An illustrated tutorial on the deadweight loss of taxation, how it varies with the the relationship between deadweight loss and tax revenue, and how these. First, we must examine the difference between legal tax incidence and economic .. b) If there is no deadweight loss, then revenue raised by the government is. Relationship between tax revenues, deadweight loss, and demandelasticity. The government is considering levying a tax of $ per unit on suppliers of either.
Now, let's think about what happens when you add the tax. This is what the suppliers are going to get or the producers are going to get, but when you put a tax, the consumers are going to have to pay a dollar more.
They're going to have to pay that much. One way to think about it is the supply curve, from the consumer's point of view, is going to be shifted a dollar more than the supply curve from the producer's point of view. I can do a better job than that. It's going to look something like that.
From the consumer's point of view, what we have is now a new price that they're willing to consume at, because now this reality is not possible anymore. It's about, let's just say just for round numbers, that's about 3 million burgers per day. Before this whole area was a total surplus.
Below this green line was the producer surplus, above the green line and below this curve right here was the consumer surplus.
Taxation and dead weight loss
Now we've lost part of it. We've lost this part right over here, so this is our dead weight loss. This is no longer part of the total consumer and producer surplus. That is dead weight loss.
The taxation got us from an efficient situation, where we had that maximum consumer and producer surplus. This is our dead weight loss over here.Chapter 8: Application: The Costs of Taxation.
How much revenue is the government going to get now? Well, if we assume that this is 3 million, they're going to have 3 million burgers. This is 3 million right over here.
Deadweight Loss of Taxation
They're going to have 3 million burgers times a dollar per burger. Let me do it this way. This length right over here is going to be the area of this rectangle that I'm doing in orange.
This length right over here is 3. That length right over there is 3 million and then height is that dollar. Let me shade it in. The height is that dollar right over there. The actual clearing quantity or the actual equilibrium quantity now is only going to be 3 million. The way we see it, it removed this surplus here, from both the consumer surplus and the producer surplus and no one's getting that, not even the government's getting that.
No one's getting that white part right over there and this orange part right over here is eating into the consumer surplus, so now they're paying more than Another way to think about it is the difference between the benefit they're getting and what they're paying at any given point, for any given incremental consumer, is now less and the producer surplus is less.
The excess of what they're getting for each hamburger versus their opportunity cost is now less. Although, as described later, there is no deadweight loss in taxing gratuitous transfers, such transfers benefit the wealthy, so they are taxed considerably less than work.
He argued that tax revenue generated from labor increases at first, but then, at a certain point, it starts to decline until it reaches zero. In the s, the Republicans presented this argument as a way to increase tax revenue by actually lowering tax rates. Of course, this argument only makes sense if anyone knew that the economy was actually past the point of maximum tax revenue.
He argued that if taxes were lower, then people would work harder, yielding more tax revenue. This came to be known as supply-side economics, because lower taxes increases the supply of everything, but especially labor. While the above argument makes sense to some extent, the supply of labor is relatively inelastic, since most everyone except the wealthy have to work to survive.
Hence, the tax burden on labor falls on labor. This is best evidenced by the fact that when Bill Clinton increased the tax rate, particularly on the wealthy, tax revenue increased proportionately.
So the economy must have been before the maximum tax revenue point. Deadweight Loss of Transaction Taxes, Value Added Taxes, and Property Taxes Transaction taxes include taxes on buying and selling propertywhich includes sales and use taxes, excise taxes, and value-added taxes. Transaction taxes also incur a deadweight loss, since they increase the price for the buyer and decrease the money received by the seller.
Property taxes on raw land incur no deadweight loss because its supply is perfectly inelastic. However, there is some deadweight loss from property taxes on developed land since they may impact development. More info on tax types: However, the supply of investments is also inelastic, because you can only do 3 things with money: Poor people spend all their money, but the wealthy have much more money than they can spend on life's necessities, or even its conveniences.
If they keep it, then inflation diminishes its value. Furthermore, money has a time value which is forfeited if the money is not invested.
Even if investment income was highly taxed, people would still invest because it does not require the time and effort that work requires. Indeed, the type of investment that requires the least amount of effort — long-term capital gains — is taxed the least. Another reason that deadweight loss is lower on investment income than on working income is because higher taxes help to reduce the sting of losses. Taxes on investment income reduces the net income received, but it also reduces losses.
You make 2 investments: So taxes on investment income helps to mitigate losses, which offsets some of the deadweight loss of the tax. These are often referred to as gratuitous transfer taxes because the beneficiaries do nothing to earn their gift. When a person dies, governments can either choose to tax the estate of the deceased person or tax the inheritance that the beneficiaries receive, or a combination of both, or neither. Because death is inevitable and because beneficiaries do nothing to earn their inheritance, no deadweight loss arises from either estate taxes or inheritance taxes collectively known as death taxes.
The deadweight loss of gratuitous transfer taxes is zero — tax revenue increases proportionately with the tax rate, as can be seen from this graph of the Laffer curve for gratuitous transfer taxes. Elasticity of supply and demand is usually discussed with respect to prices. Property transferred gratuitously, by definition, has no price, so elasticity in regard to the supply and demand for gratuitous property must be measured in regard to the tax itself.
For gift taxes, under federal tax law, demand is also perfectly inelastic, since the beneficiaries pay nothing for the gift in the United States, the donor pays the gift tax — not the donee. Therefore, beneficiaries will take whatever is given to them.
Although gift taxeswhether they are assessed on the donor or the donee, may reduce the number or value of gifts given, this has no economic consequence, since gifts are freely given. Moreover, since everyone will have to part with their property either while they are alive or when they are dead, all their property will either be a gift or a bequest — hence, there is no deadweight loss from gratuitous transfer taxes.
This amount greatly exceeds what most American workers will earn in their entire lives. So if there is a large deadweight loss from income taxes on work, but no deadweight loss from gratuitous transfer taxes, why is working income the most heavily taxed form of income while gratuitous transfers are taxed the least? Where is the unified tax credit for labor? The answer is because gratuitous transfers benefit mostly the wealthy, allowing them to increase their wealth from generation to generation, part of which is used to influence politicians to maintain the status quo.
Moreover, most politicians are also wealthy. Since many politicians come from wealthy families, they receive a great deal of wealth as beneficiaries, and most have a great deal to pass on, since they often become wealthier while holding office. So politicians have a vested interest in keeping gratuitous transfer taxes low, or even eliminating them entirely, as the Republicans want to do.
The Republicans did try to eliminate gratuitous transfer taxes in their latest tax reform for the wealthy, the Tax Cuts and Jobs Actbut there was no way they could eliminate these taxes completely without exploding the deficit even more than they already are. Deadweight Loss from Imperfect Competition Deadweight loss also arises from imperfect competition, especially from oligopolies and monopolies.
This deadweight loss arises because these firms restrict supply to increase prices over and above average total costs. The higher prices will still restrict some consumers from enjoying the product, and as with the deadweight loss of taxation, it will reduce the consumer surplus of the remaining buyers, but the restricted supply allows these firms to enjoy economic profitsprofits that exceed the normal profits included in average total costs.
However, the additional revenue from the higher prices goes not to the government, in the form of taxes, but to the price-setting firms, in the form of additional producer surplus.