What is the Laffer Curve?
Laffer Curve is a curve that describes the relationship between tax rate and amount of tax revenue government collect and shows that increasing tax rates do increase revenues for the government but only to a certain extent, after a certain level the tax income starts to decline with an increased tax rate. This theory was proposed by an economist named Arthur Laffer.
Understanding the Laffer Curve
Generally, the Laffer curve draws a relation between tax rate and tax income for the government assuming, that a single tax rate exists, and it increases the revenue of the government from taxation. Let us deep dive into this to understand it deeper with a diagram:
The vertical axis that is the Y-axis represents the tax rate and X-axis (Horizontal) represents the revenues received. Now let us try to analyze this diagram:
- As we can clearly see that when the tax rate is 0% and 100% revenues are NIL, it means that when taxes are 0% government won’t have any income while it is 100% people will find it useless to earn since all the earnings might go in taxes. So, both the scenarios it is NIL income for the government.
- Point E is the point where government revenues are maximum at that tax rate, which indicates that is the median point after which if the rates are increased the income will start to decline.
- The horizontal line bisecting the point E divides the curve in 2 sections of tax rates into terms of their relationship to income.
- The normal range i.e. the below portion in the curve indicates that an increase in the tax rate will increase the revenue of the government and vice versa.
- On the contrary, the above portion which is the shaded region known as prohibitive range depicts the inverse relation of the tax rates and revenue, where increasing the tax rate would decline the income of the government.
- The vertical line intersecting the curve at points A and B show the symmetric nature of the curve and it proves that two different tax rates can generate the same amount of income for the government.
- Point A indicates the relatively high tax rate but not maximum, it is close to 100% and on the other hand point B is relatively low tax rate, hence laffer curve tells us that a relatively high rate on the small groups will generate the same revenue as the small rate on a large group.
Major Two Effects of Laffer Curve
Laffer curve as described portrays two effects of tax rates on tax revenues namely, arithmetic effect and economical effect.
- Arithmetic Effect
- Basically, the increase and decrease of tax revenues depending on the tax rate.
- Economical Effect
- This is the controversial effect of the Laffer curve, which means that an increase or decrease in the tax rate will have a respective effect on the tax revenue because of the incentives or disincentives created to meet the work, output, and employment.
- One assumption this effect holds is that reducing tax rates is a boost up for the economy and it encourages people to work and increase their productivity, which enables in increasing income while on the contrary raising tax rate has quite the opposite effect.
Limitations of the Laffer Curve
Laffer curve has been in controversy since its inception, the main reason being that the curve is too simple in its assumptions which don’t fit well in the real-world scenario.
- The curve doesn’t exactly say that a tax cut will lead to an increase in revenues since a lot of other factors are also involved in determining the same as the tax system, time period, level of current tax rates and many more.
- The chief limitation is to apply this curve for most of the tax systems and determining whether the current system lies in the curve or not. That is, point E in the diagram is different for different tax systems and the generic curve won’t be able to satisfy those conditions.
- The critical limitation is the lack of empirical evidence for the curve to be true in the real economy, Arthur laffer stated examples of U.S history namely the three major tax cuts the Harding–Coolidge cuts of the mid-1920s, the Kennedy cuts of the mid-1960s and the Reagan cuts of the early 1980s.
- However, the systems of taxation are different in every situation and different tax system exists making the effects of the tax rate and cuts difficult to be applied in a practical manner.
- One of the major drawbacks is that the Laffer curve takes a simple and single rate for the analysis of tax change effects, this is quite the baseless assumption to fit in the current economic and taxation systems for most nations.
- Lastly, the curve assumes that increasing the tax revenue is the desirable policy goal for most of the policymakers in the world. It is not very imperative for any government to increase or decrease their revenue based on only the tax rates, there are scenarios where the government can easily meet the demands of the citizens even if it doesn’t have the maximum possible tax revenue from the economy.
- Also, maximizing tax increases the political cost for the government whereas an economy can survive on minimal tax income to achieve social goals, which is the opposite of the Laffer curve purpose.
Laffer curve can be used for policy and decision-makers in the economy to judge the tax rate and income, however, the concept doesn’t always fit in all the tax systems and has some serious limitations. Lastly, the main take away of the Laffer curve is that it helps to determine the individual’s behavior to different changes in the tax structure system.
This has been a guide to what is the Laffer curve and its definition. Here we discuss the effects (Arithmetic Effect and Economical Effect) of the Laffer curve with limitations. You can learn more about economics from the following articles –