Efficiency of an Excise Tax (II)
In the last section, we saw how we could see the welfare
cost of an excise tax using a supply and demand graph.
Another way of illustrating the loss of value that an excise
tax can cause is with the production-possibilities frontier
in the graph below. Suppose that initially the society is at
point a and that this point is economically
efficient. Now suppose that the government collects revenue
by placing a tax on good A but not on good B
and then returns it to the citizens. The introduction of the
tax will reduce the amount of good A that people will
buy relative to the amount of good B because, with
the tax, the price of A has risen relative to
B. Hence, people will shift from point a to
point b on the graph. But point a was
economically efficient--not point b.
The price system is a method of communicating
information. The system works efficiently only when the
information that is communicated is accurate. Taxes can
distort the signals that prices carry so that they no longer
correctly describe the costs and benefits that various
decisions have for society as a whole. Hence, they can
distort decisions as well.
Note that the welfare costs of a tax are not the same as
the resources that the government uses to collect revenue or
the resources that the private sector uses to comply with
the tax laws. These are costs in addition to the welfare
cost of taxes illustrated above.
The analysis up to this point has avoided complications.
In fact, there are at least three complications that one
must consider before one tries to draw any conclusions about
the actual effect of an excise tax in the real world.
First, the first graph is drawn with a horizontal supply
curve, implying that resources used to produce the product
are all equally productive in producing the item. Often,
resources are not identical. For example, in producing
grain, some land is much more productive than other land. If
the price of grain drops, land that is least productive will
usually be switched to pasture land or left idle. As the
price continues to drop, the land that is taken from
production will continue to be the "marginal" land, or that
which is least productive (relative to other uses). This
pattern of resource productivity will yield an
upward-sloping supply curve such as that in the graph below.
The hatched area above P1 and below the demand curve is
consumer surplus. The hatched area under P1 and above the
supply curve is producer surplus.
If an excise tax is imposed in a market such as that
illustrated above, the graph below results. In this case,
the price rises less than the amount of the tax, and tax
revenue--the total hatched area--exceeds the loss of
consumers' surplus. But there is another loss, one of the
producers' surplus. Economic rents are diminished. The total
reduction of surpluses will exceed the tax revenue by the
amount of the triangular area a-c-b. Hence, an
upward-sloping supply curve does not change the conclusion
that the tax causes economic inefficiency, though it does
alter the conclusion about who bears the tax.
A second complication to our story is that for some cases
a simple supply and demand graph may not be appropriate to
examine the consequences of a tax. Using a supply and demand
graph to analyze a tax is a case of partial equilibrium
analysis. Such analysis assumes that any effects on
other markets can be ignored. Sometimes this assumption may
be inappropriate. A tax on item A may affect the
price of item B, which in turn may alter the supply
or demand of item A. When this sort of situation
occurs, economists can attempt to analyze it with a much
more complicated technique of general equilibrium
analysis, a topic best left to advanced courses in
economics.
A third complication of the economic efficiency of a tax
is that up to now we have been assuming that we started from
a position of economic efficiency. If the starting point is
not economically efficient, the distortion that the tax
causes may offset some initial distortion, and, as a result,
the tax can increase economic efficiency rather than reduce
it.
We will finish this group of readings with rent
seeking.
Copyright
Robert Schenk
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