The tax wedge is the deviation from the equilibrium price and quantity ( P ∗ {\displaystyle P^{*}} and Q ∗ {\displaystyle Q^{*}} , respectively) as a result of the taxation of a good. Because of the tax, consumers pay more for the good ( P c {\displaystyle P_{c}} ) than they did before the tax, and suppliers receive less for the good ( P s {\displaystyle P_{s}} ) than they did before the tax . Put differently, the tax wedge is the difference between the price consumers pay and the value producers receive (net of tax) from a transaction. The tax effectively drives a "wedge" between the price consumers pay and the price producers receive for a product. Following the law of supply and demand, as the price to consumers increases, and the price received by suppliers decreases, the quantity that each wishes to trade will decrease. After a tax is introduced, a new equilibrium is reached, where consumers pay more ( P ∗ → P c ) {\displaystyle (P^{*}\rightarrow P_{c})} , suppliers receive less ( P ∗ → P s ) {\displaystyle (P^{*}\rightarrow P_{s})} , and the quantity exchanged falls ( Q ∗ → Q t ) {\displaystyle (Q^{*}\rightarrow Q_{t})} . The difference between P c {\displaystyle P_{c}} and P s {\displaystyle P_{s}} will be equivalent to the size of the per-unit tax.
Implications of a tax wedge
Deadweight loss The filled-in "wedge" created by a tax actually represents the amount of deadweight loss created by the tax. Deadweight loss is the reduction in social efficiency (producer and consumer surplus) from preventing trades for which benefits exceed costs. Deadweight loss occurs with a tax because a higher price for consumers, and a lower price received by suppliers, reduces the quantity of the good sold. Thus, the equilibrium quantity of a taxed good is lower than the equilibrium quantity when the same good is not taxed. The deadweight loss created by the tax is equal to 1 2 × T a x × ( Q ∗ − Q t ) {\displaystyle {1 \over 2}\times \ Tax\ \times (Q^{*}-Q_{t})} , represented by the shaded triangle in the figure.
… excerpt ends here. Continue reading the full article.
