Government Taxation Causes A Deadweight Loss For The Economy
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Per Figure 1:
For the economy, maximization of total consumer + producer surplus is the goal
Consumer surplus (satisfaction) is the price consumers are willing to pay for a good minus the price they actually pay for it .
Producer surplus (profit) is the price producers receive for a good minus their costs of producing that good.
In Figure 1, maximum total surplus is at equilibrium E.
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Per Figure 2:
Pre-tax total surplus = consumer surplus (A + B + C) + supplier surplus (D + E + F).
Government needs tax revenues, but taxation creates deadweight loss.
Government tax revenue = B + D
Consumer and producer surplus reduced to A and F
Deadweight loss caused by taxation = C + E
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Per Figure 3:
Example of deadweight loss.
Consumer surplus:
Joe values a pizza at $8, the maximum he would pay for a pizza.
Jane values pizza at $6.
The pre-tax price of pizza is $5, so both Joe and Jane will buy one.
Joe gets consumer surplus of $8 - $5 = $3.
Jane gets consumer surplus of $6 - $5 = $1.
Total consumer surplus is $4.
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Then government levies a $2 tax on each pizza
The price of pizza rises to $5 + $2 = $7.
Joe still buys a pizza, but now receives a consumer surplus of only $8 - $7 = $1.
Jane decides not to buy a pizza because the new after-tax $7 price is higher than its $6 value to her.
Total consumer surplus after tax is reduced to $1.
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Supplier surplus:
Rico’s is the only local pizza restaurant, so Joe and Jane both buy there.
The pre-tax price of pizza is $5, so both Joe and Jane will buy one.
It costs Rico’s $4 to make a pizza, so it makes $1 producer surplus (profit) from each pizza sold.
Then government levies a $2 tax on each pizza.
Before the new $2 tax per pizza Rico’s sells two pizzas, one each to Joe and Jane, for a total of ($5-$4) x 2 = $2 producer surplus.
After the tax Rico’s sells one pizza, only to Joe, total producer surplus is reduced to $1.
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Total tax and deadweight loss overall result:
Before tax total surplus: Joe $3, Jane $1, Rico’s $2, and tax revenue $0, total economy benefit is $6.
After tax total surplus: Joe $1, Jane $0, Rico’s $1, tax revenue $2, total society benefit is $4
Total deadweight loss created by the tax is $6 - $4 = $2
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Per Figure 4:
Another cause of deadweight loss is government wasteful spending.
Government wasteful spending is mainly caused by no profit motivation and great political motivation.
This results in favoring projects that benefit special interest groups, expecting political (vote-getting, campaign contributions) gains.
Costs are a secondary concern.
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These conclusions can be drawn:
With the smallest possible taxation and government we have the smallest deadweight loss, biggest consumer and producer surplus, and maximized economy size.
Government should minimize its amount of taxing and spending.
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