Micro Ch08 Lecnotes 6e

7/28/2019 Micro Ch08 Lecnotes 6e

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PowerPoint Lecture Notes for Chapter 8: Application: The Costs of Taxation

Pri nciples of Microeconomics4th

edition, by N. Gregory Mankiw

PowerPoint Slides by Ron Cronovich

2006 Thomson South-Western, all rights reserved

N . G R E G O R Y M A N K I W

PowerPointSlidesby Ron Cronovich

8

P R I N C I P L E S O F

F O U R T H E D I T I O N

MICROECONOMICS

Application: The Costs of TaxationApplication: The Costs of Taxation

This chapter builds very closely on material from the previous threechapters: It uses the tools of welfare economics (from chapter 7) toanalyze the effects of a tax (introduced in chapter 6). It explores therelationship between the price elasticities of demand and supply(chapter 5) with the deadweight loss of the tax. Covering thischapter immediately after the previous three will reinforce theconcepts students learned in those chapters.

The material in chapter 8 is important. The government must raiserevenue to pay for the police, the court system, interstate highways,national defense, public education, and so forth. The governmentmust choose which goods to tax, and how much to tax each one.Effective tax policy generates the needed revenue while striving for(the sometimes conflicting goals of) efficiency and equity.

This is not one of the longer chapters; most instructors cover it in 1.5or 2 hours of class time. But if youre pressed for time and lookingfor things to cut, you might consider cutting some of these (mypersonal suggestions, not the official recommendations of GregMankiw or Thomson Learning):* revenue and the size of the tax, the Laffer Curve* DWL and the size of the tax* Active Learning 3, the slide with the discussion question on

whether to tax groceries or meals at fancy restaurants* Active Learning 2

CHAPTER 8 APPLICATION: THE COSTS OF TAXATION 1

In this chapter, look for the answers tothese questions:

How does a tax affect consumer surplus, producer

surplus, and total surplus?

What is the deadweight loss of a tax?

What factors determine the size of this deadweight

loss?

How does tax revenue depend on the size of the

tax?


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Review from chapter 6:

A tax is a wedge between the price buyers pay

and the price sellers receive.

A tax raises the price buyers pay, and lowers the

price sellers receive.

A tax reduces the quantity bought & sold.

These effects are the same whether the tax is

imposed on buyers or sellers, so we do not

make this distinction in this chapter.


QT

The effects of a taxP

Q

D

S

With no tax,

eqm price is PEand quantity is QE.

PS

PB

PE

QE

Govt imposes a

tax of $Tper unit.

the price sellers

receive is PS,and quantity is QT.

The price buyerspay is PB,

Size of tax = $T



Q

D

S

The tax generates

revenue equal to

$T x QT.

PS

PB

PE

QEQT

Size of tax = $T


The effects of a tax

Next, we use the tools of welfare economics to

measure the gains and losses from a tax.

We will determine consumer surplus (CS),

producer surplus (PS), tax revenue, and total

surplus with and without the tax.

Tax revenue is included in total surplus,

because tax revenue can be used to provideservices such as roads, police, public education,

etc.


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Q

D

S

Without a tax,

PE

QEQT

A

B C

D E

F

CS = A + B + C

PS = D + E + F

Tax revenue = 0

Total surplus= CS + PS

= A + B + C+ D + E + F



Q

D

S

PS

PB

QEQT

A

B C

D E

F

CS = A

PS = F

Tax revenue

= B + D

Total surplus= A + B

+ D + F

With the tax,

The tax causestotal surplus to

fall by C + E



Q

D

S

PS

PB

QEQT

A

B C

D E

F

C + E is called the

deadweight loss

(DWL) of the tax,

the fall in total

surplus that

results from amarket distortion,

such as a tax.


About the deadweight lossP

Q

D

S

PS

PB

QEQT

Because of the tax,

the units between

QT and QE are notsold.

The value of these

units to buyers isgreater than the cost

of producing them,so the tax has

prevented some

mutually beneficial

trades.


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AA CC TT IIVVE LE L EEAA RRNN II NN GG 11::

Analysis of taxAnalysis of tax

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A. Compute

CS, PS, and

total surplus

without a tax.

B. If $100 tax

per ticket,

compute

CS, PS,

tax revenue,total surplus,

and DWL.

D

S

050

100

150

200

250

300

350

400

0 25 50 75 100 125

P

Q

$

The market forairplane tickets

In chapter 7, students learned how to compute the area of trianglesrepresenting CS, PS, and total surplus. This skill is required to dothis exercise.

Most students will need a calculator to do part B.

Your students need not draw the graph in order to do these

calculations. However, if your students have handouts of thesePowerPoint slides with the graphs already on them, ask your studentsto shade the areas corresponding to CS, PS, and so forth directly onthe printed graphs.


