Government Taxation Causes A Deadweight
Loss For The Economy
…
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.
…
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
…
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.
…
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.
…
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.
…
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
…
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.
…
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.
…
A
helpful video:
https://www.youtube.com/watch?v=dbuU8S1x0Ro&feature=youtu.be
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