Basic Economics

Tax and Deadweight Loss

We saw earlier how taxes on goods and services of businesses can change the demand by citizens, supply, and equilibrium price and quantity. Taxes provide revenues to the government and are usually paid by both buyers and sellers. To see the welfare effect of taxes, we need to compare the revenue received by the government, and the dead weight loss (also known as "excess burden" or "distortionary cost") to the consumers and producers.

Deadweight Loss of Taxation

Recall that in a competitive market, a given tax surcharge added to the price of each unit of a particular good (gasoline tax, food tax, federal tax) will:

  • lower the price received by the seller and;
  • increase the price paid by the buyer.

This allows us to use supply and demand diagram to analyze the effects of a tax on total surplus. We see that the tax places a wedge between the gross price and net prices, and the equilibrium quantity will fall as a result of the tax. What are the gains and losses as a result of a tax? The government receives tax revenue of T x Q, where T is the amount of tax per unit, and Q is the quantity sold. This is a benefit to those on whom the government spends the tax revenue.

To see the welfare losses, consider the total surplus before and after the tax. Deadweight loss, also known as "excess burden", is a pure loss to society. It represents lost value to consumers and producers due to the reduction in the sales of the good, but not captured by government revenue. In other words, the loss to consumers and producers from the tax is larger than the size of the tax revenue.

Determinants of Deadweight Loss

How large will the deadweight loss be from a particular tax? It depends on how much a given tax reduces the amount that:

  • consumers are willing to purchase and;
  • producers are willing to supply.

What determines how much the market will shrink? Reduction in quantity supplied as a result of a tax depends on the elasticity of supply. Generally, the more inelastic the supply, the smaller the reduction in quantity, and the smaller the deadweight loss. Reduction in quantity demanded depends on the elasticity of demand. Generally, the more elastic the demand, the more quantity demanded decreases and the greater the deadweight loss.

In general, the smaller the decrease in quantity, the smaller the deadweight loss. This occurs since the main cost of a tax is that it shrinks the size of a market below its optimum level. Overall, the more elastic the supply and demand, the larger the dead weight loss of a tax.

Deadweight Loss and Tax Revenue

For the most part, tax revenue will first increase as we raise taxes but as the gross price keeps rising, the quantity decreases more and more. Eventually, the tax revenue will also begin to decrease. the more inelastic the demand, the slower the tax revenue falls. This helps to explain why governments often put taxes on goods in inelastic demand like tobacco and gasoline. Overall, taxes on specific items will:

  1. Influence people’s behaviour by inducing them away from the goods that are taxed.
  2. Raise revenue for the government to spend, making those who receive the expenditures better off.
  3. Create a dead weight loss.