Question

What are the currently known theoretical/empirical relationships between taxation and social welfare? What are the implications for public policymaking? Draw upon any taxation covered in class. Answer must incorporate the rational individual model.

Answer 1

Social welfare is the aggregate of producer and consumer surplus and tax revenues received by the government. Therefore, small amount of taxes that increase government revenues without much affecting the consumer and producer surplus, is good for the economy. This kind of taxation increases social welfare. However, according to the economists, excessive amount of taxation creates dead weight loss in the economy.

Initially producer surplus was P₁E₁O and after unit tax imposition, the producer surplus becomes P₂E₂B. The area of the triangle decreases signifying that unit tax reduces the producer surplus as the supply curve shifts upward. Consumer surplus also decreases from P₁E₁A to P₂E₂A due to hike in price of the product. Total surplus or social welfare reduces in the short term. Social welfare reduces as it creates deadweight loss in the economy. The dead weight loss is the amount of loss in production that is accrued by nobody in the economy. Unit tax initially increases government revenue, which can also be expended for improvement in social welfare. P₂E₂GP₁ is the amount of government tax revenues. Total social loss is E₂FE₁ + E₁FG. The tax burden is more upon the consumers is the demand curve is less elastic or inelastic. Tax burden increases upon producers if the supply curve is less elastic.

Rational individual wants to maximize utility subject to budget constraint. Excess amount of taxation increases the intensity of tax evasion as tax reduces consumer welfare. Tax reduces the disposable income of individual and thus individuals are reluctant to pay taxes to keep their consumer expenditure smooth. Hence, when tax rate is very high, decrease in tax rate increases tax revenues and the the rate of tax evasion decreases. For the indirect taxes, the incidence of taxes are borne by either consumers or producers reducing the social welfare. Therefore, it is important for the public policy makers to fix the tax rate, which increases the social welfare.