What is Laffer Curve?

Ever wondered about the relationship between rates of taxation and tax revenues? 

The iconic Laffer curve illustrates this intuitive relationship compellingly.

Laffer Curve — a bell-curve analysis — was popularised by American economist Arthur Laffer plotting the relationship between different levels of tax rates and tax revenue.

Starting at 0% tax, the curve shows that the government will earn nothing in tax revenue. 

Recommended

Creative Destruction

If tax rates are 100%, well, there’s no use for individuals and businesses to work, invest take risks, and give back everything to the government. So the government doesn’t earn anything.

However, as the tax rate rises from zero, the revenue also rises and reaches a peak, after which it begins declining. 

The curve shows that if the government taxes too little, it doesn’t raise enough revenue, and if it taxes too much, the economy suffers. But there’s an optimal tax rate that maximises the revenue for the government (the peak).

One policy implication of the curve is tax cuts when the government is taxing too much. 

Recommended

Bank Runs

The economic effect occurs over time with an exponential effect. Tax cuts can incentivise individuals and businesses to work, spend and invest as there will be larger disposable income.

On the other hand, tax hikes beyond a certain point can discourage economic activity.

Attaining the optimal rate of taxation is tricky and requires a balancing act.

Policymakers need to carefully consider many variables such as economic conditions, social and environmental factors, and long-term goals, among others. While economists and politicians may disagree on the optimal level of tax rate.