DISCLAIMER: This publication is intended for EDUCATIONAL purposes only. The information contained
herein is subject to change with no notice, and while a great deal of care has been taken to provide accurate
and current information, UBC, their affiliates, authors, editors and staff (collectively, the "UBC Group") makes
no claims, representations, or warranties as to accuracy, completeness, usefulness or adequacy of any of
the information contained herein. Under no circumstances shall the UBC Group be liable for any losses or
damages whatsoever, whether in contract, tort or otherwise, from the use of, or reliance on, the information
contained herein. Further, the general principles and conclusions presented in this text are subject to local,
provincial, and federal laws and regulations, court cases, and any revisions of the same. This publication is
sold for educational purposes only and is not intended to provide, and does not constitute, legal, accounting,
or other professional advice. Professional advice should be consulted regarding every specific circumstance
before acting on the information presented in these materials.
© Copyright: 2017 by the UBC Real Estate Division, Sauder School of Business, The University of British
Columbia. Printed in Canada. ALL RIGHTS RESERVED. No part of this work covered by the copyright
hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any
means – graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or
used in any information storage and retrieval system – without the prior written permission of the publisher.
©Copyright 2017 by the UBC Real Estate Division
LESSON 10
Costs of Taxation
Assigned Reading
1.
Mankiw, N. Gregory, et al. 2014. Principles of Microeconomics (6th Canadian Edition). Toronto:
Nelson Education Ltd.
Chapter 8: Application: The Costs of Taxation
Recommended Reading
1.
Mankiw, N. Gregory, et al. 2014. Study Guide to Accompany Principles of Microeconomics
(6th Canadian Edition). Toronto: Nelson Education Ltd.
Chapter 8: Application: The Costs of Taxation
Learning Objectives
After studying this lesson, students should be able to:
1.
discuss how taxes reduce consumer and producer surplus;
2.
explain the meaning and causes of the deadweight loss of a tax;
3.
explain why some taxes have larger deadweight losses than others;
4.
discuss the relationship among deadweight loss, tax revenue, and the size of a tax; and
5.
discuss the relationship suggested by the Laffer curve.
Instructor's Comments
This lesson is a direct application of the material presented in Chapters 6 and 7 of the text. Using the
concepts of consumer and producer surplus, the chapter demonstrates how to measure the reduction in
consumer and producer surplus because of taxation. The chapter also discusses the allocative inefficiencies
caused by taxes and the distributional consequences of taxes.
The material provided in Chapter 7 of the text provided a foundation for welfare economics, looking at the
net social gain from production at the competitive equilibrium. We saw in that chapter that maximizing the
society's total surplus requires production up to but not beyond the point at which the marginal benefit of
another unit of output equals its marginal cost. By creating a wedge between the price consumers pay and
the amount producers receive, taxes cause a deviation from this efficient production rule. The deviation
results in a deadweight loss, consumer and producer surpluses that are lost because taxes reduce the level of
output below that which maximizes total surplus.
10.1
©Copyright 2017 by the UBC Real Estate Division
Lesson 10
Governments levy property taxes at different rates for different classes of property. For instance, in the City
of Vancouver in 2010, the municipal property tax rate for heavy industry properties was over 14 times the
rate for residential properties. For commercial and office buildings, the rate was almost five times as high as
that for residential real estate. It is instructive to ask whether or not it is possible to reduce the deadweight
loss from property taxation by setting rates that reflect the economic loss of the taxes. As the discussion in
the text on Henry George indicates, it is most efficient to tax unimproved land. The supply of this land is
fixed and the supply curve is perfectly inelastic. Therefore, the property taxes imposed on the unimproved
value of the land incur no deadweight loss. Deadweight losses are greatest for properties with more elastic
supply and demand curves. Thus, the efficiency losses from taxation will be lowest when those types of
properties, or more accurately improvements on land with either a more elastic supply of structures and
improvements or demand for them, have lower property tax rates. From a political perspective this can be a
problem. Demand for luxury and vacation homes is more elastic than demand for more basic homes. It is
hard to imagine the local politician who would call for the wealthy to be taxed at a lower rate than people of
more modest means without being tossed out of office.
Review and Discussion Questions
1.
Taxes that promote economic efficiency often have negative effects on equity, especially if equity is
perceived to require progressive taxes (taxes with a higher average tax rate on those with higher
incomes). Why would this goal conflict with efficiency?
2.
The following graph shows the market for gasoline before and after the imposition of a gasoline tax.
(a)
How much is the gasoline tax, and by how much does the price of gasoline rise in response
to the tax? Explain. By law, is this a tax on the buyer or the seller? How can you tell?
(b)
Label the area of deadweight loss on the diagram and explain. What would happen to the
total deadweight loss if demand were more elastic? Why?
