Laffer Curve-Inside Out!

Most of us heard the FM talking about him attempting an increase in tax revenues this fiscal though there has been a significant improvement in the tax slabs. This aspect is described by the LAFFER CURVE.

So, following is an insight into the WHAT and HOW of the Laffer Curve!

Laffer Curve

The Laffer curve is used to illustrate the concept of “taxable income elasticity”, which is the idea that government can maximize tax revenue by setting tax rates at an optimum point and that neither a 0% tax rate nor a 100% tax rate will generate government revenue. The curve was popularized by Arthur Laffer, although the underlying principle was known since the time of Ibn Khaldun’s Muqaddimah. John Maynard Keynes, in his General Theory of Employment, Interest, and Money, described how increasing taxation past a certain point might lower revenue and vice versa.  Libertarian economist Ludwig Von Mises wrote in 1949: “In the United States the recent advances in tax rates produced only negligible revenue results beyond what would be produced by a progression which stopped at much lower rates”. Other economists have questioned the utility of the Laffer Curve. According to Nobel prize laureate James Tobin, “[t]he “Laffer Curve” idea that tax cuts would actually increase revenues turned out to deserve the ridicule with which sober economists had greeted it in 1981.”

The curve is most understandable at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government’s revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a “rational” economic model) taxpayers presumably change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing. Somewhere between 0% and 100%, therefore, lies a tax rate percentage that will maximize revenue. Critiques commonly point out that socialist states, such as the U.S.S.R., have been able to derive revenues at a 100% tax rate, though they would have derived more if tax rates had been lower.

Laffer Curve

Diagram 1: Laffer Curve

Laffer Curve

Diagram 2: Laffer Curve

The extent to which these assumptions are true beyond the scope of the underlying mathematics is unprovable, as most economics takes place in the realm of political theory with implied objectivity that is impossible to prove or completely disprove. They nonetheless provide a basis for argument. You can “back into” a continuous curve by assuming the tax rate will be legislated with no more than a given number of decimal points. The resulting discrete function could then be interpolated with line segments, with the same result as the assumption of continuity.

The point at which the curve achieves its maximum will vary from one economy to another and depends on elasticities of demand and supply and is subject to much theoretical speculation. Complexities arises when taking into account possible differences in incentive to work for different income groups and when introducing progressive taxation.

Another contentious issue is whether a government should try to maximize its revenue in the first place. Moreover, the ideal level of taxation is dependent upon the use of government funds, as certain types of spending do more to encourage growth than others. The curve is primarily used by advocates who want government to reduce tax rates (such as those on capital gains) and believe that the optimum tax rate is below the current tax rate. In that case, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing.

The Laffer-curve concept is central to supply side economics, and the term was reportedly coined by Jude Wanniski (a writer for The Wall Street Journal) after a 1974 afternoon meeting between Laffer, Wanniski, Dick Cheney, and his deputy press secretary Grace-Marie Arnett (Wanninski, 2005; Laffer, 2004). In this meeting, Laffer reportedly sketched the curve on a napkin to illustrate the concept, which immediately caught the imaginations of those present. Laffer himself professes no recollection of this napkin, but writes, “I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me” (Laffer, 2004). Laffer also does not claim to have invented the concept, attributing it to 14th century Islamic scholar Ibn Khaldun and, more recently, to John Maynard Keynes.

Critiques of the Laffer Curve

Conventional economic paradigms acknowledge the basic notion of the Laffer curve, but they argue that government was operating on the left-hand side of the curve, so a tax cut would thus lower revenue. The central question is the elasticity of work with respect to tax rates. For example, Pecorino (1995) argued that the peak occurred at tax rates around 65%, and summarized the controversy as:
Just about everyone can agree that if an increase in tax rates leads to a decrease in tax revenues, then taxes are too high. It is also generally agreed that at some level of taxation, revenues will turn down. Determining the level of taxation where revenues are maximized is more controversial.

At least one empirical study, looking at actual historical data on tax rates, GDP, and revenue, placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) as high as 80%. Paul Samuelson argues in his popular economic textbook that Reagan was correct in a very limited sense to view the intuition underlying the Laffer curve as accurate, because as a successful actor, Reagan was subject to marginal tax rates as high as 90% during World War II. The point is that in a progressive tax system, any given person’s perspective on the validity of the Laffer curve will be influenced by the marginal tax rate to which that person’s income is subject.

Keynesian Critique

Some economists argue that while tax cuts are beneficial to the economy, they are beneficial for different reasons. Keynesian economics suggests that an increased government deficit – for instance, resulting from a tax cut – will stimulate economic output. This leads some to identify instances of the ‘Laffer curve’ as periods of Keynesian demand stimulation.


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