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.

Answer 1

To see how a tax affects welfare, let's consider Welfare before the government imposes a tax. See the figure below. The equilibrium price and quantity are found at the intersection of the supply and demand curves. The price is P1 and quantity sold is is Q1. Consumer surplus is the area between the demand curve and the price, A+B+C. Similarly producer surplus is the area between the supply curve and the price, D+E+F.Thus Total surplus is the sum of consumer surplus and producer surplus equals the area A+B+C+D+E+F.

Welfare with a tax

Suppose government levies a tax on the final products of seller. This tax places a wedge between the price that buyers pay and the price that sellers receive. In this case, price paid by buyers rises from P1 to Pb , so consumer surplus now equals only area A. The price received by sellers falls from P1 to Ps, so producer surplus now equals only area F. The quantity sold falls from Q1 to Q2 and the government collects tax revenue equal to the area B+D. Now, Total surplus is the area A+B+D+F. The tax causes consumer surplus to fall by the area B+C and producer surplus to fall by the area D+E. Thus both buyers and sellers are worse off. Since the price is now higher so consumer would be willing to buy less and consequently sellers will produce less. Thus the economy shrinks(lower output production).