P 0 was the price before the tax was imposed, p D is the price consumers pay and p S the price producers receive. The adjacent figure shows the effects of imposing a new tax on a good. Governments usually increase taxes to increase their revenue, which they use to relocate wealth and increase social welfare. Welfare analysis and government’s revenue: Producer surplus will remain equal to zero, since there are no profits to be made.
In the long run, since the supply curve is completely elastic, the new tax will reduce only consumer surplus. Higher elasticity (right figure) will have the opposite effect. The lower the elasticity in absolute terms (left figure), the higher the loss in consumer surplus, and the lower in producer surplus. The loss in consumer and producer surplus will depend on the elasticity of the demand curve, as shown in the figures below. Only consumers actually pay more, but producers are getting less out of the sale. A corresponds to the amount of the tax paid by consumers, while B is the amount paid by producers. In this case, as shown in the adjacent figure, supply will shift to the left, decreasing the quantity being produced, which increases its prices since demand remains unchanged: the new equilibrium price will be p D (if the tax was to be imposed to consumers, there would be a shift in demand instead). Let’s say this tax is imposed to firms, which increase their prices in order to cover their losses. In the short run, both consumers and producers will suffer from the tax imposed.
The impact on both surpluses depends on the period analysed. However, a distinction between the loss in consumer and producer surplus must be made. When considering taxes to firms, it must be noted that these taxes will increase the price of goods being produced and sold, which translates into a welfare loss. Governments will choose to implement taxes to either individuals or firms in order to increase its revenue.
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