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Laffer Curve

The Laffer Curve illustrates the relationship between tax rates and tax revenue, suggesting that there is an optimal tax rate that maximizes revenue, while both 0% and 100% tax rates yield no revenue. It posits that increasing taxes beyond a certain point discourages production and reduces overall tax revenue due to decreased taxpayer motivation. Introduced by Arthur Laffer in 1974, the concept challenges Keynesian economics by arguing that high taxes can hinder economic growth and reduce government revenue in the long term.

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55 views3 pages

Laffer Curve

The Laffer Curve illustrates the relationship between tax rates and tax revenue, suggesting that there is an optimal tax rate that maximizes revenue, while both 0% and 100% tax rates yield no revenue. It posits that increasing taxes beyond a certain point discourages production and reduces overall tax revenue due to decreased taxpayer motivation. Introduced by Arthur Laffer in 1974, the concept challenges Keynesian economics by arguing that high taxes can hinder economic growth and reduce government revenue in the long term.

Uploaded by

buzzpricelessanytime
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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What is the Laffer Curve?

The Laffer Curve is a theoretical explanation of the relationship


between tax rates set by a government and the tax revenue
collected at that tax rate. It was introduced by American supply-
side economist, Arthur Laffer. The concept was not invented by
Laffer; there were other antecedents from the 14th-century writings
of Ibn Khaldun.

The Laffer Curve says that there is no tax revenue collection at the
two extreme tax rates of 0% and 100%. However, there is one
optimal tax rate between both these extremes that maximizes tax
revenue collection.

One of the theory’s main assumptions is that if taxation on a certain


activity, such as production, is increased beyond a certain point,
less of it is produced. Beyond the optimal tax rate, workers start to
believe that their extra efforts are resulting in lower additional
income. Thus, they work less, income falls, and tax collection
decreases.
Workings of the Laffer Curve

We plot the tax rate on the horizontal axis and the government
revenue from taxation on the vertical axis. The curve assumes a
parabolic shape. It suggests that at the initial point, the origin when
the tax rate is 0%, there is no revenue for the government. As the
government increases the tax rate, the revenue also increases until
T*. Beyond point T*, if the tax rate is increased, revenue starts to
fall. In short, attempts to tax above a certain level are
counterproductive and actually result in less total tax revenue.

The taxpayers’ desire to work hard for more income begins to fall
because they feel that more of their money is being taken away by
the government. At the tax rate of 100%, the tax base of the
country will be nil and nobody would work because they will need to
give away all their earnings as taxes. T* is the optimal tax rate that
a government should aim to achieve.

Significance of the Laffer Curve


Laffer brought his concept to the attention of policymakers in 1974
when the general approach of most economists was
a Keynesian one. They advocated more government spending to
stimulate demand, which in turn meant more taxes. The policy was
proving to be ineffective and Laffer asserted that the problem was
not because of too little demand but due to the burden of heavy
taxes and regulations that left producers without incentive to
produce more.

Tax rate cuts affect revenues in two ways. Every tax rate cut
translates directly to less government revenue but also puts more
money in the hands of taxpayers, increasing their disposable
income. In the long term, business activity increases, companies
hire more, who in turn spend more, and this leads to economic
growth. The growth creates a larger tax base and generates higher
total tax revenue.

A higher tax rate increases the burden on taxpayers. In the short


term, it may increase revenues by a small amount but carries a
larger effect in the long term. It reduces the disposable income of
taxpayers, which in turn, reduces their consumption expenditure.
Aggregate demand in the economy falls and producers create less.
This leads to higher unemployment. The tax base for the
government falls and so does its tax revenue.

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