Laffer Curve - Explained
What is the Laffer Curve?
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What is the Laffer Curve?
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.
Back to:ECONOMIC ANALYSIS & MONETARY POLICY
What is the History of 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 Fords 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 governments 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 Reagans 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-
- The tax system in place
- The time period being considered
III. The ease of entering into underground activities
- The level of current tax rates
- The legal and accounting-driven tax loopholes
- 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.
- Supply-Side Economics
- Say's Law
- Laffer Curve
- Neo-Classical Economics
- New Keynesian Economics
- Classical Economics
- Supply-Side Economics
- Keynesian Economics
- Keynes' Law
- Keynesian Analysis
- Demand Side Theory
- Market Forces
- Aggregate demand
- Aggregate Demand Curve (and shifts)
- Aggregate supply
- Aggregate Supply Curve (and Shifts)
- Aggregate Demand / Aggregate Supply Models
- Potential GDP
- Aggregate Supply and Demand Equilibrium
- Aggregate Supply and Aggregate Demand in Macroeconomics and Microeconomics
- Input-Output Model
- Growth and Recessions in the Aggregate Demand - Aggregate Supply Model
- Unemployment in the Aggregate Demand - Aggregate Supply Model
- Inflation in the Aggregate Demand - Aggregate Supply Model
- Keynesian, Intermediate, and Neoclassical Zones