6.7 The Effects of Taxation

Taxes create deadweight loss

A per-unit tax raises the price buyers pay and lowers the price sellers receive, driving a wedge between them. This shrinks the quantity traded below the efficient level, destroying mutually beneficial trades. The lost consumer and producer surplus that isn't captured as tax revenue is called deadweight loss, representing a loss of overall market efficiency.

Tax revenue and surplus effects

Government tax revenue equals the tax per unit times the new quantity sold, shown as a rectangle on the supply-demand graph. Both consumer surplus and producer surplus shrink after a tax — part becomes tax revenue, part becomes deadweight loss. The statutory incidence (who pays legally) can differ from economic incidence (who truly bears the burden).

Elasticity determines tax burden

The side of the market with the more inelastic curve bears more of the tax burden, because they're less able to change quantity in response to price changes. Similarly, deadweight loss is larger when supply and demand are more elastic, since more trades are eliminated. Taxing goods with inelastic demand/supply raises revenue efficiently with less distortion.

Key terms

Deadweight loss

The loss in total surplus (consumer + producer) caused by a tax reducing quantity traded below the efficient level.

Tax revenue formula

Tax per unit × after-tax equilibrium quantity; shown as a rectangle on a supply-demand graph.

Statutory incidence

Who is legally required to pay the tax (buyer or seller).

Economic incidence

Who actually bears the burden of the tax in terms of higher prices paid or lower prices received, determined by relative elasticity.

Elasticity and tax burden

The more inelastic side of the market (less responsive to price changes) bears a greater share of the tax burden.

Try an AP-style question

This tax is…

1. regressive
2. progressive
3. proportional
4. lump-sum