What is the Laffer Curve?

The Laffer Curve is one of the main theoretical constructs of supply-side economics. It is frequently used as a shorthand to summarize the entire supply-side economics pro-growth worldview.

 

The Laffer Curve, on the other hand, simply depicts the tradeoff between tax rates and total tax revenues collected by the government.

 

Lower tax rates have a positive impact on work, output, and employment, providing incentives to increase these activities. Raising tax rates, on the other hand, penalizes people for engaging in these activities. The Laffer Curve shows what happens when economic and arithmetic effects collide, explaining why a tax increase may reduce taxed activity and raise less revenue than expected, while a tax cut may increase taxed activity and raise more revenue than expected.

 

What is The Laffer Curve? 

 

The Laffer Curve, named after American economist Arthur Laffer, was a bell-curve analysis that plotted the relationship between changes in the government tax rate and tax receipts. It implies that taxes may be too low or too high to generate maximum revenue, and both a 0% and a 100% income tax rate generate $0 in receipts.

 

Tax cuts, according to Arthur Laffer, have both arithmetic and economic effects on the federal budget.

 

The Laffer Curve was named after a 1978 article in The Public Interest by the late Jude Wanniski (then-associate editor of the Wall Street Journal) titled "Taxes, Revenues, and the 'Laffer Curve.'" Wanniski recounted a 1974 dinner he attended with Arthur Laffer (then a professor at the University of Chicago), Donald Rumsfeld (chief of staff to President Gerald Ford), and Dick Cheney (Rumsfeld's deputy and a former classmate of Laffer) in his subsequent book The Way the World Works. 

 

When the foursome's dinner conversation turned to President Ford's "WIN" (Whip Inflation Now) tax increase proposal, Dr. Laffer is said to have grabbed his napkin and drew the curve to illustrate the tradeoff between tax rates and tax revenues. Wanniski coined the phrase.

 

According to the Laffer curve, tax rate cuts may increase or decrease tax revenue depending on whether taxpayers have already reached the optimal taxation rate. Nonetheless, there is little empirical evidence of an optimal tax rate, despite its credibility. However, supporters of lower tax rates on high-income individuals continue to support this theory.

 

According to the Laffer curve analysis, increasing the tax rate can reduce total taxable income. It occurs as a result of significant tax evasion incentives., increased tax avoidance rates, potential brain drain consequences, and market disincentives

 

According to Dr. Arthur Laffer, tax cuts have both arithmetic (government expenditure and proceeds) and economic (long-term profits and economic growth) effects. Among other things, the overall impact is determined by the taxation rate prior to the cut.

 

The tail of the curve shows zero tax rates, implying no federal revenue and, as a result, no government at all. Surging taxes gradually increase total income, indicating the flatness of the curve. The curve then steepens as the continuously raised effective tax rate reduces the amount of surplus revenue.

 

Also Read | 13 Types of Taxes

 

Working of Laffer Curve:

 

The Laffer curve depicts the relationship between a tax rate and the total revenue generated by taxes. It is represented by a graph with tax rates ranging from 0% to 100% and was developed by economist Arthur Laffer who believed that lowering tax rates would increase tax revenue and economic growth. 

 

This is because people are less likely to want to work and invest when tax rates are so high. As a result, once the tax rate reaches 100%, people will have no incentive to work. When the tax rate falls, people are more likely to want to work because leisure time becomes too expensive.

 

The Laffer curve is commonly depicted as a bell-shaped curve, but it is important to note that the shape of the Laffer curve will vary depending on employee and investor preferences for leisure, work, and other factors. 

 

As a result, the curve will appear lopsided and skewed on either side of the maximum point. The optimal region is shown from 0% to maximize revenue growth, while the prohibitive region is shown from maximum revenue growth to a 100% tax rate.

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Working on the Laffer Curve

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On the horizontal axis, we plot the tax rate, and on the vertical axis, we plot the government revenue from taxation. The curve takes on a parabolic form. It implies that there is no revenue for the government at the start when the tax rate is 0%. Revenue increases as the government raise the tax rate until T*. If the tax rate is raised beyond point T*, revenue begins to fall. In short, attempts to tax above a certain threshold are counterproductive and result in lower overall tax revenue.

