Tax Revenue and Deadweight Loss
The amount of revenues raised by a commodity tax, and the loss in the economic benefit from exchange (deadweight loss) depend on the supply and demand curves.
Alex Tabarrok (reference below, video on right) illustrates the effects of a tax in the following graph, which shows how the area between the supply curve, demand curve and the vertical axis (which equals the gains from exchange in a no-tax scenario) changes with the introduction of a commodity tax. The economic benefits of the consumer surplus and the producer surplus are reduced and an economic benefit of tax revenue is generated. But the overall benefit is lowered because no one gets the greyed portion, which is called the deadweight loss associated with the tax.
Problems with taxing a good with a high demand elasticity
Tabarrok notes that:
Deadweight loss = value of the trades not made because of the tax
He makes the general case that society is better off if commodity taxes are applied to inelastic goods rather than elastic goods. This is because deadweight losses are larger the more elastic the demand curve is. When demand is inelastic, a tax will not deter many trades.
Tabarrok uses the example of the U.S. federal government introducing in 1990 a 10% tax on luxury yachts – which led to only half the projected revenues because of the decline in yacht sales, while requiring additional expenditures on unemployment benefits for laid off yacht workers – as an example of the problem of trying to gain government revenue through commodity taxes on goods with high elasticity of demand. The aforementioned tax was repealed in 1993.
Practice questions (from MRU Chapter 4)
From http://www.mruniversity.com/node/186784, accessed 29 April 2016.
- Decades ago, Washington, DC, a fairly small city, wanted to raise more revenue by increasing the gas tax. Washington, DC, shares borders with Maryland and Virginia, and it’s very easy to cross the borders between these states. How elastic is the demand for gasoline sold at stations within Washington, DC? In other words, if the price of gas in DC rises, but the price in Maryland and Virginia stays the same, will gasoline sales at DC stations fall a little, or will they fall a lot?
Alex Tabarrok, Tax Revenue and Deadweight Loss, Marginal Revolution University, 12-minute video, at http://www.mruniversity.com/courses/principles-economics-microeconomics/deadweight-loss-definition-yacht-tax, accessed 29 April 2016.
Atlas topic and subject
Page created by: Ian Clark, last modified on 29 April 2016.
Image: Minute 0.20 of MRU Video, at http://www.mruniversity.com/courses/principles-economics-microeconomics/deadweight-loss-definition-yacht-tax, accessed 29 April 2016.