Tax: A deeper analysis with 9 figures6 min read


Tax in Economics

Basic Concept

Tax is a compulsory contribution to state revenue, levied by the government on workers’ income and business profits, or added to the cost of some goods, services, and transactions[1]. The cost of goods and services increases with the levy of tax; consequently, the quantity demanded of the goods and services fall.

Indirect tax is the tax levied on the goods and services, and the impact and incidence of the indirect tax fall on different parties, means, the burden of tax can be shifted to other person or party. The ability to shift the burden of tax depends on the elasticity of demand and supply. Elasticity is ‘Escape’, that is, if the demand is elastic (keeping elasticity of supply constant), then the consumers escape from tax burden and vice-versa.

Tax and Dead-weight loss

Deadweight loss is the loss in total welfare as a consequence of allocative inefficiency. Deadweight loss results if the price of a commodity is not identical to the marginal cost. A deadweight loss is a loss in producer and consumer surplus due to a socially inefficient level of production resulting from one or more market failures. Thus, Deadweight loss occurs due to the monopoly power of the firm, taxes, and subsidy by the government, externalities, asymmetric information and so on. The deadweight loss can be escaped entirely if the economy is perfectly competitive, else there is no escape from the deadweight loss.

consumer surplus, producer surplus, dead-weight loss and Tax

In the figure, X-axis measures quantity and Y-axis measures price. Initially, the equilibrium was at ‘E’ with quantity ‘Qe’ and Price ‘Pe’. This level of price and quantity is the socially optimal price and quantity. When the government levies tax, the supply curve shifts from ‘S’ to ‘ST’. The shift in supply curve shifts the equilibrium of the firm from ‘E’ to ‘E1’.

The new consumer surplus is a portion in blue color; the producer surplus is the portion in grey color; the tax is the portion in green; the dead-weight loss is the portion in the red color. Thus, the tax reduces fruitful trade. PB is the price that the buyer will pay, and Ps is the price that the seller will receive. The difference between PB and PS is the tax. Video by ,strong> Marginal Revolution University>

Video by Marginal Revolution University

Types of tax in Economics

In Economics, there are three types of tax. They are a lump-sum tax, profit tax, and specific tax.

The lump-sum tax has no impact on the marginal cost, so the firm’s profit-maximizing position [MR = MC] is unaltered. The lump-sum tax is like the fixed cost, so it affects the total cost, not the variable cost.

Similarly, the profit tax has no impact on the marginal cost, so the firm’s profit-maximizing position [MR = MC] is unaltered. Like a lump-sum tax, profit tax acts like the fixed cost, so it affects the total cost, not the variable cost. 

Specific tax is the per-unit tax levied on the goods and services. It is proportional to the particular quantity of a product sold, regardless of its price. For example, the Government of Nepal announced to levy Rs. 0.25 tax on each stick of cigarette [2] is an example of a specific tax. Unlike, lump-sum tax and profit tax, the specific tax affects the marginal cost of the product. Thus, the profit maximization position [MR = MC] of the firm is affected. The firm has an ability to shift the burden of tax based on the elasticity of demand and supply of the products.

Specific Tax in Perfect Competition

In perfect competition, the price and the quantity are determined by the market forces, that is, the interaction of demand and supply. If a tax is levied on the product, then the supply curve will shift to left, which changes the profit-maximizing price and quantity of the product. The ability to shift the burden of tax depends on the elasticity of demand and supply. If the supply curve is elastic in comparison to the demand curve, then the consumers shall bear an extra burden of the tax, and vice-versa. We will use figures to depict this phenomenon.

tax in perfect competition and elasticity

In the figure, if the supply is inelastic then the producer is able to shift a small portion of the tax burden to the consumers, as shown in Figure 1(A). Similarly, if the supply curve is relatively elastic, then the producer is able to shift a certain portion of the tax burden to the consumers, as shown in Figure 1(B). If the supply curve is perfectly elastic, then the producer is able to shift the entire tax burden to the consumers. Likewise, if the supply curve is downward sloped, then the price of the product increased by ‘∆P3’ and the specific tax by ‘ab’ in Figure 1(D), and ∆P3 > ab.

Thus, elasticity is ‘Escape‘. Keeping the elasticity of demand constant, the increase in the elasticity of supply puts suppliers in better-off. The ability of the supplier to shift the tax burden increase with the rise in the elasticity of supply.

Specific Tax in Monopoly

In a monopoly, monopolist determines the price and the quantity not by the market forces. The monopolist faces downward-sloping marginal revenue and average revenue as it can control either price or quantity. The supply curve shifts to left with levying of tax, which changes the profit-maximizing price and quantity of the product. The ability to shift the burden of tax depends on the elasticity of demand and supply. If the supply curve is elastic in comparison to the demand curve, then the consumers shall bear an extra burden of the tax, and vice-versa.

tax in monopoly and its economic impact

The figure illustrates that the elasticity of supply is the factor that affects the respective burden of the tax. The producer is unable to shift the tax burden with inelastic supply in the figure. With perfectly elastic supply, the monopolist is able to shift a significant portion of the tax burden onto consumers. Figure 2(B) clearly presents this phenomenon.

Perfect competition vs Monopoly

A perfectly competitive firm can shift the entire tax burden onto the consumers if its supply curve is perfectly elastic. But the monopolist, despite the perfectly elastic supply curve, cannot shift the entire tax burden on its consumers. This is due to downward-sloping marginal revenue and average revenue facing the monopolist.

tax in perfect competition and monopoly

The figure presents the difference between perfect competition and monopoly. The monopolist obtains its profit-maximizing price and output at the point of intersection between marginal revenue and marginal cost. Conversely, the competitive firm obtains its profit-maximizing price and output at the point of intersection between demand and supply curves. Such differences in the profit-maximizing position create differences in the ability to shift the tax burden onto consumers. Given the perfectly elastic supply, the competitive firm shifts the entire tax burden onto consumers; but the monopolist fails to do so. To understand this phenomenon, refer to Figure 1(C) and Figure 2(B).

End Notes

[2] Budget of Nepal – 2075/76

[1] Oxford Dictionary. (2018). Tax. Retrieved from https://en.oxforddictionaries.com/definition/tax

Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

Our other articles on Economics

Subsidy: A Deeper Analysis with 6 Figures

Equilibrium and Stability Test [11 diagrams]

Price and Output Determination in Perfect Competition

Suggested Readings:

Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

Tax: A deeper analysis with 9 figures6 min read
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