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Gregory Lackner

on 8 December 2014

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Transcript of Market

8 // Deadweight loss of TAXATION
12 // Design of the TAX SYSTEM
Deadweight losses!
I'm so glad you asked about them!
First: Some basics
Tax imposed to raise revenue - from whom?
Revenue comes out of

' and
' pocket - though not always equally.
Tax levied on
curve shifts
Tax Levied on
curve shifts

Outcome is the same: A
Tax Wedge
in supply and demand graph, which is equal to the size of the tax.
Consumer and producer surplus after a tax
We know consumer and producer surplus are a measure of economic welfare.

After a tax, both

Moreover, the losses to buyers and sellers due to a tax exceed the revenue raised by the government.

The amount by which the fall in surplus exceeds tax revenue is called the
deadweight loss

As tax raises price to buyers and lowers price to sellers, the incentive tends to less consumption and less production.
This leads to the size of the market shrinking to below optimum
What is market failure?
Market failure
occurs when freely-functioning markets fail to deliver an efficient allocation of resources.

This leads to a
loss in economic and social welfare.

Causes include:

-Positive and negative externalities
-Imperfect information
-Inability to profitably supply public and quasi-public goods
-Market domination by monopolies

Deadweight loss: in depth
Elasticity: the
more elastic
the supply and demand, the
the deadweight loss
Size of tax: the
the tax, the
the deadweight loss
The Laffer Curve, or why not to tax too much
In 1974 the economist Arthur Laffer theorised the following curve:
It suggests that at a certain level of taxation, productivity and therefore tax revenue will begin to decrease. This would be due to people working less, as well as measures richer individuals might take to avoid taxation altogether.

Governments want to be at the highest point of the curve so as to maximize tax revenue as well as productivity.
Case study
Deadweight loss of taxation
What is an externality?
occurs when a person engages in an activity ;) that influences the well being of a
third party
neither pays nor receives compensation
for that effect
Negative externalities
Positive externalites
Passive smoking
Food waste

Socially optimum quantity is
than equilibrium quantity
Research into new tech
Better health care services

Socially optimum quantity is
than equilibrium quantity
Externalities can be solved through
government intervention
Government intervention
Command-and-control policies

- policies which regulate behaviour directly eg. banning dumping of toxic waste in the sea
Market-based policies
: policies which provide incentives that encourage private decision makers to solve the problem on their own eg. coin tosses. 'If I flip this coin what are the chances of getting head? (1/2)
Pigovian taxes and subsidies
Taxes enacted to correct the effects of a negative externality
levy on each tonne of toxic chemicals that is dumped in the sea.

They are very efficient - unlike other taxes which distort incentives to move allocation of resources away from the social optimum.

Can take form of permits, eg. a pollution permit for up to 100 tonnes of waste.

Liability rules
Laws enacted to hold polluters accountable for the proper management and disposal of their waste or emissions, but also for cleanup and remediation costs.

Liability assignment most often targeted at entities who produce emissions or waste easily identifiable to them.

Private solutions
The Coase Theorem:

If private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own

free riders benefit
from the solution themselves,
at no cost
to themselves. This happens when the problem's solution is difficult or impossible to charge everyone for - as the problem potentially affects a large and ever changing number of people.

In these cases government intervention is often effective.
When the invisible handy doesn't solve it all
Coase theorem in practice
Two neighbours, one of whom owns a dog that barks all night, depriving the neighbour of sleep. According to the Coase theorem, the 2 neighbours (the private market) will reach the efficient outcome on their own, without need for intervention - The neighbour can pay the dog owner to get rid of the dog. The dog owner would accept if the amount of money offered is greater than the (perceived) benefit of keeping the dog. He then can go to the local animal shelter and repeat the process.
Private solutions do not always work due to transaction costs - (lawyers, interpretors, breakdown in negotiations or coin tosses).

Public Goods and Common resources
Why do these goods cause market failures?
When a good does not have a price attached to it, private markets have no incentive to ensure consumption and production of said good remains optimal, either socially or economically. Market failure thus arises in the form of non allocation of resources to production of the good, and thus to a decrease in consumption.
Two things to look for : Is the good
? Is the good

: a person can be prevented from using it when they do not pay for it
: One person's use of a good diminishes other people's use

Private Goods: Excludable and Rival
Public Goods: Neither excludable nor rival. Eg. National defense system
Common resources: Rival, but not excludable. Eg. Fish in the ocean
(Natural monopolies/Club Goods): Excludable, but not rival. Eg. Paid fire brigade service. Use of protection applied to everyone in town, protecting extra house unlikely to reduce protection of others.
Public Goods
Public Goods create market failure do to being non excludable or rival.

