The deadweight loss caused by taxes
taxation 
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A $1,000 tax on used cars causes the number of units exchanged to fall from 750,000 to 500,000. It reduces the quantity of units exchanged by 250,000 units. Remember, trade results in mutual gains for both buyers and sellers. The loss of the mutual benefits that would have been derived from -these additional 250,000 units also imposes a cost on buyers and sellers. But this cost the loss of the gains from trade eliminated by the tax- does not generate any revenue for the government. Economists call this the deadweight loss of taxation. The size of the triangle ABC measures the deadweight loss. The deadweight loss is a burden imposed on buyers and sellers over
and above the cost of the revenue transferred to the government. Sometimes it is referred to as the excess burden of taxation. It is composed of losses to both buyers (the lost consumer surplus consisting of the upper part of the triangle ABC) and sellers (the lost
producer surplus consisting of the lower part of the triangle ABC). The deadweight loss to sellers includes an indirect cost imposed on the people who
supply resources to that industry (such as its suppliers and employees). The 1990 luxury- boat tax provides a good example. Supporters of the luxury-boat tax assumed the tax burden would fall primarily on wealthy yacht buyers. The actual effects were quite different, though. Because of the tax, luxury-boat sales fell sharply and thousands of workers lost their jobs in the yacht-manufacturing industry. The deadweight loss triangle might seem like an abstract concept, but it wasn’t so abstract to the employees in the yacht industry who lost their jobs! Their losses are part of what is reflected in the triangular area. Moreover, because luxury-boat sales declined so sharply, the tax generated only a meager amount of revenue. The large deadweight loss (or excess bur- den) combined with meager revenue for the government eventually led to the repeal of the tax.
The impact of tax
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How do taxes affect market exchange? When governments tax goods, who bears the burden? Economists use the term tax incidence to indicate how the burden of a tax is actually shared between buyers (who pay more for what they purchase) and sellers (who receive less for what they sell). When a tax is imposed, the government can make either the buyer or the seller legally responsible for payment of the tax. The legal assignment is called the statutory incidence of the tax. However, the person who writes the check to the government – that is, the person statutorily responsible for the tax – is not always the one who bears the tax burden. The actual incidence of a tax may lie elsewhere. If, for example, a tax is placed statutorily on a seller, the seller might simply increase the price of the product. In this case, the buyers end up bearing some, or all, of the tax burden though the higher price.
The tax has statutorily been placed on the seller. When a tax is imposed on the seller, it shifts the supply curve upward by exactly the amount of the tax- $1,000 in this example. To understand why, remember that the height of the supply curve at a particular quantity shows the minimum price required to cause enough sellers to offer that quantity of cars for sale. Suppose you were a potential seller, willing to sell your car for any price over $6,000, but you were unwilling to sell it unless you could pocket at least $6,000 from the sale. Because you now have to pay a tax of $1,000 when you sell your car, the minimum price you will accept from the buyer will rise to $7,000, so that after paying the tax, you will retain $6,000. Other potential sellers will be in a similar position. The tax will push the minimum price each seller is willing to accept upward by $1,000. Thus, the after-tax supply curve will shift vertically by this amount.
Sellers would prefer to pass the entire tax on to buyers by raising prices by the full amount of the tax, rather than paying any part of it themselves. However, as sellers begin to raise prices, customers respond by purchasing fewer units. At some point, to avoid losing additional sales, sellers will find it more profitable to accept part of the tax burden themselves (in the form of a lower price net of tax), rather than to raise the price by the full amount of the tax.
Before the tax was imposed, used cars sold for a price of $7,000 (at the intersection of the original supply and demand curves shown by point A). After the $1,000 tax is imposed, the equilibrium price of used cars will rise to $7,400 (to point B, the intersection of the new supply curve including the tax, and the demand curve). Thus, despite the tax being statutorily imposed on sellers, the higher price shifts some of the tax burden to buyers. Buyers will now pay $400 more for used cars. Sellers now receive $7,400 from the sale of their used cars. However, after sending $1,000in taxes to the government, they retain only $6,400. This is exactly $600 less than the seller would have received had the tax not been imposed. In this case, each $1,000 of tax revenue transferred to the government imposes a burden of $400 on buyers (in the form of higher used-car-prices) and a $600 burden on sellers (in the even though sellers are responsible for actually sending the $1,000 tax payment to the government.
The tax revenue derived from a tax is equal to the tax base (in this case, the number of used cars exchanged) multiplied by the tax rate. After the tax is imposed, the quantity exchanged will fall to 500,000 cars per month because some buyers will choose not to purchase at the $7,400 price, and some sellers will decide not to sell when they are able to net only $6,400. Given the after-tax quantity sold, the monthly revenue derived from the tax will be $500 million (500,000 cars multiplied by $1,000 tax per car).