Costs of Taxation

Taxes are often a source of heated political debate. In 1776, the anger of the American colonies over British taxes sparked the American Revolution. More than two countries later, Ronald Reagan was elected President on platform of large cuts in personal income taxes, and during his eight years in the White House, the top tax rate on income fell from 70 per cent to 28 percent. In 1992, Bill Clinton was elected in part because incumbent George Bush had broken his 1988 campaign promise. Read my lips no new taxes.

At least in this regard, the younger George Bush did not follow in his father’s footsteps. As a candidate he promised a tax cut, and as president he made sure to deliver. His critics however, say are cut taxes too much depriving the government of revenue needed for vital public purposes. Certainly no one would deny that some level of taxation is necessary. As Oliver Wendell Holmes Jr. once said Taxes is what we pay for civilized society.

Because taxation has such a major impact on the modern economy, we return to the topic several times throughout this book as we expand the set of tools we have at our disposal. There we saw how to tax on a good affects its price and the quantity sold and how the forces of supply and demand divide the burden of a tax between buyers and sellers. We extend this analysis and look at how taxes affect welfare the economic well being of participants in a market. In other words, we see how high the price of civilized society can be.

The effects of taxes on welfare might at first seem obvious. The government enacts taxes to raise revenue, and that revenue must come out of someone’s pocket. Both buyer and sellers are worse off when a good is taxed. A tax realizes the price buyers pay and lowers the price sellers receive. Yet to understand more fully how taxes affect economic well-being we must compare the reduced welfare of buyers and sellers to the amount of revenue the government raises. The tools of consumer and producer surplus allow us to make this comparison. The analysis will show that the cost of taxes to buyers and sellers exceeds the revenue raised by the government.

The Deadweight loss of Taxation

We begin by recalling one of the surprising lessons. It does not matter whether a tax on a good is levied on buyers or sellers of the good. When a tax is levied on buyers the demand curve shifts downward by the size of the tax; when it is levied on sellers the supply curve shifts upward by that amount. In either case, when the tax is enacted, the price paid by buyers rises, and the price received by sellers falls. In the end, buyers and sellers share the burden of the tax, regardless of how it is levied.

Figure shows these effects. To simplify our discussion this figure does not show a shift in either the supply or demand curve, although one curve must shift. Which curve shifts depends on whether the tax is levied on sellers (the supply curve shifts) or buyers (the demand curve shifts). We can simplify the graphs by not bothering to show the shift. The key result for our purposes here is that the tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge the quantity sold falls below the level that would be sold without a tax. In other words a tax on a good causes the size of the market for the good to shrink. These results should be familiar.