Application The Costs of Taxation

Taxes are often a source ~ heated political debate. In 1776, the anger of the American colonies over British taxes sparked the American Revolution. More than two centuries later, Ronald Reagan was elected president on a platform of large cuts in personal income taxes, and during his eight years in the White House the top tax rate on income fell from 70 percent to 28 percent In 1992, Bill Clinton was elected in part because incumbent George Bush liad broken his 1988 campaign promise, “Read my lips: no new taxes At least in this regard, the younger George Bush did not follow in his father’s footsteps As a candidate he promised a tax cut, and as president, he made sure to deliver. His critics, however say he cut taxes too much, depriving the government of revenue needed for vital public purposes. Certainly, no one would deny that some level of taxation is necessary. As Oliver Wendell Holmes Jr. once said, “Taxes are what we pay for civilized society Because taxation has such a major impact on the modem economy, we return to the topic several times throughout this book as we expand the set of tools we have at our disposal. We began our study of taxes in Chapter 6. There we saw how a tax on a good affects its price and the quantity sold and how the forces of supply and demand divide the burden of a tax between buyers and sellers. In this chapter we extend this analysis and look at how taxes affect welfare, the economic well-being of participants in a market. In other words, we see how high the price of civilized society can be. The effects of taxes on welfare might at first seem obvious. The government enacts taxes to raise revenue, and that revenue must come out of someone’s pocket. As we saw in Chapter 6, both buyers and
sellers are worse off when a good is taxed: A tax raises ,the price buyers pay and lowers the price sellers receive. Yet to understand more fully how taxes affeot economic well-being, we must compare the reduced welfare of buyers and sellers to the amount of revenue the government raises. The tools of consumer and producer surplus allow us to make this comparison. The analysis will show that the cost of taxes to buyers and sellers exceeds the revenue raised by the government.

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