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Lecture 9

EC120 Lecture Notes - Lecture 9: Black Market, Laffer Curve, Tax Rate

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ECON120 MICRO, Natasha Park
Chapter 8 - The Costs of Taxaon
Without tax, the equilibrium price is PE, and quan"ty is QE
When the government imposes a tax of $T per unit
- The price buyers pay is PB
- The price sellers receive is PS
- The quan"ty demanded/sold is Qr
- The tax revenue = T x Qr
Total Surplus
Tax revenue is included in total surplus, because tax revenue can
be used to provide services such as roads, educa"on, etc.
Without a tax with a tax
CS = A + B + C CS = A
PS = D + E + F PS = F
TS = A + B + C + D + E + F A + B + D + F
Tax revenue AFTER tax = B + D
Deadweight loss: TS falls by C + E
Deadweight Loss
Results from a market distor"on, such as a tax fall in TS
Losses to buyers/sellers exceed the revenue raised by government
Value of the units C + E to buyers is greater than the cost of
producing them, so the tax has prevented some mutually bene6cial trades
The goods/services with the smallest deadweight loss are taxed depends on elas"city of S & D
- Inelas"c supply/demand = small deadweight loss
- Elas"c supply/demand = large deadweight loss
- tax causes less Q, so elas"city determines how MUCH the tax
distorts the market outcome
The deadweight loss increases more than by the amount the tax
increases the higher the tax rate, the more the deadweight loss is
a;ected when the tax rate is changed. (more “elas"c” at high tax rates)
- When tax is small, increasing it causes revenue to rise
- When the tax is large, increasing it decreases revenue
Laer curve shows rela"onship between size of the tax and tax revenue
Tax reduces QD, raises P buyers pay and lowers P sellers receive regardless of who its imposed on
How big should the government be?
A bigger government provides more services, but requires higher taxes causes deadweight loss
For many workers, marginal tax rate (tax on last dollar of earnings) is almost 50% ra"onal people
- If labor supply is inelas"c, then the deadweight loss is small they work regardless of the wage
- But when labor supply is elas"c, deadweight loss is large
1. Many workers can adjust hours (work over"me)
2. Many families have 2 workers with discre"on over whether/how much to work
3. Elderly choose when to re"re based on their wages
4. Some work in the “underground economy” to evade high taxes
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