(c)
What would happen to the market for gasoline if the tax were switched to the other side of
the market, but at the same tax rate? Does it matter whether the buyer or the seller is
responsible for the tax? Would the equilibrium quantity change if the tax is switched?
Would there be any change in the deadweight loss? Explain.
(d)
Who really pays the tax? The consumer? The seller? Both? How can you tell? What caused
the result?
10.2
©Copyright 2017 by the UBC Real Estate Division
Costs of Taxation
3.
In recent years, proposals to increase the cigarette tax drastically have gained strength. Critics of the
proposed tax argue that such an increase would be undesirable, because it would cause tremendous
deadweight loss to society. They also argue that it would be unproductive in reducing smoking,
because the demand for cigarettes is inelastic. Is this argument consistent? If the demand is inelastic,
will the tax have a large impact on total surplus? Is the notion of deadweight loss even appropriate
when the goal is to distort behaviour away from smoking? Discuss.
4.
What general statement can be made about the magnitude of the revenue raised by a tax relative to
the magnitude of the losses in consumer surplus and producer surplus resulting from the tax,
assuming that demand curves are downward sloping and supply curves are upward sloping?
5.
Which of the Ten Principles of Economics discussed in Chapter 1 can be used to explain why taxes
impose deadweight losses?
6.
What happens to the gains from trade when a tax is imposed? Explain.
7.
According to the Laffer curve, what will happen to tax revenue if tax rates are reduced?
8.
Some economists believe that the deadweight loss of taxes on labour in Canada is relatively small,
while other economists believe that the deadweight loss is relatively large. What are the arguments
employed to support these conflicting beliefs?
9.
How does the deadweight loss of a tax increase relative to the tax revenue from the tax as the size of
the tax increases? Explain carefully.
10.
Evaluate the following two statements. Do you agree? Why or why not?
11.
(a)
"If the government taxes land, wealthy landowners will pass the tax on to their poorer
renters."
(b)
"If the government taxes apartment buildings, wealthy landlords will pass the tax on to their
poorer renters."
Suppose that the government imposes a tax on heating oil.
(a)
Would the deadweight loss from this tax likely be greater in the first year after it is imposed
or in the fifth year? Explain.
(b)
Would the revenue collected from this tax likely be greater in the first year after it is
imposed or in the fifth year? Explain.
10.3
©Copyright 2017 by the UBC Real Estate Division
Lesson 10
12.
Suppose that a market is described by the following supply and demand equations:
QS = 2P
Q = 300 − P
D
[Note: this problem may be somewhat algebraically challenging.]
(a)
Solve the equilibrium price and the equilibrium quantity.
(b)
Suppose that a tax of T is placed on buyers, so the new demand equations is:
QD = 300 − (P + T)
Solve for the new equilibrium. What happens to the price received by sellers, the price paid
by buyers, and the quantity sold?
(c)
Tax revenue is T × Q. Use your answer to part (b) to solve for tax revenue as a function of
T. Graph this relationship for T between 0 and 300.
(d)
The deadweight loss of a tax is the area of the triangle between the supply and demand
curves. Recalling that the area of a triangle is 1/2 × base × height, solve for deadweight
loss as a function of T. (Hint: Looking sideways, the base of the deadweight loss triangle is
T, and the height is the difference between the quantity sold with the tax and the quantity
sold without the tax.)
(e)
The government now levies a tax on this good of $200 per unit. Is this a good policy? Why
or why not? Can you propose a better policy?
10.4
©Copyright 2017 by the UBC Real Estate Division
Costs of Taxation
ASSIGNMENT 10
CHAPTER 8: Application: The Costs of Taxation
Marks: 1 mark per question.
1.
Imposing a tax will:
(1)
(2)
(3)
(4)
improve welfare for producers, but reduce welfare for consumers.
improve welfare for consumers, but reduce welfare for producers.
improve welfare for both producers and consumers.
reduce welfare for both producers and consumers.
THE NEXT FOUR (4) QUESTIONS ARE BASED ON THE FOLLOWING GRAPH:
2.
The equilibrium market price before the tax is imposed is:
(1)
(2)
(3)
(4)
3.
P1
P2
P3
impossible to determine
Total welfare before the tax is:
(1)
(2)
(3)
(4)
A
A+B+C
A+B+C+D+E
A+B+C+D+E+F
Assignment 10 continued on the next page
10.5
©Copyright 2017 by the UBC Real Estate Division
Lesson 10
4.
If the tax shown is levied on sellers of the good, then the total loss of consumer surplus as a result
of the tax is:
(1)
(2)
(3)
(4)
5.
If the tax shown is levied on the buyers of the good, then the deadweight loss to society as a result
of the tax is:
(1)
(2)
(3)
(4)
6.
a greater
a lesser
neither a greater nor a lower
either a greater or a lesser
According to Laffer's theory, tax revenues could be raised if:
(1)
(2)
(3)
(4)
9.
entirely by the landowners.
entirely by the renters or users of the land.
partly by landowners and partly by land users.
only by workers.