Answers to AAnswers to A

11

D

S

CS

= x $200 x 100

= $10,000

0

50

100

150

200

250

300

350

400

0 25 50 75 100 125

P

Q

$

total surplus

= $10,000 + $10,000

= $20,000

PS

= x $200 x 100

= $10,000

P =

The market forairplane tickets


Answers to BAnswers to B

12

D

S

CS

= x $150 x 75

= $5,625

0

50

100

150

200

250

300

350

400

0 25 50 75 100 125

P

Q

$

total surplus= $18,750

PS = $5,625

tax revenue

= $100 x 75

= $7,500

DWL = $1,250

PS=

PB=

A $100 tax onairplane tickets

To compute DWL, simply subtract total surplus with the tax ($18750)from total surplus without the tax ($20,000, which was computed onthe preceding slide).


What determines the size of the DWL?

The govt needs tax revenue to finance roads,

schools, police, etc, so it must tax some goods

and services.

Which ones? One answer is that govt should tax

the goods or services with the smallest DWL.

So when is the DWL small vs. large? Turns out it

depends on the elasticities of supply and demand. Recall: The price elasticity of demand (or supply)

measures how much quantity demanded

(or supplied) changes when the price changes.


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the DWL of atax is small.

When supply

is inelastic,

DWL and the elasticity of supply

P

Q

D

S

Sizeof tax


the larger isthe DWL.

DWL and the elasticity of supply

The more elastic

is supply,

P

Q

D

S

Sizeof tax

In this graph, the demand curve, equilibrium price, and size of the taxare identical to those in the graph on the preceding slide. The onlything thats different is the supply curve here is flatter; as a result, thesame size tax as before causes a larger DWL.


the DWL of atax is small.

DWL and the elasticity of demand

When demand

is inelastic,P

Q

D

S

Sizeof tax


the larger is

the DWL.

DWL and the elasticity of demand

P

Q

D

S

Sizeof tax

The more elastic

is demand,

In this graph, the supply curve, equilibrium price, and size of the taxare identical to those in the graph on the preceding slide. The onlything thats different is the demand curve here is flatter; as a result,the same size tax as before causes a larger DWL.


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Why elasticity affects the size of DWL

A tax distorts the market outcome:

consumers buy less and producers sell less,

so eqmQis below the surplus-maximizing

quantity.

Elasticity measures how much buyers and

sellers respond to changes in price,

and therefore determines how much the

tax distorts the market outcome.


Elasticity and DWL of a taxElasticity and DWL of a tax

Would the DWL of a tax be larger if the

tax were on

A. Rice Krispies or sunscreen?

B. Hotel rooms in the short run or hotel rooms in

the long run?

C. Groceries or meals at fancy restaurants?

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These examples (rice krispies vs. sunscreen) were chosen not becausethey are exciting real-world policy debates, but because they linkback to the examples used in Chapter 5 to help students deduce thefactors that determine elasticity.

Suggestion: Display all three questions and give students a fewmoments to think about it. Then, proceed to the following slides

It might be worth mentioning to students: For each pair of goods, weare considering taxes of similar relative magnitude. (E.g., it wouldntbe fair to ask whether a $10 per bottle tax on sunscreen has a biggerDWL than a $0.01 tax on boxes of Rice Krispies.)


AnswersAnswers

A. Rice Krispies or sunscreen

From chapter 5:

Rice Krispies has many more close substitutes

than sunscreen, so demand for Rice Krispies is

more price-elastic than demand for sunscreen.So, a tax on Rice Krispies would cause a larger

DWL than a tax on sunscreen.

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Suggestion: Display the first line, then invite students to volunteertheir answers before displaying the explanation.


AnswersAnswers

B. Hotel rooms in the short run or long run

From chapter 5:

The price elasticities of demand and supply

for hotel rooms are larger in the long run thanin the short run.

So, a tax on hotel rooms would cause a larger

DWL in the long run than in the short run.

21


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AnswersAnswers

C. Groceries or meals at fancy restaurants

From chapter 5:

Groceries are more of a necessity and therefore

less price-elastic than meals at fancy restaurants.

So, a tax on restaurant meals would cause a

larger DWL than a tax on groceries.

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Discussion questionDiscussion question

The government must raise tax revenue to pay

for schools, police, etc. To do this, it can either

tax groceries or meals at fancy restaurants.

Which should it tax?

23

Engage your students and give them a brief break from lecture. Showthis slide and ask for students to volunteer their thoughts. Thequestion on this slide will almost certainly elicit a few differentopinions.

Of course, there is no single correct answer one choice is notunambiguously better than the other. A tax on groceries would bemore efficient (smaller DWL) than a tax on restaurant meals.However, a tax on groceries would hurt people with low incomesproportionately more than people with higher incomes, as the formerspend a larger percentage of their income on groceries. Hence, such atax would be regressive.

