Laffer Curve

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Laffer Curve?

The Laffer curve is a postulation by Dr. Arthur B. Laffer demonstrating the relation between tax rates and total government tax revenue. It helps assess the impact of taxation amendments on government funds. For example, the Laffer curve graph theory analysis helped bring the US economy from recession after two decades.

There is no tax income collection at two severe taxation rates of 0% and 100% per this concept. The Laffer curve theory proposes an optimal taxation rate that enhances the total tax revenue. Beyond this point, the government earnings tend to plummet. 

Key Takeaways

  • The Laffer curve theory is an illustrative portrayal of the correlation between tax rates and the overall government income.
  • It assumes an optimal taxation rate beyond which any surge in tax rates decreases the comprehensive government income. However, there is little strong evidence of its existence.
  • As per the theory, tax revenue accumulation is null at 0% and 100% at two critical tax rates.
  • It is also criticized for being oversimplified. The Laffer curve examples include President Ronald Regan’s tax policies in the 80s, which helped the US come out of recession. 

Laffer Curve Explained

The laffer curve

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The Laffer curve deduces that tax rate cuts might soar or reduce tax income based on whether taxpayers have already passed the optimal taxation rate. Nonetheless, although credible, there is little empirical evidence of an optimal tax rate. However, supporters of lesser taxation rates on high salaried individuals still back this theory.

According to the Laffer curve analysis, the full tax income can decline upon boosting the taxation rate. It happens due to major incentives for tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. read more, surged tax avoidance rates, likely brain drain consequences, and possible disincentive results in the marketplace.

To clarify, the Laffer curve graph also encountered criticism since,

  1. Decreased taxation rates may raise income inequalityIncome InequalityIncome inequality refers to the crucial imbalance of income dispersal across the population.read more.
  2. Besides taxation rates, the benefits system also influences work incentives.
  3. Tax rates have limited relevance to work incentives because numerous people are on zero-hours or fixed hours agreements.
  4. Lower taxation can cause few people to relax more than work, mainly at higher remunerationRemunerationRemuneration refers to overall monetary and non-monetary compensation that employees or independent contractors receive for providing services to an organization or company.read more or income.
  5. There is limited solid evidence of the highest income tax rates blocking the internal migration of skilled workers.

Dr. Arthur Laffer mentions that tax cuts have both arithmetic (government expenditure and proceeds) and economic (long-term profits and economic expansion) effects. Among other elements, the overall impact also relies upon the taxation rate before the cut.

The rear end of the curve displays zero tax rates meaning no federal revenue and, therefore, no government at all. Gradually, surging taxes increases the total income, indicating the curve’s flatness. Then the curve steepens as the continuously raised   effective tax rateEffects Of Tax RatesEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more decreases the surplus revenue amount.

Resultantly, demand plunges to an extent where the long-term reduction in the taxation base counterbalances the sudden uplift in tax income. Then, the curve rebounds in reverse throughout the “Prohibitive Range.” After this point, any surge in taxation rates leads to decreased federal revenue.

The top of the curve signifies 100% taxation rates and zero federal income. If taxpayers Taxpayers A taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read moregive away all earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more and profits, there is nothing left to work or produce. Hence, the tax baseTax BaseTax base refers to the total value of the income or assets of an individual or firm which is taxable by the government or the relevant taxing authority. This taxable amount is used to evaluate the tax liability of the individual or company.read more is dissolved. 

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Examples

Now, here are some relevant Laffer curve examples.

Example #1

Say, the federal government initially imposes 0% taxation rates suggesting no taxation revenue. Over time, it increases the rate to 20% and thus, is starting to collect a bit of tax revenue. Then, it gradually boosts the rate to 50% and then 80%, inferring increased government income and tax burden.

As per the Laffer curve analysis, when the tax rate hike reaches 100%, it implicates no government revenue. This is because it leads to no further production or work. So, the government cannot further increase the tax rate or it will lead to tax income reduction.

Example #2

As republicans go ahead with taxation reforms, they highly consider the limited empirical evidence of the Laffer curve theory. Moreover, the Republican Congress and contemporaneous US President Donald Trump are preparing to enforce some tax amendments.

US government taxation income assessment relative to a gross domestic product Gross Domestic Product GDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more(GDP) percent infers that this theory potentially has a somewhat flat section in the middle. Since World War II, the taxation revenue has fundamentally remained between 15%-20% of GDP while topmost marginal rates have fluctuated from 20%-92%.

Laffer Curve Significance

The Laffer curve graph created the foundation of supply-side economics as well as the regulation of tax rate cuts. In the 80s, the president of the United States named Ronald Regan followed this approach through tax cuts to provide taxpayers with more cash for expenditure. Resultantly, it surged demand for products and utilities and earnings and employment.

This policy certainly helped the US come out of the recession by the end of two decades. The basic economic idea and supposition are that taxpayers will adjust their financial behavior because of federal tax incentives. Laffer suggested that it will increase demand, decrease the tax burden, and offer an incentive to producers for more production.

Please note that tax rate cuts directly infer lower federal income and higher disposable earnings of taxpayers. Over time, expansion of business affairs leads to increased recruitment and more expenditure resulting in economic development. It forms an extended taxation base producing higher total tax earnings.

Contrastingly, higher taxation rates raise the tax burden, uplifting revenues in the short run but with considerable long-term impacts. This declines the discretionary income Discretionary Income Discretionary income refers to the portion of gross income available after paying taxes, obligate payments like rent, and other essentials like food. It capacitates people to enjoy luxuries of life and has a positive influence in improving the quality of life.read moreof taxpayers, reducing consumer spending. Therefore, gross demand in the financial systemFinancial SystemA financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors.read more diminishes with lesser production and more unemployment.

Resultantly, the government taxation base and tax income are minimized. Though often criticized for being oversimplified, its directness makes the theory easily comprehensible. In addition, it allows for better comprehension of the link between tax rates and the aggregate tax income received by the government.

This concept certainly results in a robust financial period for the US due to Ronald Regan’s tax regulations and transformations in the taxation rate. Therefore, needlessly, there is valid reasoning behind the illustration.

Frequently Asked Questions(FAQS)

What Is the Laffer Curve?

The Laffer curve is the theoretical connection between tax rates and total government tax revenue. Moreover, Dr. Arthur B Laffer proposed this theory around 1973 or 1974. It also presumes an optimal taxation rate that boosts tax income. Unfortunately, there is no strong evidence for the same.

What Does the Laffer Curve Show?

The Laffer curve shows the link between tax rates and the total tax income accumulated by the government. It demonstrates that, sometimes, decreasing tax rates may lead to increased tax revenues. As per the concept, there is zero government income at its two furthermost points (0% and 100%).

Is The Laffer Curve Accurate?

No, the Laffer curve analysis is inaccurate. This model is a doubtful determinant of financial results. There is limited evidence that an optimum taxation rate may boost income inequality. Also, multiple factors affect work incentives.

This has been a guide to Laffer Curve and its Definition. Here we describe Laffer curve graph theory, its analysis, examples, and significance. You can learn more about economics from the following articles –