[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

TAXES AND EFFICIENCY
Economists use the law of demand and supply to study the impact of taxes on
consumers and producers. In Chapter 4 we learned that taxes imposed on producers
can be passed on, or shifted, to consumers in the form of higher prices. There,
two examples were contrasted. In the first, the law of supply and demand was used
to study the impact of a tax on cigarette producers. When the demand for the taxed
good is very inelastic, as is true of cigarettes, most of the burden of the tax is shifted
to consumers. The second example involved a tax on one particular type of cheese,
cheddar. In this case, the demand for the taxed good is very elastic, since close substitutes
for cheddar cheese are available. When demand is elastic, most of the tax is
borne by producers. Using the concepts of consumer surplus, producer surplus, and
efficiency, we can gain additional insights into the effects of a tax.
Figure 10.3 shows the markets for cigarettes in panel A and the market for cheddar
cheese in panel B. In each case, the equilibrium quantity without a tax is denoted
by Q 0 . The tax on the output of an industry paid by firms can be thought of as increasing
the costs of production. This increase in cost shifts the supply curve up by the
amount of the tax. Because the demand curve for cigarettes is relatively inelastic, the
main impact of the tax is to raise the price to consumers. The price received by producers
falls slightly, as does the quantity produced in the new equilibrium. In contrast,
when the demand curve is relatively elastic, as shown in panel B for cheddar
cheese, the effect is to cause a larger fall in the price producers receive and a smaller
rise in the price paid by consumers.
The figure also shows what happens to consumer surplus when a good is taxed.
In panel A, the entire blue area is equal to consumer surplus without the tax. After
the tax, consumer surplus is equal only to the blue hatched area. Producer surplus
is also reduced. It is equal to the entire orange region without the tax and the orange
hatched area with the tax. Because the demand curve for cigarettes is inelastic, the
reduction in consumer surplus is greater than the reduction in producer surplus,
reflecting the fact that here the burden of the tax is shifted mainly to consumers.
While both consumer surplus and producer surplus fall, not all of this is lost to
society—after all, the government collects revenue from the tax on cigarettes, and
this revenue is then available to spend on government services. The tax revenue
that is collected equals the tax per unit of output times the quantity of output produced.
The difference between the price consumers pay and the price received by
producers is equal to the tax on each unit of output. So the tax revenues collected
will equal the area outlined in green. When we add up consumer surplus, producer
surplus, and the revenue collected by the government, we can see that this total is
less than the total surplus without the tax—the efficiency cost of the tax is measured
by the area outlined in orange. This is called the deadweight loss caused by a
tax. A tax thus has a cost beyond the revenue actually collected by the government.
Panel B illustrates the situation for a market in which the demand curve is relatively
elastic. Here, the deadweight loss of the tax (the area outlined in orange) is
larger. Because consumers are more sensitive to price when the demand curve is
elastic, the tax causes them to substitute away from the taxed good. The tax “distorts”
consumers’ choices more in this case, and the resulting efficiency loss is larger.
220 ∂ CHAPTER 10 THE EFFICIENCY OF COMPETITIVE MARKETS