Chapter 8: Application: The Costs of Taxation

Chapter 8 continues on from chapter 6’s brief introduction to taxes. It amplifies the effects of taxes on the economy and introduces a new idea concerning taxes called deadweight losses. Deadweight loss is defined as the fall in total surplus when a tax changes the market. This occurs when taxes reduce the amount of marginal buyers and sellers, so the size of the market decreases (as discussed earlier in Chapter 6). Deadweight loss is determined by the elasticity of the supply or demand curve. Deadweight loss increases as a curve goes closer to elasticity. For example, if the demand curve becomes more and more elastic, the deadweight loss increases. The same applies to the supply curve. As the supply curve becomes more and more elastic, the deadweight loss increases.

Furthermore, deadweight increases with the size of the tax. A small tax would result in a relatively small deadweight loss but also a small tax revenue. A medium tax would result in a slightly larger deadweight loss and tax revenue. The largest tax would result in the most deadweight loss but also the most tax revenue. This occurs because as the tax increases, the area used to calculate the tax revenue increases, but also as the tax increases, marginal buyers and sellers leave the market which results in a higher deadweight loss.

Finally, another topic concerning taxation is the Laffer Curve. The Laffer curve states that by decreasing tax costs, the total tax revenue increases. This idea was implemented by Ronald Reagan when he ran for president. There is no way to determine whether or not the theory was true because history cannot be altered to make it testable. However, it is an idea that is prominent and known by economists today.