Laffer Curve – Definition

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Laffer Curve Definition

The Laffer Curve is a graphical representation that illustrates the relationship between tax rates and the resulting tax revenue collected by the government. The curve suggests if the rates of taxation are increased above a certain point, the revenues from the tax can fall. It is based on the assumption that people do not want to work when the tax rate is too high.  

The curve is named after the U.S based supply-side economist Arthur Laffer. The curve is parabolic in shape plotted on a graph. The vertical axis represents the tax revenue of the government and the horizontal axis signifies the rate of taxation. The graph starts at 0% tax with zero revenue, then it gradually increases to a maximum revenue at an intermediate rate of taxation and falls again to no tax revenue at a 100% tax rate.

A Little More on What is the Laffer Curve

The Laffer Curve was first drawn on the back of a napkin in 1974, while Arthur Laffer was talking to the senior staff members of President Gerald Ford’s administration. Arthur Laffer was trying to explain the causes of the economic crisis and its possible solutions. Most of his contemporary economists were trying to find a solution to the problem in a Keynesian way. They were of the view that more government spending would boost up the economy by increasing the demand. Laffer contradicted this view and argued the problem is not the little amount of demand rather it is the result of the burden of the tax. He said the high rate of tax is the main cause of low production and lower government revenue.  

Laffer further argued that when the companies are charged with a high amount of tax, they have less money to invest in the business. In this situation, the companies usually try to protect their capital from taxation, or they relocate their business in part of fully to other countries with a lower tax rate. The high rate of tax also discourages the investors in investing their capital in the business as a large portion of the profit goes to the government. The workers also lose their incentive to work harder as they need to pay a large part of their salaries to the government. Laffer suggested there is a threshold rate for every type of tax if the tax rate rises beyond that point it negatively affects the government’s revenue from taxation.   

The basic concept of this curve was however not completely new. The same concept was discussed in the writings of the social philosopher of the 14th century Ibn Khaldun.

The Laffer Curve theory provided the premise of the economic policy adopted by President Ronald Reagan’s administration. It inspired the Reaganomics and the Kemp-Roth Tax Cut of 1981. It is of the biggest tax cut in the history of the United States.  However, Davis Stockman, the budget director during the first administration of Ronal Reagan maintained that the Laffer curve should not be taken literally, at least not in the economic environment of the 1980s United States.

The Laffer curve has been criticized by the economists for being too simplistic in its assumptions. The curve is based on the assumption that society functions on a single tax rate and a single supply of labor. It does not consider the complexity of the public finance structure. The curve fails to explain how the multivalued tax rates affect tax revenue. Tax avoidance is also not considered in this assumption.

Dr. Arthur B Laffer himself states, “The Laffer Curve itself does not say whether a tax cut will raise or lower revenues”.

He explains, there are six factors that determine whether a tax cut would lead to economic growth. Those factors are-

  1.      The tax system in place
  2.            The time period being considered

  III.            The ease of entering into underground activities

  1.            The level of current tax rates
  2.            The legal and accounting-driven tax loopholes
  3.            The productivity level of the economy

The economists also do not agree on the level at which high rates of tax discourage the people to work. It is a misinterpretation that tax cuts always lead to a rise in the tax revenue in the long-term.     

