13.5 : Taxes

A tax is a mandatory financial charge levied by the government on the quantity of a good sold in the market. An excise tax targets specific goods, often to curb the consumption of certain harmful products.

When an excise tax is imposed on good X, the supply curve shifts leftward by the amount of the tax, reflecting higher production costs for sellers. This shift results in a new equilibrium where the price consumers pay increases while the quantity of good X sold decreases.

The increase in the price of good X that consumers must now pay reduces consumer surplus, which is now the area under the demand curve and above the new, higher supply curve. Consumers face higher prices and reduced availability of the good, causing some consumers to cut back on consumption and decrease their welfare. Similarly, producer surplus declines because fewer units of good X are sold, and producers must accept lower net prices after accounting for the tax. The reduction in both consumer and producer surplus reflects the decline in economic welfare for market participants.

The government collects tax revenue, calculated as the tax rate multiplied by the quantity of good X sold at the new equilibrium. However, the imposition of the tax also creates deadweight loss, which represents the loss of value to both consumers and producers from lost potential transactions that would have occurred at the original equilibrium price. This deadweight loss reflects the decline in market efficiency, as some mutually beneficial trades between consumers and producers no longer take place due to the higher price caused by the tax.

Thus, while the government benefits from increased revenue, the tax reduces overall economic welfare by shrinking consumer and producer surplus and introducing deadweight loss into the market.