label class="form-check-label" for="choiceD3">
            rise exponentially.
        </label>
    </div>
    <br>
    <button class="btn btn-custom mt-3" onclick="checkAnswer('D', 'result3', 'choice3')">Submit</button>
    <div class="result" id="result3"></div>
  </div>

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# Deadweight Loss Diagram

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# Effects of Taxation on Welfare

<table class="none">
  <tr style="background-color: transparent;">
    <td style="text-align: right; vertical-align: top; width: 50px;"><i class="fa fa-plus"></td>
    <td style="width: 20px"> </td>
    <td style="text-align: left; vertical-align: top; width: auto;">Tax revenues finance the activities of the state, which themselves may be very useful and welfare-generating in a way which cannot be substituted by ordinary market interaction (the usual examples for such government activities are defense, maintaining public order, administration of justice).</td>
  </tr>
</table>

<table class="none">
  <tr style="background-color: transparent;">
    <td style="text-align: right; vertical-align: top; width: 50px;"><i class="fa fa-minus"></td>
    <td style="width: 20px"> </td>
    <td style="text-align: left; vertical-align: top; width: auto;">Taxation decreases total welfare of society with respect to the goods or resources taxed, because it leads to people abstaining from economic activity in which they would have engaged in in the absence of taxation.</td>
  </tr>
</table>

<table class="none">
  <tr style="background-color: transparent;">
    <td style="text-align: right; vertical-align: top; width: 50px;"><i class="fa fa-balance-scale"></td>
    <td style="width: 20px"> </td>
    <td style="text-align: left; vertical-align: top; width: auto;">Taxation allows government to potentially generate welfare in ways important for society, but it is crucial to always include the welfare cost (the deadweight loss) of taxation when deciding whether and how much government activities should be financed through taxes!</td>
  </tr>
</table>

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<strong>  Taxation and Elasticity</strong>
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# Deadweight Loss and Elasticity

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# <span style="position: relative; top: -75px">Deadweight Loss and Elasticity of Demand and Supply</span>

The link between elasticities and deadweight loss means that:

-   Taxation of inelastic (in demand or supply) goods and resources leads to smaller deadweight loss and, other things equal, is to be preferred from welfare point of view

-   The effect of taxation on welfare is larger in the long run than in the short run due to the fact that in the long run elasticities are higher

From the point of view of long-run welfare, lower taxes, which lead to smaller distortions and welfare losses, are to be preferred to higher taxes, which lead to larger distortions and welfare losses!

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<strong>  Case Study: Trump's Tariffs</strong>
]
<hr>

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.pull-right-2[
_To me, the most beautiful word in the dictionary is tariff. It's my favorite word. It needs public relations firm to help it, but to me it is the most beautiful word._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
<span style="float: right; font-variant: small-caps; "> Donald Trump </span>
]

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# <span style="position: relative; top: -75px">Tariff Imposed on Relatively Price Elastic Goods</span>

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# <span style="position: relative; top: -75px">Tariff Imposed on Relatively Price Inelastic Goods</span>

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<strong>  Conclusion</strong>
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<hr>

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# How Big Should the Government Be?

A bigger government:

The larger the deadweight loss from taxation, the greater the argument for smaller government!

The tax on labor income is especially important because it is the largest source of government revenue in most countries! But how big is the deadweight loss?

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# How Big Should the Government Be?

Arguments that labor supply is fairly inelastic with respect to wage:

-  People work to in order to find meaning in life and maintain their self-esteem/social status

-  People have to work to maintain their standard of living

Arguments that labor supply is fairly elastic with respect to wage:

-  People can choose how many hours to work (part-time vs. full-time)

-  People can choose when to work (retired vs. working)

-  People can choose whether to work at all (stay-at-home parents vs. working parents)

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# Questions?

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# Thank You!

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