Tax

A tax is a compulsory charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (e.g., tribes, secessionist movements or revolutionary movements). Taxes could also be imposed by a subnational entity.

Economics of taxation

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Figure 1: Equilibrium

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Figure 1 indicates a good without any government interference. This good could represent anything from apples to zippers. At this equilibrium quantity Q1 of the good are sold at price P1. The consumer and producer surplus are both high.

Related Topics:
Apple - Zipper - Consumer - Producer surplus

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Figure 2: With a tax

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Figure 2 shows the introduction of a very simple tax. The tax charges a flat fee whenever a consumer wishes to purchase the good. The price thus rises to P2, and since fewer consumers wish to purchase the good at the higher price, the quantity produced falls to Q2. The government receives the amount of the tax for each unit sold, and this amounts to the region shown in grey. This is the amount of revenue the government receives for this tax.

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Note that in this situation the price of the good to consumers only increases by half the amount of the tax, the other half of the tax is borne by the producer. Thus both consumer and producer surpluses shrink by equal amounts. For many goods this is not the case. Who bears the cost of the tax is determined by the elasticity of the good. For inelastic goods like cigarettes, and gasoline almost all of the tax is paid by the consumer.

Related Topics:
Elasticity - Cigarette - Gasoline

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Figure 3: Net Societal Loss

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The tax is not a simple transfer of wealth from producers and consumers to government. A permanent loss of surplus occurs, shown in orange. This loss is often called dead weight loss which is is a permanent loss to sociey as if some of the goods (Q1 to Q2) were destroyed.

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However, because this model greatly simplifies the economics of taxation, governments must weigh many other factors when choosing a tax system. The size of the dead weight loss usually increases exponentially with regards to the size of the tax meaning a broad small tax (sales tax) would normally have less negative impact than a narrow large tax (taxing a particular good heavily).

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