Question

Taxes are generally distortionary. This means they affect the behaviour of consumers and/or producers. If the private market would achieve a Pareto efficient outcome without the tax, then when a distortionary tax is introduced, it moves society away from the Pareto efficient outcome. In other words, it makes society as a whole worse off. The efficiency loss is known as the "excess burden" or "deadweight loss" of the tax.

Give an example of a tax and explain how it distorts consumer and/or producer decisions. Explain why this impact on consumer and/or producer behaviour might be inefficient.

Note: Be specific! Do not give a general example like "the GST makes consumers buy fewer goods" - instead, try to think of a tax on a very specific item (or at least how a general tax like the GST might affect a very specific item.（100 words

）

Answer 1

Taxes are generally distortionary. This can be explained with the effects of imposition of an excise tax on the consumption of Liquor.

· Let’s assume a market for Liquor. Given the below diagram, X –axis shows the quantity of liquor demand and supplied. Y-axis shows the price. The demand curve (D) & the supply curve (S) intersect at equilibrium point E. Here, the equilibrium market Quantity is Q_E, demand & sold at equilibrium price P_E. The consumer surplus (area above price andbelowdemand curve) is given by area of triangle EAP_E. The producer surplus (area below price and above the supply curve) is given by area of triangle BEP_E.

· Let’s say with a motive to reduce unhealthy consumption of liquor, the government imposes an excise tax of T per unit on liquor. From consumer point of view, for each additional unit they now have to pay a higher price in terms of additional tax. This shifts the supply curve upwards from S to “S + Tax” (equivalent to the amount of tax)

· The new supply curve and the unchanged demand curve intersects at new market equilibrium point E(T) - from consumer point of view. There is a fall in the equilibrium market quantity demanded to Q_T. For the reduced quantity, the consumers now have to pay a higher price Pc , however the producers receives price according to the old supply curve only which is Ps. The difference between the price that consumer pay and the price that producer receives is equivalent to the amount of excise tax imposed.

· This creates inefficiencies in the market for Liquor. The consumer surplus (area above the price – Pc and below the demand curve) fall to area of triangle APcE(T). The producer surplus (area below the price Ps and above old supply curve) fall to area of triangle PsKB. The tax revenue which the government receives is given by the area of rectangle PcPsKE(T).

· Thus an imposition of excise tax, redistributes a part of the producer and consumer surplus to the government and create inefficient outcome leading to deadweight loss equivalent to the area of shaded triangle KEE(T).