13.6 : Tax Size and Deadweight Loss

When a government imposes a tax, it increases the price consumers must pay and reduces the net price producers receive at equilibrium. This leads to adjustments in market behavior of both consumers and producers.

Initially, a small tax raises the market price slightly. Consumers continue to buy the goods but in reduced quantities. The supply curve shifts leftward by the amount of the tax, and the new equilibrium reflects a higher price and lower quantity. Though some consumer and producer surplus is lost, the deadweight loss remains relatively small. This is because the tax is low, and relatively fewer trades are discouraged.

However, as the tax rate increases, the price of goods climbs further, discouraging even more consumers from purchasing the good. Producers also sell fewer units, resulting in reduced revenues. The deadweight loss triangle, which captures the value of missed trades that would have occurred at the original equilibrium, grows larger.

As taxes rise, the area representing consumer surplus—the space under the demand curve but above the price—shrinks, reflecting the burden on consumers. Producers also suffer losses as they sell fewer items at the higher taxed price, decreasing producer surplus—the area above the supply curve and below the price. Thus, both consumers and producers bear the economic cost of ever larger taxes.

The direct relationship between the size of the tax and the resulting deadweight loss demonstrates the trade-off that is inherent in taxation. While higher taxes generate greater government revenue, higher tax rates also lead to increased deadweight loss, reflecting lost economic opportunities and reduced market efficiency. Conversely, smaller taxes minimize deadweight loss but yield less government revenue.