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Microeconomics and Taxation

Posted by on October 23, 2016 5:52 PM
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Categories: Business Economics

Most government revenue comes from the taxation of transactions and labor. Taxes impact both the supply and demand curves. Taxes cause a buyer to pay more for something and suppliers to receive less. The loss of value for both buyers and sellers is called the deadweight loss of taxation. Taxation has an enormous impact on the economy and thus stock market. Traders and investors need to understand the effects that taxation has on the economy and thus stock market. We will examine deadweight loss from a microeconomics perspective, ending with a macroeconomics viewpoint.

In a market without taxation, we will say that a package of socks will sell at a fair market price of $14. This $14 equilibrium price is set where the supply and demand curves cross.


When taxes hit the package of socks, the buyer pays a higher price of $15.40, and the seller receives a lower price of $11. Taxation lowers demand to d1 because buyers have to pay a higher price for socks. The seller is also taxed, and so he receives less profit for his package of socks. If there’s less profit, the supplier will supply fewer socks at a level of s1.


The amount that the government receives in taxes is equal to the buyer’s price minus the seller’s price, multiplied by the quantity of the transaction, whether for goods or services. The area of the light red rectangle is the tax revenue collected by the government. The area of the dark red triangle is equal to the economic value that is lost to taxation.

This loss of economic value consists of buyers who will either buy less or not at all because the price is higher than what they can afford so they decide to do without. Likewise, some suppliers will not produce the product because they are not receiving a high enough price to cover their costs. The benefit that these buyers and sellers would have added to the economy if it were not for taxation is called the deadweight loss of taxation. Because these buyers and sellers do not participate in the market, they do not contribute to the tax. Instead, the taxes are paid by the buyers and sellers who continue to participate in the market. The tax burden falls on the fewer buyers and sellers who continue to participate in the market. A vicious taxation loop can start where a government raises taxes more to offset lower tax revenues caused by rising deadweight loss.

Demand and Supply Elasticity

Demand elasticity is the change in quantity demanded at a particular price. If a large change in price results in little change in the quantity demanded, then demand is considered inelastic. If a small change in price results in large changes in the quantity demanded, then demand is considered elastic.

Products that have good substitutes have a high elasticity of demand, since if the price of one substitute increases, buyers can switch to another substitute. For example, if the price of beef increases, then people will buy more chicken, ham, pork, or some other meat. Beef is considered an elastic product.

Products that have fewer or no substitutes have a high inelasticity of demand since if the price increases, there are no substitute products buyers can switch to. For example, if gasoline and oil prices increase, buyers have to pay the higher price because there are no close substitutes.

Supply elasticity is the change in supply costs at a particular price. If the supply changes little with a change in price, then supplies are considered inelastic. Supply is elastic if there are large changes in supply for a small change in price.

For example, the supply of land is inelastic because no one is making any more of it. By contrast, the supply of software is fairly elastic since it costs very little to make and distribute copies of software over the internet.

Deadweight Loss Varies with Elasticity

The amount of the deadweight loss varies with both demand elasticity and supply elasticity. When either demand or supply is inelastic, then the deadweight loss of taxation is small, because the quantity bought or sold does not vary much with the price.

Demand Inelasticity and Deadweight Loss

Buyers need to have the product and so changing the price through taxation is not going to change that. For example, buyers need gasoline to operate their automobile. Gasoline is inelastic as there are no substitutes. Raising taxes on gasoline will result in a lower deadweight loss.


Supply Inelasticity and Deadweight Loss

Sellers want to sell land, and so the tax rate is not going to heavily influence the supply of land for sale. The supply of land is inelastic because, as Will Rogers once said, they’re not making any more of the stuff. Raising taxes on land sales will result in a lower deadweight loss.


Deadweight loss increases proportionately to the elasticity of either supply or demand.

Higher Taxes and Deadweight Loss

Balancing the tax rate which gives the most tax revenue with the least amount of deadweight loss is impossible. The tax rate that worked during the Bill Clinton Administration did not work during the Obama Administration. An endless amount of factors come into play when determining a moderate tax rate with the most yield versus minimal deadweight loss. What we do know is that when the tax rate is small, there is less deadweight loss and conversely, when the tax rate is high, there is more deadweight loss as illustrated in the two graphs below.



As can be seen from the graph below, as taxes are increased, the deadweight loss of the tax also increases, gradually at first, then steeply as the size of the tax approaches the market price of the product without the tax. Likewise, tax revenue increases at first but then starts to decline as a decrease in quantity more than offsets the increase in the tax rate.


Macroeconomics and Taxes

The Federal Reserve has been unable to get the meaningful shift from aggregate demand outward that they wanted to increase GDP. It’s no coincidence that under the Obama Administration, the US has the third highest corporate income tax rate in the world, at 38.92 percent. The U.S. rate is exceeded only by the United Arab Emirates and Puerto Rico. Higher taxes shift the aggregate demand curve inward from AD1 to AD2.


Conversely, lower taxes shift the aggregate demand curve outward.

Higher taxes also negatively impact the number of people willing to work as illustrated by the Laffer Curve.


The marginal tax rate is measured on the vertical axis, and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward-bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, “m” in the figure, an increase in the tax rate will cause overall tax revenues to fall. Note also, for a supply-side tax cut to increase tax revenues, the existing tax rate before the tax cut must be above “m,” perhaps at a rate associated with point “n” on the curve. The tax rate being above “m” is an important point because, in the early 1980s, the Reagan Administration’s economists believed that the economy was on the backward-bending portion of the Laffer curve (above “m”) and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history.

The Reagan Administration also took actions to shift the supply curve outward such as cutting back sharply on the regulation of everything from monopoly and oligopoly to pollution and product safety, critical elements that shift the aggregate supply curve outward.


Policies which can successfully shift the economy’s supply curve out, do so with the twin advantages of both lower unemployment and lower inflation.

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Lance Jepsen

For ethical purposes, I try not to hold any position in any stock I profile on unless specifically stated in the article. Owner of Seasoned entrepreneur, investor, and writer. I love God, family, country, stock trading, economics, and helping people learn how to trade.
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