Many states and localities derive a special source of financing from Hotel and Motel taxes. These taxes are largely responsible for the shock most tourists experience at check out time. "I thought you quoted me a price of $50 a night?" "That is correct, Madam." "But I only stayed here two nights." "That is correct, Madam." "And your telling me that I owe you $149?" "That is correct, Madam." "But that's outrageous!" "That is correct, Madam." We know tourists are hurt by this tax, but remember...we care only about the big picture. We care only about the tax's overall effect on society's happiness.

The first question we want to ask ourselves is what effect will Hotel and Motel taxes have on the allocation of society's resources? Will more or less resources be devoted to the provision of hotel and motel accommodations after the tax? It certainly seems reasonable that these taxes will make tourists and other travelers less willing to stay in hotels and motels. That means that there will be less demand for hotels and motels. And that means that profit-maximizing firms will build fewer hotels and motels, or maybe they will build hotels and motels with fewer rooms. The bottom line is that fewer resources will be transferred from other activities to provide accommodations for travelers. The table below illustrates the effect of this tax on a representative resource transfer affected by this tax policy.

Before the adoption of the Hotel and Motel tax, a hotel would have found it profitable to provide two nights' lodging to a traveler. At $50 a night, these resources would have generated around $50 times 2, or $100 in social happiness. And that would have been great. Because the hotel figured that it only cost $75 to provide a room for two nights to a guest. Resources--say sheets, maid service, electricity, etc.--that could have generated $75 in pleasure in doing something else are withdrawn from those activities and directed towards the provision of hotel services. Here they generate $100 in happiness, resulting in a net gain of $25. Since the profit-maximizing firm can make a buck at this activity, this resource transfer goes through and society is made better off.

But look what happens after the tax. The hotel no longer finds this transaction profitable. As a result, it either goes out of business or sells off some of its facilities. And that is a shame. A resource transfer which would have increased social happiness by $25 now does not take place. Resources are withdrawn from a higher valued activity (hotel lodging) to a lower valued activity (who knows what). Again, from the perspective of social happiness, the only two numbers that matter in the table are the Revenues and Costs that the hotel would have experienced before the tax was imposed. These are the numbers that reveal the gains and losses, respectively, of transferring additional resources to hotel guest services. In this case, the economy has been "tricked" into not providing additional accommodations, even though providing them would have made society better off.

The fact that taxes can make people worse off probably isn't a new insight for you. But there's an additional reason to dislike taxes here that you might not have appreciated before (just in case you needed one more reason). Suppose the government raises $10 million in tax revenues from a variety of specific taxes on goods and services. What is the total cost to taxpayers? Most people would say $10 million, the amount of the tax revenues. Since you are smarter than the average reader, you know that this isn't the full story. On top of the actual tax revenues taken away from taxpayers, there is the additional cost due to the lost happiness from misallocated resources. Economists call this the WELFARE COST OF TAXATION. It is the lost happiness that results when taxes take resources out of higher-valued uses and divert them to lower-valued uses--just like in our hotel/motel example.¹

Does this mean that all taxes are bad? A full answer would require us to compare the value of government services society receives from its tax burden with the value of private consumption given up through taxation. We will examine this topic in more detail when we talk about government finances later in this book. For right now it's worth noting that if society wants to raise a given amount of revenues for a particular purpose, taxes should be set so that the disruption in the allocation of society's resources is minimized.

If a government decided to raise all of its revenues through a Hotel and Motel Tax, the size of this tax would be huge, and there would be dramatic changes in the way society allocated resources. (For example, most travelers would probably choose to pack a tent in their suitcases or just stay home.) But if a government spread the tax burden across all of the goods and services in the economy, there would be relatively little change in the way resources are allocated. Think about it. If all prices only go up by a penny, consumers will probably not alter their consumption patterns by much. This would minimize the likelihood that taxes would distort the allocation of resources by "tricking" the economy to place resources in lower-valued activities. This is why economists generally advise that taxes be broad-based (like a sales or income tax), rather than narrowly focused on a few goods (like a Hotel/Motel tax).

Now that we have developed the theory of the PROFIT TABLE to analyze government subsidy and tax policies, the next step is to learn how to apply this framework to news stories that are commonly encountered in the media. That is the goal of the next few chapters.