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What’s it: The Laffer curve is a graphical representation of the relationship between the tax rate and total government tax revenue. The curve takes its name from Arthur Laffer, the American economist.
This curve shows you the revenue-maximizing tax rate concept. When rates are too low, government tax revenues are less maximized. The government has the opportunity to raise tariffs and increase revenue. But, if it is too high, it burdens the taxpayer and, in the end, leads to less tax revenue.
Revenue-maximizing tax rates vary between tax types and countries. For example, the optimal tax rate is in the range of 32.67% – 35.21%, based on Y. Hsing’s analysis of the United States economy between 1959 and 1991. Meanwhile, a study by Mathias Trabandt and Harald Uhlig in 2011 shows that the percentage is at 30% for labor tax and 6% for capital tax in the United States. Furthermore, a comparison of several studies shows the optimal range for the tax rate is 70%.
How the Laffer curve works
Laffer brought his concept to the attention of policymakers in 1974. At that time, the common approach of economists was the Keynesian approach. They advocate more government spending and lower taxes to stimulate aggregate demand. An increase in aggregate demand stimulates economic growth.
Businesses see their demand and profit prospects increasing, prompting them to spur production. That, in turn, creates more jobs and income in the economy. Ultimately, these interventions will bring more tax revenue as business profits and household incomes improve.
But, such views have some critics. Laffer argued that the economy did not grow due to a lack of demand. But, it is more because the tax burden has been too high. High tax rates discourage producers from producing more output, and households are reluctant to work.
At the extreme point, namely the 0% and 100% tax rates, the government does not earn revenue. 0% means the government does not set a tax rate. Meanwhile, at the 100% level, businesses and households pay all of their profits and income as taxes.
In between these two extremes percentages, there is an optimal tax rate. At that point, the government can collect the maximum tax revenue. When it is lower (between 0% -x%), tax collection is less than optimal because it can increase the rate and collect more revenue.
In this range, the private sector is relatively free of tax rates. So, when the government raises them, tax revenue will still increase, and the private sector may not really mind the increase.
Conversely, when it is higher (between x% -100%), the tax rate is too burdensome, disincentives businesses and households from raising money. In that situation, the government should lower the tariff to maximize revenue.
Taxpayers are reluctant to work harder to earn more income. They reasoned that, despite the pain, they would ultimately have to pay most of the money in taxes.
At a 100% tax rate, zero tax revenue. Nobody wants to work and produce. Even if they make money, they can’t enjoy it. So why work if they have to hand over all the money as taxes?
Tax rate policy: the long-term impact
Some economists use the Laffer curve to support tax cuts to stimulate the economy. Tax rates affect government revenue in two ways. The first is the direct effect on its revenue. The second is the indirect effect through changes in the tax base and the number of taxpayers.
Say, the government cuts the tax rate. Lower tax rates mean less revenue in the short run.
But in the long run, the increasing taxpayer base compensates for this effect. Tax rate cuts put more money in taxpayers’ hands, companies have more profits for capital investment, and households have more money to spend on goods and services.
Hence, tariff cuts should spur demand for goods and services, encouraging businesses to increase production. Several new businesses emerge. They hire more workers, pushing the unemployment rate down.
As a result, economic growth creates a more tax base as household income and business profits increase. Also, taxpayers increased as unemployment fell, and several new businesses emerged. The higher the tax base, the greater the tax revenue in the long run.
Conversely, a higher tax rate increases the burden on the taxpayer. In the short term, it might increase government revenue. However, in the long run, it has the potential to reduce the tax base, thereby lowering government revenues.
An increased tax rate reduces households’ disposable income. Because they have less money on hand, they reduce their consumption of goods and services, resulting in a fall in the economy’s aggregate demand.
A decrease in aggregate demand creates an increase in unsold stock. For manufacturers, it puts upward pressure on operating costs. In response to the increase in stock, producers began to reduce production.
A decrease in production encourages businesses to demand fewer workers, increasing the unemployment rate and decreasing the tax base from the household sector.
Businesses see no incentive to produce more output. Falling demand and increasing taxes have squeezed their profits. Profits are less, and some companies may book losses. As a result, the tax base from the business sector also decreases.
Overall, a high tax rate increase weighs on economic growth and generates less of a tax base. Some taxpayers may seek to evade taxes and shift their wealth and money offshore. That, in turn, leads to a decrease in government revenue.
Criticisms and considerations
While a thought-provoking concept, the Laffer Curve has its share of criticisms and limitations. Understanding these complexities is crucial for economics students, investors navigating the tax landscape, and anyone interested in a balanced perspective on tax policy.
Challenges in measuring the optimal tax rate:
- Abstract model: The Laffer Curve is a theoretical model, and the exact location of the optimal tax rate on the curve is difficult to pinpoint in real-world economies. There’s no one-size-fits-all answer, as economic conditions, tax structures, and societal values can all influence the ideal tax rate.
- Limited empirical evidence: While some studies suggest a potential revenue-maximizing tax rate, there’s a lack of conclusive empirical evidence to definitively prove the Laffer Curve’s existence or pinpoint the exact optimal rate. Real-world data can be messy and influenced by complex factors beyond tax rates alone.
The role of other economic factors:
- Beyond tax rates: Economic growth is influenced by a multitude of factors beyond just tax rates. Government spending, regulations, global trade, and technological advancements all play a role in shaping economic activity. A focus solely on tax rates can overlook the broader economic picture.
- Behavioral considerations: The Laffer Curve assumes a rational response from taxpayers and businesses to tax changes. However, human behavior and decision-making can be complex. Factors like risk aversion, uncertainty about future tax policy, and the overall tax code’s structure can all influence how individuals and businesses react to tax changes.
Is the Laffer Curve a reliable model for tax policy?
Despite the criticisms, the Laffer Curve offers a valuable framework for considering the relationship between tax rates and government revenue. It highlights the potential drawbacks of excessively high tax rates that can stifle economic activity. However, it’s important to recognize the limitations of the model and the need for a nuanced approach to tax policy, considering various economic factors and societal goals.