 

The taxpayers' desire to work hard for more money begins to wane as they perceive the government taking more of their money. At a tax rate of 100%, the country's tax base is nil, and no one would work because they would have to give away all of their earnings as taxes. T* denotes the optimal tax rate that a government should strive for.

 

In 1974, Laffer brought his concept to the attention of policymakers. The Keynesian approach was the common approach among economists at the time. To stimulate aggregate demand, they advocate increased government spending and lower taxes. Increased aggregate demand promotes economic growth.

 

Businesses anticipate increased demand and profit margins, prompting them to increase output. As a result, more jobs and income are created in the economy. These interventions will generate more tax revenue as business profits and household incomes rise.

 

However, such viewpoints are not without their detractors. According to Laffer, the economy did not grow because of a lack of demand. However, this is due to an excessive tax burden. High tax rates deter producers from increasing output, and households are hesitant to work.

 

Also Read | What is Expansionary Fiscal Policy?

 

Significance of Laffer Curve: 

 

The Laffer curve graph laid the groundwork for supply-side economics and the regulation of tax rate cuts. In the 1980s, Ronald Reagan, the president of the United States, used tax cuts to provide taxpayers with more cash for spending. As a result, it increased demand for goods and services, as well as earnings and employment.

 

This policy undoubtedly aided the United States exit from the recession by the end of two decades. The basic economic idea and assumption are that taxpayers will change their financial behavior as a result of federal tax breaks. According to Laffer, it will increase demand, reduce the tax burden, and provide an incentive for producers to produce more.

 

Tax cuts directly imply lower federal income and higher taxpayer disposable earnings. Expansion of business affairs over time leads to increased recruitment and expenditure, resulting in economic development. It creates a larger tax base, resulting in higher total tax earnings.

 

Higher taxation rates, on the other hand, increase the tax burden, increasing revenues in the short run but with significant long-term consequences. This reduces discretionary income. taxpayers, lowering consumer spending As a result, as output and unemployment fall, so does gross demand in the financial system.

 

As a result, the government's tax base and tax revenue are reduced. Though often criticized for oversimplification, its directness makes the theory easily understandable. Furthermore, it facilitates a better understanding of the relationship between tax rates and total tax revenue received by the government. Because of Ronald Reagan's tax regulations and changes in the taxation rate, this concept almost certainly results in a strong financial period for the United States. As a result, there is valid reasoning behind the illustration.

 

Despite all of the factors at play, the Laffer curve continues to be criticized for providing a simplistic view of economic practices. For example, a change in policy can drastically alter the relationship between tax revenue and tax rate. Furthermore, as previously stated, the preferences of an employee and an investor will differ.

 

Criticism faced by Laffer Curve:

 

The Laffer curve has been widely criticized for its simplistic assumptions. For starters, the chart lacks figures illustrating actual tax rates and total revenues. Second, it presumes that people will always act in accordance with their economic interests.

 

Others have claimed that it does not provide an accurate forecast of the future economy. This is because the impact of tax cuts on the economy is determined by a variety of factors, including the current tax rate, the economy's current growth rate, the current tax system, and others. However, Laffer has stated that the curve should not be the only consideration in the government's decision to raise or lower taxes. Finally, some critics argue that this model would result in higher taxes for lower to middle-income workers while providing tax breaks for those with higher incomes.

 

Many of the Laffer curve's criticisms can be viewed as drawbacks, For starters, the relationship between tax rate and tax revenue is determined by a citizen's decision to work more or less. As a result, the Laffer curve's depiction of this relationship isn't entirely accurate. Its estimations have been a hotly debated and contentious topic. Second, when citizens choose not to work due to higher taxes, the Gross National Product, or the value of a good or service in a given year, suffers.

 

Third, implementing this way of thinking may encourage citizens to avoid paying taxes and thus cheat the system. Of course, it's important to remember that a variety of factors are at work here, including culture, the current state of the economy, and others. Finally, it can be argued that the Laffer curve does not show how increasing tax revenue is a goal for choosing a specific tax rate.

 

It is concluded that  The Laffer curve depicts the relationship between tax rates and total tax revenue collected by the government. It demonstrates that, in some cases, lower tax rates can result in higher tax revenues. According to the concept, there is no government income at the two extremes (0% and 100%).