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Module 10
OPTIMAL TAXATION
Lecture (34 - 37)
Topics
NPTEL-Economics-Public Economics
2
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
Module
Lecture 34
Topics
10.1 TAX INEFFICIENCIES AND THEIR IMPLICATIONS
FOR OPTIMAL TAXATION
Focus in incidence analysis is on prices, not quantities
Incidence analysis: effect of policies on distribution of economic pie
Focus in efficiency analysis is on quantities, not prices
Efficiency or deadweight loss: effect of policies on size of the pie.
3
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
Figure 34.1
Consider the impact of a per liter tax on the suppliers of diesel.
Initial equilibrium at A:
Tax on diesel shifts the supply curve up.
BC is the rift between SMB and SMC due to the tax.
Tax creates a Dead weight loss = ABC.
.
4
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
5
Indian Institute Of Technology, Kanpur
NPTEL-Economics-Public Economics
As the market moves farther and farther from the competitive equilibrium, there is
a widening gap between demand and supply. The loss of these higher surplus
trades means marginal Deadweight Loss gets larger.
Marginal deadweight loss is the increase in deadweight loss per unit
increase in the tax.
Figure 34.3 a
Harberger trapezoid
Government revenue loss: Rectangle in trapezoid This area is proportional to the
change in tax rate, .
Consumer surplus & Producer surplus: triangles in trapezoid Proportional to the
square of change in tax rate,
.
Harberger Trapezoid
Figure 34.3 b
Where
CS = Consumer Surplus
PS = Producer Surplus
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NPTEL-Economics-Public Economics
As tax rate doubles the DWL triangle quadruples. So the Marginal DWL
increases to a value four times the initial DWL, when tax rate is doubled.
Total DWL from 2t tax is ADE in fig 34.3b.
The area BC DE is 3 times larger than ABC.
7
Indian Institute Of Technology, Kanpur