Once again, we see the tradeoff between efficiency and equity.


How big should the government be?

A bigger government provides more services,

but requires higher taxes, which cause DWL.

The larger the DWL from taxation,

the greater the argument for smaller government. The tax on labor income is especially important,

its the biggest source of govt revenue.

For many workers, the marginal tax rate(the tax

on the last dollar of earnings) i s almost 50%.

How big is the DWL from this tax?

It depends on elasticity.

The next few slides are adapted from the section Case Study: TheDeadweight Loss Debate in this chapter of the textbook. The title ofthis slide is actually a direct quote from this section. I think it makesa catchier title for these slides than the deadweight loss debate.

Why the marginal tax rate is relevant: One of the 10 Principles fromChapter 1 is rational people think at the margin. This applies toworkers, as well. When Susan considers increasing her hours, shetakes into account the extra income shed earn from working a fewmore hours a week. The extra income on each additional hour equalsthe hourly wage minus the marginal tax rate.



If labor supply is inelastic, then this DWL is

small.

Some economists believe labor supply is

inelastic, arguing that most workers work

full-time regardless of the wage.

According to this view, the DWL from labor taxes is small. This isrelevant to the question how big should the government be?,because a high DWL would argue for restraining the size ofgovernment.


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Other economists believe labor taxes are highly

distorting because some groups of workers have

elastic supply and can respond to incentives:

Many workers can adjust their hours,e.g. by working overtime.

Many families have a 2nd earner with discretion

over whether & how much to work.

Many elderly choose when to retire based on the

wage they earn.

Some people work in the underground economyto evade high taxes.

The fourth edition of the textbook has a new In The News boxcontaining an excellent WSJ article on the effect of tax rates on workeffort.


The effects of changing the size of the tax

Policymakers often change taxes, raising some

and lowering others.

What happens to DWL and tax revenue when

taxes change? We explore this next.


Q2

Q1

DWL and the size of the tax

P

Q

D

S

causes the DWL

to more than

double.

Doubling the tax

2T T

Initially, the tax isTper unit.

initial

DWL

newDWL

The new DWL is four times the initial DWL, even though the tax isjust twice as large.


Q3


P

Q

D

S

Q1

3T Tcauses the DWL

to more than

triple.

Tripling the tax

Initially, the tax isTper unit.

initialDWL

newDWL

The new DWL is nine times the initial DWL, even though the tax isonly three times as large.


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DWL

Tax size

Summary

When a tax increases,

DWL rises even more.

Implication

When tax rates are

low, raising them

doesnt cause much

harm, and lowering

them doesnt bring

much benefit.

When tax rates are

high, raising them is

very harmful, andcutting them is very

beneficial.

Implication

When tax rates are

low, raising them

doesnt cause much

harm, and lowering

them doesnt bring

much benefit.

When tax rates are

high, raising them is

very harmful, andcutting them is very

beneficial.

The implication in the green box is not in the textbook, andtherefore not supported in the study guide or test bank. So, you maywish to delete it from this slide.

If you keep it, note that the harm of raising taxes and the benefitof lowering them refer to the impact on total surplus.


Q2

Revenue and the size of the tax

P

Q

D

S

Q1

PB

PS

PB

PS

2T T

When the

tax is small,

increasing it

causes taxrevenue to rise.


Q3


P

Q

D

S

Q2

PB

PS

PB

PS

3T 2TWhen thetax is larger,

increasing it

causes taxrevenue to fall.


The Laffer curve

shows the

relationship

betweenthe size of the tax

and tax revenue.


Tax size

Taxrevenue

The Laffer curve

The Laffer curves shown here and in the book are symmetric, andtheir peak occurs in the middle. This need not be the case, andprobably is not the case. However, we just dont know where thepeak is it could be at a tax rate of 20% or a tax rate of 200% - andsurely varies across goods.

The textbook has some excellent discussion of the Laffer curve,President Reagan, and supply-side economics, which you shouldencourage your students to read.


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CHAPTER SUMMARY

A tax on a good reduces the welfare of buyers and

sellers. This welfare loss usually exceeds the

revenue the tax raises for the govt.

The fall in total surplus (consumer surplus,

producer surplus, and tax revenue) is called the

deadweight loss (DWL) of the tax.

A tax has a DWL because it causes consumers to

buy less and producers to sell less, thus shrinking

the market below the level that maximizes totalsurplus.


CHAPTER SUMMARY

The price elasticities of demand and supply

measure how much buyers and sellers respond to

price changes. Therefore, higher elasticities imply

higher DWLs.

An increase in the size of a tax causes the DWL to

rise even more.

An increase in the size of a tax causes revenue to

rise at first, but eventually revenue falls becausethe tax reduces the size of the market.

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Micro Ch08 Lecnotes 6e