[MUSIC] In this video, I will explain the Meaning of the Distorting Effect of Taxes. We will consider a classic market on which the demand aimed at the producer decreases according to the price of the good. The higher the price, the fewer the consumers ready to buy the good. Conversely, from the producer's point of view, the higher the price at which the good is sold, the more producers will want to to offer this good in the markets. When this offer and this demand meet, you get a simultaneous equilibrium both in price and quantity. From there, we can determine the producers profit which is linked to the fact they can sell the good at the p* price while the offer curve showed that they were ready to sell it cheaper. This creates a profit for them. The blue area represents the producer's profits. Symmetrically, we can define what's called the consumer's surplus, that is to say, the fact that they benefit from paying the good at a cheaper price than they were willing to pay it. We see that the first purchasers were ready to buy the good at a rather high price but they only pay it the p* price. They will have the opportunity to spend these money on other markets and this will increase the satisfaction. There is an equivalent with the surplus notion for the consumer to the notion of profit for the producer. We see that if we left markets spontaneously we'd find the balance. For some of the consumers surplus and the producers profits is spontaneously maximized. Now, let's just add some taxes in this market, such as a VAT. We tell the people that the shoes is no longer 100 Euros but 120. Purchasers will then say that in that case, they will buy shoes less often or in smaller quantities. They adjust the quantity they consume after the implementation of a VAT. This state can collect new revenues corresponding to the VAT rate multiple by the quantity actually bought by consumers. We see that the consumer surplus is reduced as well as the producers profits. We see a red area here which corresponds to wealth that is not created anymore. It is not collected by producers, consumers, or the state anymore. It is net loss of wealth. It means that this wealth is not produced anymore because of the implementation of a VAT. This distorting effect, this loss of wealth created by the implementation of VAT is not linearly related to the VAT rate. When the VAT rate is doubled, what do we see? We see that consumers will adjust and reduce even more the consumption of the given good. It means that in terms of revenue it is not necessarily favorable since the orange rectangle is not necessarily larger than the previous blue rectangle. It depends on the consumers reaction to the increasing VAT rate, thus to the price elasticity of conception on this market. We also see that the loss of wealth created by doubling the VAT rate is more than twice as important as what we previously had. There is indeed a wealth lost that is not linearly related to the VAT rate. Is VAT the only distorting tax? No, let's take the example of an income tax. When we add an income tax, what happens? Of course, the demand aimed at producers in the market depends on the income level. When an income tax is implemented, the demand decreases, since the consumers available income has decreased. This leads to surplus loss corresponding to the red area here. It is important to understand that when a tax is collected, it is not a simple transfer from the taxpayer to the state. When taxpayer adjusts the demand of behavior after the implementation of this tax, there is a distorting effect. The size of the cake being shed between the state, producers, and consumers is reduced. Most taxes are distorting, since most acts as it adapt to the implementation of a VAT, an income tax, etc. Some taxes, such as the profit tax, are not distorting since there is an interest in maximizing benefits even when they are taxed. All taxes are not distorting but most are. The distorting effect is usually non-linear. It's grows faster than the tax rate. Finally, in developed countries, tax shifting tells environmental taxes on polluting emissions generates revenues. Which creates an opportunity to decrease preexisting taxes that generated distorting effects. This might be a way to improve the un-remmital quality, and the economic situation, by reducing the average distorting rates of the tax system.