Question

Explain the effect of a tax on the market. Be sure to elaborate on what happens to the price of buyers pay, the price sellers receive, the extent to which a government gains, and the deadweight loss.

Answer 1

A tax represents a compulsory levy that is charged on a taxpayer by the government authority to fund various public expenditures. The two major economic effect of taxes are fall in quantity traded and the diversion of revenue to the government. But considering each sector in an economy, taxation has differential effects

Effect of taxes on buyers

· Taxation increases the price payment of the buyer

· It reduces the willingness to pay for any given unit by the amount of tax and hence shifts the demand curve down by this amount.

· With increase in taxation, the buyer price increases and the buyer will be forced to opt out of buying non-essential products and vice versa.

Effect of taxes on sellers    

· The taxation decreases the price a seller obtains by the amount of tax imposed

· The seller will be forced to reduce the quantity of supply with increase in taxation and vice versa.

Effect of taxation on government

· Taxation increases the revenue earning capacity of a government.

· It helps the government to undertake many public expenditures.

· At times of economic instability, taxation can be suitably adjusted, say increased at times of inflation and decreased at times of deflation so that the government may appropriate the flow of money in the market. Thus taxation policy also helps a government to stabilise market instability

Taxation and deadweight losses

· A higher price for the consumer will cause a decrease in the quantity demanded and a lower price for the producers will cause a decline in the quantity supplied. This reduction from equilibrium causes deadweight losses in the market.

· Thus the opportunity costs of taxation would result in deadweight losses which represents a loss to the society.

                                       Thus, we can see that regardless of whether the tax is imposed on the buyer or seller, both will experience a reduction in the surplus and alters the quantity traded in the market causing deadweight losses to rise, although it would help the government mechanisms that imposes the tax to deal with economic incidents.