Laffer Curve: Meaning, How it Works, Tax Rate Policies

What’s it: 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 1959-1991. 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 it, tax revenue will still increase. 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, in the end, they had to pay most of the money as 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

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. Likewise, 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 increase as unemployment fell, and several new businesses emerge. 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, it has the potential to reduce the tax base, in the long run, thereby lowering government revenues.

Increased tax rate reduces the disposable income of the households. Because they have less money on hand, they reduce their consumption of goods and services. As a result, the economy’s aggregate demand falls.

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. Thus, the unemployment rate increases. As a result, the tax base from the household sector decreases.

Businesses see that there is no incentive to produce more output. Falling demand and increasing taxes 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.