Effect of Taxes on Demand and Supply

Topics: Supply and demand, Tax, Economics Pages: 11 (1818 words) Published: April 15, 2014
“Effects of Taxes on Demand and Supply”
Definition:
A fee charged ("levied") by a government on a product, income, or activity. If tax is levied directly on personal or corporate income, then it is a direct tax. If tax is levied on the price of a good or service, then it is called an indirect tax.

Overview:
The legal definition and the economic definition of taxes differ in that economists do not consider many transfers to governments to be taxes. For example, some transfers to the public sector are comparable to prices. Examples include tuition at public universities and fees for utilities provided by local governments. Governments also obtain resources by creating money (e.g., printing bills and minting coins), through voluntary gifts (e.g., contributions to public universities and museums), by imposing penalties (e.g., traffic fines), by borrowing, and by confiscating wealth. From the view of economists, a tax is a non-penal, yet compulsory transfer of resources from the private to the public sector levied on a basis of predetermined criteria and without reference to specific benefit received. In modern taxation systems, taxes are levied in money; but, in-kind and corvée taxation is characteristic of traditional or pre-capitalist states and their functional equivalents. The method of taxation and the government expenditure of taxes raised are often highly debated in politics and economics. When taxes are not fully paid, civil penalties (such as fines or forfeiture) or criminal penalties (such as incarceration) may be imposed on the non-paying entity or individual.

Purpose of Taxes:
The purpose of taxation is to finance government expenditure. One of the most important uses of taxes is to finance public goods and services, such as street lighting and street cleaning. Since public goods and services do not allow a non-payer to be excluded, or allow exclusion by a consumer, there cannot be a market in the good or service, and so they need to be provided by the government or a government agency, which tend to finance themselves largely through taxes. Money provided by taxation has been used by states and their functional equivalents throughout history to carry out many functions. Some of these include: expenditures on war, the enforcement of law and public order, protection of property, economic infrastructure (roads, legal tender, enforcement of contracts, etc.), public works, social engineering, subsidies, and the operation of government itself. Governments also use taxes to fund welfare and public services. A portion of taxes also go to pay off the state's debt and the interest this debt accumulates. These services can include education systems, health care systems, pensions for the elderly, unemployment benefits, and public transportation. Energy, water and waste management systems are also common public utilities. Colonial and modernizing states have also used cash taxes to draw or force reluctant subsistence producers into cash economies.

The Effects of a Tax:
With no tax, eq’m is PE and quantity is QE.
Govt. imposes a tax of Rs. T per unit.
The price buyers pay is PB, the price sellers receive is Ps, and quantity is QT.

The Tax generates revenue to
Rs. T x QT.

The tools of welfare economics are used to measure the gains and losses from a tax. Consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus can be determines with and without the tax. The revenue is included in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.

Without a Tax,
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
= A + B + C + D + E + F

With the Tax,
CS = A
PS = F
Tax revenue
= B + D
Total surplus
= A + B + D + F
The tax causes total surplus to fall by C + E

C + E is called the Deadweight loss (DWL) of the tax, the fall in total surplus that results from a...
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