Taxation and Deadweight Loss Overview

Governments get paid by enforcing taxes on both producers and consumers. When taxes are imposed, this reduces the quantity of a product that will be sold in the market. And whenever the market is not in equilibrium due to an imposed restriction, there will be inefficiencies.

In a perfectly competitive market, both consumer and producer surplus is the same.

But when a tax burden is enforced, it will reduce consumer or producer surplus based on where it is being applied.

This per unit tax is also called Excise Tax – taxes that are imposed on various goods, services and activities. Such taxes may be imposed on the manufacturer, retailer or consumer, depending on the specific tax.

TAXES ON PRODUCERS

If the socially optimum quantity of a given product is 100 at €3, and government enforces a tax on the supply of €2, this means that for the same price €3, the producers will supply less, shifting the Supply Curve to the left, causing a demand loss of 20 (100-80).

We now have 3 players: the Consumer, the Government and the Producer). Before we had the Consumer and Producer Surplus optimized by having each occupy the above and below level of the €3 horizontal line. Now each of these areas has shrunk by €1 each(€1 loss for consumer surplus and €1 loss for producer surplus) and a deadweight loss is now present between 80-100 quantity.

This can also be applied to the consumer, having the effect of a decreased demand, shifting the demand curve to the left. Prices will go down to adjust to the new demand, but a deadweight loss is present to acommodate tax-revenue.

In either case, remember that: The larger the deadweight loss, the larger the tax revenue.

ELASTICITY AND TAX

While government intervention adds a third party to the market making it inneficient as not all supply is going to be equally consumed, it’s important to undertand who bears more of the tax burden.

Perfectly Inelastic Demand – Tax burden paid entirely by the consumer

Relatively Inelastic Demand – Consumers pay the majority of tax

When Demand and Supply’s Elasticity is the same – Consumers and producers share the tax burden equally

Relatively Elastic Demand – Tax burden is mostly paid by the producers

Perfectly Elastic Demand – Tax burden is entirely paid by the producers