Relationship between tax revenue and dead weight loss graph

Deadweight Welfare Loss of Tax | Economics Help

relationship between tax revenue and dead weight loss graph

Deadweight loss refers to the loss of economic efficiency when the not happen and the government would not receive any tax revenue from you. To figure out how to calculate deadweight loss from taxation, refer to the graph shown below. How can tax cause deadweight welfare loss to society? - and inefficient consumer behaviour. Specific tax, income tax and externalities. Answer to Relationship between tax revenues, deadweight loss, and The following graph shows the annual supply and demand for this good. It also shows .

People earn less, firms produce less and government tax revenue may not increase but actually fall. However, this analysis is quite simplistic and ignores certain facts. Income Tax and Incentives The elasticity of labour supply tends to be very inelastic. If income tax increases, your disposable income falls. This acts as an incentive to work longer hours to compensate for the fall in income.

At most levels of income, these tend to balance each other out. In addition, there are often practical difficulties to changing your hours; just because income tax is increased, your boss is unlikely to allow you to do three hours a week less. Certainly at some tax rates, e. Also for the very high earners, it may be practical to actually move abroad and escape high tax rates.

But, the disincentives of higher income tax are often exaggerated. Deadweight Welfare Loss and Specific Taxes In theory, the government should place a tax on goods with negative externalities cigarettes, petrol, alcohol, e.

This is because negative externalities are over consumed. This over-consumption leads to a deadweight welfare loss.

If the government tax this good, it makes people pay the social cost and achieve the socially efficient level of output at Q2. In this case, the tax is reducing deadweight welfare loss.

How to calculate deadweight loss

This can increase economic welfare. Also, the example of the petrol tax needs more analysis. If we tax petrol, people may choose not to drive, leading to a deadweight welfare loss. However, instead, people may buy a bike and cycle. Thus economic welfare is created in different markets, so there is just a transfer of activity from one market to another.

Related The religion of Tax Cuts which gives away my political views on the matter. This entry was posted in economics. When supply is inelastic or demand is elastic, then the seller suffers the major tax burden, as can be seen in the orange-shaded areas in graphs 2 and 4, above; when supply is elastic or demand is inelastic, then the buyer pays most of the tax Graphs 1 and 3.

Of course, the effect of elasticity on the tax is no different from its effect on any other price change.

  • Deadweight Loss of Taxation
  • Deadweight Loss

Tax Revenue and Deadweight Loss Tax revenue varies with the proportion of the tax as a percentage of the product price. In most cases, a moderate tax rate will yield the most tax revenue, as can be seen from the first diagram above.

Taxation and dead weight loss (video) | Khan Academy

When the tax rate is small or high, tax revenue will be less. When the tax rate is small, the government only gets a small portion of the price paid. When the tax rate is high, then the quantity sold is much less, so even when it is multiplied by the high tax rate, it yields less revenue, which can be seen in the diagrams below.

relationship between tax revenue and dead weight loss graph

Also illustrated is that the deadweight loss of a high tax rate is much greater than the deadweight loss of a low tax rate. A high tax rate, as a low tax rate, yields little government revenue, but the high tax rate comes at a bigger expense to the economy, since it reduces total surplus more: Of course, this is desirable for excise taxes on goods or services that are detrimental to people or society, such as tobacco and alcohol consumption.

In this case, a high tax rate not only earns some revenue for the government, but also promotes more desirable goals. As can be seen in this schematic graph, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax.

Likewise, tax revenue increases at first, but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate. Deadweight Loss of Taxation on Labor The economic effects of taxation are often applied to labor, especially since the effective tax rate on labor is extremely high.

Although there is no question that there is a deadweight loss from taxes on labor, economists differ as to the size of the deadweight loss, since it depends on the demand and supply elasticity of labor. In the s, Arthur Laffer argued that tax revenue can be increased by reducing the tax rate.

When Arthur Laffer originally wrote his schematic curve on a napkin inhe wrote it as a symmetrical curve.

Taxation and dead weight loss

Here, I have skewed the schematic curve more to the right, reflecting the fact that the supply of labor is inelastic, because people have no choice but to work to survive. This is also 1 of the reasons why work is the most heavily taxed form of income. Although, as described later, there is no deadweight loss in taxing gratuitous transfers, such transfers benefit the wealthy, so they are taxed considerably less than work.

He argued that tax revenue generated from labor increases at first, but then, at a certain point, it starts to decline until it reaches zero.

Deadweight Welfare Loss of Tax

In the s, the Republicans presented this argument as a way to increase tax revenue by actually lowering tax rates. Of course, this argument only makes sense if anyone knew that the economy was actually past the point of maximum tax revenue. He argued that if taxes were lower, then people would work harder, yielding more tax revenue.

This came to be known as supply-side economics, because lower taxes increases the supply of everything, but especially labor.

Deadweight Loss - Examples, How to Calculate Deadweight Loss

While the above argument makes sense to some extent, the supply of labor is relatively inelastic, since most everyone except the wealthy have to work to survive. Hence, the tax burden on labor falls on labor. This is best evidenced by the fact that when Bill Clinton increased the tax rate, particularly on the wealthy, tax revenue increased proportionately. So the economy must have been before the maximum tax revenue point.

Deadweight Loss of Transaction Taxes, Value Added Taxes, and Property Taxes Transaction taxes include taxes on buying and selling propertywhich includes sales and use taxes, excise taxes, and value-added taxes. Transaction taxes also incur a deadweight loss, since they increase the price for the buyer and decrease the money received by the seller.

relationship between tax revenue and dead weight loss graph

Property taxes on raw land incur no deadweight loss because its supply is perfectly inelastic. However, there is some deadweight loss from property taxes on developed land since they may impact development. More info on tax types: However, the supply of investments is also inelastic, because you can only do 3 things with money: Poor people spend all their money, but the wealthy have much more money than they can spend on life's necessities, or even its conveniences.

If they keep it, then inflation diminishes its value. Furthermore, money has a time value which is forfeited if the money is not invested. Even if investment income was highly taxed, people would still invest because it does not require the time and effort that work requires. Indeed, the type of investment that requires the least amount of effort — long-term capital gains — is taxed the least. Another reason that deadweight loss is lower on investment income than on working income is because higher taxes help to reduce the sting of losses.

Taxes on investment income reduces the net income received, but it also reduces losses. You make 2 investments: So taxes on investment income helps to mitigate losses, which offsets some of the deadweight loss of the tax.

These are often referred to as gratuitous transfer taxes because the beneficiaries do nothing to earn their gift. When a person dies, governments can either choose to tax the estate of the deceased person or tax the inheritance that the beneficiaries receive, or a combination of both, or neither.

Because death is inevitable and because beneficiaries do nothing to earn their inheritance, no deadweight loss arises from either estate taxes or inheritance taxes collectively known as death taxes.