The Costs of Taxation: Are They Worth It?

It’s often said, “In this world nothing can be said to be certain, except death and taxes.”

Well, taxes are often a source of heated political debate. Yet no one would deny that some level of taxation is necessary. Oliver Holmes Jr. once said, “Taxes are what we pay for civilised society.”

Let’s break down what taxes actually do to an economy graphically.

How taxes on buyers/sellers affect market outcomes

A tax can be levied on buyers or sellers; either way it reduces both demand and supply. For example (refer to fig.1) , an ice-cream cone costing $3 is now taxed in such a way that the sellers will have to pay $0.50 for every cone they sell. This makes ice-cream less profitable for the sellers and shifts the supply curve to the left; in such a way that the market price compensates the effect of the tax. Thus, from the figure, it can be inferred that now buyers pay $3.30 up from $3.00; and sellers are left with $2.80 after paying the tax.

Similarly, a tax imposed on buyers works similarly like this.

Thus, the new equilibrium quantity is less than the initial quantity. Taxes discourage market activity. And buyers and sellers both share the burden of the tax imposed.

Now, for simplifying the further discussion, I will not show the shift in either the supply or the demand curve, although one curve must shift. So it will look something like this:

The Deadweight Loss of Taxation

To measure the gains and losses from a tax on a good, we use tools like consumer surplus and producer surplus. The benefit accrued by buyers in a market is called consumer surplus (the amount they are willing to pay minus the amount the actually pay for it) and the benefit accrued by sellers in a market is called producer surplus (the amount sellers receive for a good minus their costs).

Let’s see how a tax affects welfare. Refer to the following table and graph. Without a tax, the equilibrium price and quantity were P1 and Q1 respectively. The consumer surplus = A + B + C and the producer surplus = D +E +F; the tax collected being zero the total surplus = A + B +C + D +E + F.

After the imposition of the tax, we saw in the previous section that the equilibrium quantity falls. We also saw that buyers pay more(P1 to PB) and sellers receive(P1 to PS). Thus, consumer surplus falls to the area of A and producer’s surplus falls to the area of F. The government receives a tax revenue equal to the area of B + D. Total surplus = A + B + D +F. From the graph as well as the table, it can be seen that C + E is the fall in the surplus and is called the deadweight loss of the tax. Losses to buyers and sellers exceed the revenue raised by the government.

It makes sense actually. An imposition of a tax gives an incentive to buyers to consume less and sellers to produce less; leading to a fall in the size of the market (from Q1 to Q2). Thus, taxes distort incentives, they cause markets to allocate resources inefficiently.

Laffer Curve and Supply-Side economics

Refer to the graphs (a), (b) and (c) below. As the tax increases, the deadweight loss increases even more rapidly. Why? Because deadweight loss is the area of the triangle which depends on the square of its size. So, double the tax, the deadweight loss increases by a factor of 4. Triple it, the deadweight loss rises by a factor of 9, and so on.

Thus, graph (d) correctly represents the above phenomena. On the contrary, graph (e) shows that tax revenue initially increases with the size of the tax, but as the tax increases further, the market begins to shrink so much that tax revenue starts to fall. This is called the Laffer curve named after the economist Arthur Laffer.

The Laffer curve captured the imagination of Ronald Reagan. He argued that during his administration taxes were so high that they were discouraging hard work and thereby depressing incomes. He suggested that lower tax rates could raise incomes by such amount that it might actually increase tax revenue. Because the cut in tax rates was intended to encourage people to increase the quantity of labor they supplied, the views of Laffer and Reagan became known as supply-side economics.

However, this comes with a lot of debate. Some refute Laffer’s conjecture that lower tax rates would increase tax revenue; while others believe the 1980s to be favourable to the supply siders. We cannot go and rerun history by experimenting the economy without tax cuts, so evaluating Laffer’s hypothesis definitively is impossible. Some disagree about the issue partly because there is no mention about the size of elasticities. The more elastic supply and demand are in any market, the more taxes distort behaviour and the more likely it is the a tax cut will increase tax revenue.

There is no debate, however, about one thing: the amount the government gains or loses from a tax change cannot be computed just by looking at the tax rates. It also depends on how the tax change affect people’s behaviour.

Essentially we saw that on imposition of taxes, society loses some benefits of market efficiency.

But, this is not the end of the story.

Economists study how best to design a tax system that strikes the right balance between equality and efficiency. They study how taxes influence the overall economy and how policymakers can use the tax system to achieve more rapid economic growth.