Assume that the demand for salt is relatively inelastic and that the demand for orange juice is
relatively elastic. Imposing a tax on salt will cause
total deadweight loss than imposing the
same percentage tax on orange juice.
(1)
(2)
(3)
(4)
8.
A+B+C
C+E
B+C+D+E
B+D
If the supply of land is fixed, a tax on land would be paid:
(1)
(2)
(3)
(4)
7.
C
D+E
B+C
A+B+C
tax rates are increased.
tax rates for those in the highest tax bracket are decreased.
tax rates for those in lowest tax bracket are decreased.
there is a population increase.
Assume that a tax is levied on a good and the government uses the funds to build statues of the
premiers of each of the 10 provinces. In this case there would be:
(1)
(2)
(3)
(4)
a decrease in consumer surplus to consumers of the taxed good.
a decrease in producer surplus to producers of the taxed good.
the losses to buyers and sellers from a tax (the decrease in consumer and producer surplus)
exceed the revenue raised by the government.
all of the above.
Assignment 10 continued on the next page
10.6
©Copyright 2017 by the UBC Real Estate Division
Costs of Taxation
10.
A major political problem with collecting taxes to finance government spending is that:
(1)
(2)
(3)
(4)
11.
If the government quadrupled the tax on gasoline, knowing what you know (or should sense) about
the elasticity of demand for gasoline, it is quite certain that:
(1)
(2)
(3)
(4)
12.
would result in a huge deadweight tax loss.
would result in no deadweight tax loss.
causes resource allocation to diverge from resource allocation guided by market forces.
None of the above
Does increasing the tax amount always increase the tax revenue?
(1)
(2)
(3)
(4)
15.
perfectly elastic.
relatively elastic.
relatively inelastic.
perfectly inelastic.
A tax on new land:
(1)
(2)
(3)
(4)
14.
gasoline tax collections would quadruple.
gasoline tax collections would increase but they would not quadruple.
gasoline tax collections would decline.
there would be only one-fourth as much gasoline sold so gasoline tax revenues would not
change.
If an economist believes that labour taxes create a very large deadweight loss, it is because the
economist believes labour supply is:
(1)
(2)
(3)
(4)
13.
taxes make taxpayers worse off, but government spending benefits no one.
taxes make taxpayers worse off, but government spending benefits only those on welfare.
the people who pay the taxes are often not the same people who benefit from the
government expenditure of tax funds.
taxes reduce economic welfare more than the expenditure of tax funds benefits society.
Yes, because there is a larger tax amount to apply to each commodity bought and sold.
Yes, because deadweight loss increases at a decreasing rate.
Not necessarily because there is a smaller quantity to multiply the tax amount by.
No, increasing the tax amount will always decrease the tax revenue.
A tax levied on the supplier of a product shifts the supply curve
of a product shifts the demand curve
.
(1)
(2)
(3)
(4)
. A tax levied on the buyers
upward or to the left; downward or to the left
upward or to the left; upward or to the right
downward or to the right; downward or to the left
downward or to the right; upward or to the right
Assignment 10 continued on the next page
10.7
©Copyright 2017 by the UBC Real Estate Division
Lesson 10
16.
Assume that the demand for entertainment is more elastic than the demand for gasoline. We can
expect that a tax on entertainment will cause the quantity of entertainment purchased to decline
__________ than a similar percentage tax on gasoline will cause gasoline purchases to decline.
(Declines are measured in percentage terms.)
(1)
(2)
(3)
(4)
more
less
neither more nor less
either more or less – there is not enough information to know
THE NEXT THREE (3) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION:
In the graph drawn below, $4 is the free market equilibrium price. The area of a triangle is equal to 1/2 ×
base × height.
17.
A tax of $2 per unit creates a deadweight loss equal to:
(1)
(2)
(3)
(4)
18.
$10
$1
$0
$0.50
A tax of $2 per unit generates tax revenue of:
(1)
(2)
(3)
(4)
$4
$10
$18
$2
Assignment 10 continued on the next page
10.8
©Copyright 2017 by the UBC Real Estate Division
Costs of Taxation
19.
A tax of $4 per unit creates a deadweight loss equal to:
(1)
(2)
(3)
(4)
20.
What is deadweight loss?
(1)
(2)
(3)
(4)
___
20
$4
$0
$6
$12
The fall in total surplus that results from a market distortion.
The amount that tax rates need to decrease in order to maximize tax revenues.
The amount of GDP that is lost due to illegal economic activity.
The amount of tax burden that is borne by either a consumer or producer due to the
elasticity of the supply and demand curves.
Total Marks
Planning Ahead
Project 2 is due one week after Assignment 10. By now, you should be
well-advanced into the work required for this project.
End of Assignment 10
10.9
©Copyright 2017 by the UBC Real Estate Division