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Incidence of Tax

Incidence of tax is a core topic for A Levels Economics, IB Economics, GCSE Economics curriculum. The graph above shows an original equilibrium at point A with demand (D) and supply (S).

A tax of amount T is imposed, the supply function shifts up to S(T). The new equilibrium is at point B. With the incidence of tax, there is a difference in the price that consumers pay and producers receive. Consumers pay Pb and producers receive Ps, their difference is T (the amount of the tax) which goes to the government.

Deadweight Loss

Economics-Tutoring-London-ALevel-IB-Economics-Tutors-Online-Deadweight-loss

As a result of taxes, consumers pay more and producers receive less. The graph above shows that consumer surplus has reduced from area C+D+E to just area C. Similarly, producer surplus has reduced from area F+G+H to just H. The total loss in surplus is D+E+F+G. However, only D+F is reallocated to the government in terms of tax revenue. Meanwhile, area E+G is lost permanently. That is the deadweight loss due to inefficiency which arises because of the tax. In simple words, deadweight loss reflects the economic loss as both consumer surplus and producer surplus decrease as a result of taxes. Some consumers find the good too expensive and are not able to buy it. Similarly, some producers do not earn enough at the after-tax price and stop producing. This limiting of economic activity leads to an inefficiency loss which is the basis for deadweight loss.

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