Gives rise to the
Free-Rider Problem
Firm goes out of business
Free rider comes along, realises that he can benefit from the good without paying, with no impact on other's enjoyment! Gets the ride for free.
Private company's CEO decides to produce non rival, non exlcudable good, hoping to be paid for his efforts
Free Rider Problem
Doesn't pay - does anyone?
Don't be him
Practical example: firework displays
Anyone can benefit from fireworks if they see them, doesn't reduce potential paying customers' use - the free riders

Disincentivises private firework shows in public locations, where they would have the most customers

Not privately profitable, but socially desirable.

Solution? The government!
The government can then finance public goods through levies and taxes so that the cost is equally distributed amongst the population

National defence
Basic research
Fighting poverty
Common resources
roads, clean air and water

Available free of charge - but excludable eg. finite in quantity

Likely to be depleted or excessively used preventing others from doing so, as free for all to acquire or benefit from.
(Costs still can be incurred in the acquiring process eg. mining).

This is the
Tragedy of the Commons
: Excessive use of common goods leading to depletion of utility or of themselves, disadvantaging society as a whole.
Solution? The government! Regulates and taxes the use of such goods.
Why are cows not extinct?
Why does the commercial value of ivory threaten the elephant, while the commercial
value of beef protects the cow?

are a
are a

Each poacher has a strong incentive to kill as many elephants as he can find, and has only a slight incentive to preserve the elephant population.

By contrast, cattle live on ranches that are privately owned. Each rancher makes a great effort to maintain the cattle population on his ranch because he reaps the benefit.

Botswana and Namibia amongst others have responded by keeping it legal for elephants to be killed, but only on one's
own land
. Hence,
providing an economic incentive
for preserving the elephants on your land and allowing them to breed.

As a result, elephant population has gone up! Privatise the elephants!
The design of the tax system
A little more depth ;)
Taxes are inevitable as we expect the government to provide us with various goods and services.
They also are main correctors of externalities - but how does the country collect them?
UK Government, fo example
As economy has grown, so has its government (35% increase in spending as percentage of GDP)

Main source of revenue
income tax
: income from work, savings, dividends

As an individual's tax rate rises, so does his
marginal tax rate
- tax rate applied to each additional amount of income
Now how efficient can a system be? How can the government also maximise equity in taxation?
Taxes and efficiency
Taxes incur significant
administrative burden
- on the part of both the individual and the government. These are the resources devoted to complying with tax laws, as well as enforcing them.
: paying smallest amount on taxes possible without breaking laws, using loopholes
: lying about affairs to reduce taxes paid-
: can be gov't mistake/omission from tax law, usually intended to promote certain beneficial behaviourial patterns, such as saving for retirement (eg. exempting money on personal pension plan from tax up to certain limit)

Taxes incur
deadweight losses
- behavioral changes resulting from tax which warp markets away from optimal consumption/production
Let's take a closer look at this confusing new concept!
Laffer Curve influential in Thatcher's government cutting tax rates from 83% to 40% at the top rate.
3% increase in

tax revenue!

In the USA, Reagan also cut tax aggressively, but result was
tax revenue, not more.

Problem with curve is that population is distributed along the curve, not in one place. Therefore it is difficult to prove or disprove the effectiveness of policy based on the Laffer Curve. It also looks great in textbooks
National Insurance Contributions
: a form of social insurance tax, taxed on income. Contributes to funding of state run 'free' health insurance + state pensions and unemployment benefit.

- value-added tax, 15% of revenue. '
Value added
' because of ability to deduct VAT already paid for goods to yearly tax bill. Indirect tax

In 2010-11, the government spent the equivalent of £11,508 per person on
-Social security > NHS > Education > Defence > Public Order and Safety > Transport

Other cases of market failure:
: a supplier of a good or service whose dominant position in the market allows it to reduce market competitiveness and behave independently of it. Illegal.
Maintained by barriers of entry eg.
High entry costs, exclusive contracts, lobbying for favorable laws cementing its position
Information asymmetry
: when consumers or producers know more about the specifics of the transaction taking place and use their knowledge for personal gain to the detriment of the other party.

Leads to
adverse selection:
The process by which the price and quantity of goods or services in a given market is altered due to one party having information that the other party cannot have at reasonable cost.

Also leads to
moral hazard
: an adverse behavior that is brought on by allowing people to buy insurance for an adverse event. This entails when a person's behavior is hard to monitor and control and thus payment to that person is based on incomplete information
Full transcript