References for Laffer Curve

https://www.investopedia.com/terms/l/laffercurve.asp

https://en.wikipedia.org/wiki/Laffer_curve

https://investinganswers.com/financial-dictionary/economics/laffer-curve-3533

http://www.businessdictionary.com/definition/Laffer-curve.html

Academic Research on Laffer curve

  • The Laffer curve: Past, present, and future, Laffer, A. B. (2004). Backgrounder, 1765, 1-16. In this paper, Arthur B Laffer explains the Laffer curve in detail. The article discusses the historical origin of the Laffer curve, the theory it is based on, the past tax cuts and their effect. It analyzes the Laffer curve and the Capital Gains tax and examines the tax system of the United States and other countries.
  • The Laffer curve revisited, Trabandt, M., & Uhlig, H. (2011). Journal of Monetary Economics, 58(4), 305-327. This paper compares the Laffer curves for the economy of the United States, the EU-14 and individual European countries. It uses a neoclassical growth model featuring “constant Frisch elasticity” (CFE) preferences in this analysis. The paper provides new tax rate data. The analysis concludes that the US increase its tax revenues maximally by 6% with capital taxes and 30% with labor taxes. The corresponding figures for the EU-14 are 1% and 8% respectively. The paper concludes that the results are affected quantitatively by the endogenous growth and human capital accumulation. The paper further states transition is important while the household heterogeneity may not be that impactful.       
  • Taxes, revenues, and the Laffer curve, Wanniski, J. (1978). The Public Interest, 50, 3. The paper considers the Laffer curve to be powerful in its implications. The paper explains the curve and its implementation in taxes and revenues. It also discusses the politics of the Laffer curve.
  • The debt laffer curve: Some estimates, Claessens, S. (1990). World Development, 18(12), 1671-1677. This paper analyses the Debt Laffer Curve. It uses secondary market prices of commercial bank debt to provide some estimates of the Debt Laffer curves for the deeply indebted and sub-Saharan African countries. The analysis finds that there are only a few indebted countries that are on the wrong side of their Debt Laffer curve.
  • Estimating the Laffer curve and policy implications, Hsing, Y. (1996). The Journal of Socio-Economics, 25(3), 395-401. The paper analyzes the Laffer curve and its policy implications for the U.S. economy. A time-series data from 1959 to 1991 was used in the analysis. The study finds the Laffer curve to be statistically significant and it asserts that the revenue-maximizing tax rate is between 32.67% and 35.21%.
  • Some analytics of the Laffer curve, Malcomson, J. M. (1986). Journal of Public Economics, 29(3), 263-279. The paper shows a general equilibrium comprising of one private good, one public good, labor, and an income tax, does not essentially comply with certain properties of the Laffer curve. There may not be an interior maximum and it may not be continuous for wee-behaved functional forms. The technology and the tax elasticity of labor supply determine the slope.
  • Corruption, tax evasion and the Laffer curve, Sanyal, A., Gang, I. N., & Goswami, O. (2000). Public Choice, 105(1-2), 61-78. The paper discusses the Laffer curve in a situation of a corrupt tax system. It argues that in a corrupt system both the taxpayers and administrators make some complex strategic moves when there is a rise in tax rates. The paper shows that in certain circumstances this may lead to a situation where higher tax rates bring smaller tax revenue for the government.
  • On the analytics of the dynamic Laffer curve, Agell, J., & Persson, M. (2001). Journal of Monetary Economics, 48(2), 397-414. This paper analyzes the government budget balance within a simple model of endogenous growth. It discusses issues related to the dynamic revenue analysis and explains the reason of getting contradictory results in the previous studies. Then it studies the data of transfer-adjusted tax rates of the OECD countries to identify the country with the highest potential for fiscal improvements. The study concludes that only a few countries have such potential for dynamic scoring.
  • Thoughts on the Laffer curve. Blinder, A. S. (1981). In The supply-side effects of economic policy (pp. 81-92). Springer, Dordrecht. The paper argues that the foundations of the Laffer curve were established a long time ago and it does not require any economic analysis. This paper attempts to address a critical empirical issue of U.S. economy. It examines whether the U.S. tax system is over the Laffer hill. It tries to find out whether the taxes in the U.S.  have passed the points at which tax receipts cease to rise.
  • Taxation and the Veil of Ignorance–A real effort experiment on the Laffer curve, Sutter, M., & Weck-Hannemann, H. (2003).Public Choice, 115(1-2), 217-240. The role of the veil of ignorance on work incentives and tax rates is analyzed by a two-person real effort experiment. The result supports the assumption of the Laffer curve and finds tax revenues peak at intermediate tax rates of 50% to 65%. The study suggests that tax administrations do put its effort to tax in full, which earn the maximized revenue and also a fair behavior.
  • Revenue-maximizing corporate income taxes: The Laffer curve in OECD countries, Brill, A., & Hassett, K. (2007).  This note explores the changes in corporate tax receipts in the post-globalized industrialized countries and analyzes the relationship between those changes in tax receipts and tax rates. It finds strong statistical evidence supporting the argument that the Laffer curve effect exists in the international corporate tax. It holds to be true even when the potential outlier countries like Ireland, Norway, and Switzerland are not considered. The paper explores the time variation in the revenue-maximizing corporate income tax rate from 1980 to 2005 and finds that the Laffer curve has existed throughout this period. It also finds that in the 1980s the maximizing corporate tax rate was about 34% and later (around 2005) it declined to about 26%. The use of combined central and sub-central tax rates confirms this finding.  
  • Willingness to pay tax: The Laffer curve revisited for 12 OECD countries, Heijman, W. J. M., & Van Ophem, J. A. C. (2005). The Journal of Socio-Economics, 34(5), 714-723. This paper argues the Laffer curve may hold to be true for activities in the official sector but in the unofficial sector the activity can increase with the rise of the tax rate. The activity from the official sector may just switch to the hidden unofficial sector when the tax rate increases. Taking this into account, the paper analyzes the maximum revenue earning tax rate for various OECD countries and find that except for Sweden, in all other countries the marginal tax rate is below its optimum.  
  • Domestic Taxes and the External Debt Laffer Curve, Husain, A. M. (1997).  Economica, 64(255), 519-525. The paper explores how the economic consequences of an external debt overhang are determined by the domestic tax system. It specifies a simple taxation scheme and shows that if a country is on the wrong side of its debt Laffer curve then it must be on the wrong side of its tax Laffer curve.
  • What’s wrong with the Laffer Curve?, Mirowski, P. (1982). Journal of Economic Issues, 16(3), 815-828. This paper analyzes the Laffer curve in the lights of the U.S. economic policy and criticizes it for being inadequate in its assumptions.  

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