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On Income Taxes and Economics: The Laffer Curve

Updated on July 11, 2013

The Laffer curve is a graphical device used to demonstrate the relationship between income tax rates and government revenue. The graph has been often credited to economist Arthur Laffer although his claim is that he did not create it but only use it to demonstrate the relationship between income tax rates and treasury revenues. This article examines the meaning of the curve and its significance.

Figure 1

The Relationship Between Income Taxes and Government Revenue: Macroeconomics

Consider first of all two extremes. The first extreme is if a government decides to not collect income taxes (i.e. set the tax rate at 0%), then the government will not receive anything from income taxes. The second extreme is if a government sets a tax rate at 100%, effectively seizing everything made during the time period, then people and businesses will no longer have an incentive to work and will stop doing so. This also results in the government not collecting any revenue. So at the extreme rates of 0% and 100%, a government collects nothing.

Common sense though dictates that at tax rates between 0% and 100%, a government does collect some revenue from income taxes because there is still an incentive for people and businesses to work. Between the two extremes is a curve that connects the two extreme points. The curve is often shown as in Figure 1. The horizontal axis represents the tax rate while the vertical axis (or the height of the curve) represents how much money is collected by a government. However, that is where the definitive attributes of the curve ends.

One attribute that is uncertain is the shape of the graph between the two points. While often shown as an upside down parabola (bowl-shape), the actual graph may have one peak or several peaks and valleys, all above the horizontal axis. But there must be one peak that is highest (or tied for highest). It is at this peak that the government receives the maximum amount of revenue while still maintaining an incentive to work on the part of individuals and business. If a government sets tax rates higher or lower than at this peak, revenues to the treasury will go down. Political debates often have at their core where this peak is.

Another attribute uncertain about the Laffer curve is the amount of revenue a government will actually receive, whether at the maximum level or any other level. The reasoning here is that while the curve represents the relationship between income tax rates and government revenues, there are other factors that determine revenues. Such factors include economic booms, inflation, time, or government subsidies for individuals and businesses. This is just a brief list of things that affect government revenues.

The Relationship Between Income Taxes and Government Revenue: Microeconomics

An examination of behavior on an individual level is warranted here. This will also include businesses since they behave like individuals with regard to income taxes. The extreme tax rate of 0% allows individuals to work all they desire and keep everything they earn but it results in no money to the treasury. A tax rate of 100% implies a government takes everything an individual makes. Once the individual realizes everything will be taken, there is no incentive to work because the results are meaningless to the individual. At this point, the individual finds alternate sources for survival (including government handouts, if any) or begins not to report income. In both of these events, the revenue for the government will be zero and may actually cost the government.

Now consider a situation where a government sets a tax rate at 95%. Individuals and businesses must ask themselves if the 5% they get to keep is an incentive to work. Some might think so while others might not. As the rate lowers to 85%, then 75%, and so forth and individuals keep more of their money, there is a greater incentive to work. This is why the revenues into the treasury begin to rise because more people feel it is worth the effort to work. However, there is a tax rate where most individuals are working and paying income taxes. Those who are not working would be considered inconsequential because their taxes, if they were working, would be insignificant. This tax rate is where the maximum amount of revenue would be received by the treasury.

So there is some point for each individual and business to say that the tax rate (i.e. the amount of money they have to give up for income taxes) is not very significant and what they get to keep is worth the effort expended. In addition an individual weighs the value of what is kept by them after taxes and the value of the subsidies received which would have to be forfeited by working more. The individual will usually choose the greater. Thus, the amount of income taxes collected by a government is also affected by the structure of the welfare system in place.

The Relationship Between Income Taxes and Government Revenue: A Return to Macroeconomics

The previous paragraphs demonstrated that there is a relationship between the income tax rate and individual’s behavior. This applies to businesses as well. As income tax rates rise, there is less incentive to work implying income tax revenue falls. In addition the rate rise encourages individuals to seek alternative forms of support, including obtaining handouts from the government and not reporting income. Both of these create additional expenses for the government. More individuals and businesses that ask for subsidies from the government require the government procure more income to support the subsidies. An increase in hiding of income requires the government to hire more personnel to enforce tax policy. Thus, there is some point above which the income tax rate can be set where treasury revenues fall and government expenses rise, increasing a greater pressure on the government to raise more revenue.

As a result of considering the Laffer curve and behavior by individuals and businesses based on income tax rates, tax rates should be set that motivate people and businesses to work, eliminates the cost of government subsidies, and causes people and businesses to report all income.

Conclusion

The Laffer curve is a great tool for thinking about tax policy. It shows that a government cannot take all the income taxes it desires. The curve also demonstrates that individuals do change their behavior based on tax policy. These two statements together also indicate that if income tax rates are set too high, then government will not only lose revenue but increase the expenses incurred through more subsidies paid and through income tax regulation enforcement. Income tax rates should not be a tool for social engineering but rather a way of achieving the greatest good for the entire population.

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