But Congress intends to permanently ban an Internet sales tax. The reason is very simple: the incidence of a new form of taxation will result in a deadweight loss. Figure 1 shows the current situation of Internet commerce without tax.
Figure 1: Supply and demand curve without tax.
.
Without a tax, the price and quantity of Internet commerce are found at the intersection of the supply and demand curves. The price is P1, and the quantity sold is Q1. Because the demand curve reflects the online buyer's willingness to pay, consumer surplus is the area between the demand curve and the price, A+B+C. Similarly, because the supply curve reflects the online seller's costs, producer surplus is the area between the supply curve and the price, D+E+F. In this case, since there is no tax revenue, the total surplus of Internet commerce equals the area A+B+C+D+E+F. .
Figure 2: Taxation causes a deadweight loss.
.
Now consider welfare after the tax is enacted on the Internet commerce. The price paid by buyers from P1 to PB, so consumer surplus now drops to only area A. The price received by sellers falls from P1 to PS, so producer surplus drops to only area F. The quantity sold falls from Q1 to Q2, and the government collects tax revenue equal to the area B+D. In this case, the total surplus is area A+B+D+F.
Here comes the problem: where did the area C+E go? I can only answer that they disappeared! Yes, since the losses to buyers and sellers from a tax exceed the revenue raised by the government, the total surplus falls by the area C+E. Such a fall in total surplus that results when tax distorts market outcomes is referred to as deadweight loss. The area C+E measures the size of the deadweight loss. A tax gives buyers an incentive to consume less, and sellers an incentive to produce less than they otherwise would. As buyers and sellers respond to these incentives, the size of the market shrinks below its optimum.