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Measures of Excess Burden
• Equivalent variation used in last section• Other measures also available
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• Compensating variation:• If real income prior to tax is used as reference point,
the estimate of the change in welfare effect of a tax will alter
• What is the maximum sum that would compensate an individual when there is a tax so as to return the individual to the welfare level prior to tax
• How much should come from outside the system to compensate the tax distortion
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• Figure 7-3• The area of CS loss, is greater as it is based on
larger real income• Income effects based on EV or CV differ from
estimates of Marshallian uncompensated demand curve
• CV for price decrease is EV for price increase and EV for price decrease is CV for price increase
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The welfare costs of taxation
• General equilibrium analysis:• Selective excise tax is more distortive than an
equal yield income tax• So IT is superior to an excise tax??• GE framework may resolve the issues raised
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• GE analysis of resource allocation cost of taxation• Objective of this analysis: Will selective excise
tax create greater resource allocation costs (DWL) than an equal yield IT??
• Figure 7.5• Economy produces 2 goods, X and Y• PPF of 2 goods• X-efficient economy, where should it be placed?
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• Producing on the frontier, and pareto optimality the best output level for two goods is at point 1
• MRTxy=MRSxy
• Slope of PPF= slope of CIC• Perfectly competitive market, no market
failures, or externalities; 1 is the scenario best for economy pre-tax