Laffer curve

The Laffer curve is a graph of the relationship between tax rates and tax revenues. It is best known for its use as a justification for cutting taxes, but this is usually controversial as the evidence for the shape of the Laffer curve (and, most importantly its slope at particular tax rates) at in any given time and place is usually weak.

The shape of the Laffer curve at extreme is fairly obvious:

  • If you have a zero tax rate and raise the tax rate to one percent you can only increase revenues — so the Laffer curve slopes upward at those values
  • A small increase in a low tax rate (e.g. form 1 % to 2%) is almost certain to raise taxes (probably in proportion to raise) — so the curve still slopes upward
  • An increase that takes taxes to a very high level may reduce the incentive to earn: for example an increase from 99% to 100% would mean there is no gain to earning more). So at some point the Laffer curve would slope downward, and tax rises would reduce incomes.

In practice taxes are usually at too low a level to make it obvious that the Laffer curve is downward sloping, but are often high enough that it is plausible that it is downward sloping. If a government is considering raising taxes from 40% to 50% it is possible that some people may work less and earn less, but it is also possible that others will work harder to maintain their income and lifestyle in the face of higher taxes. It is difficult to find evidence about what effect will predominate.

Another possible cause of downward sloping Laffer curves is that people will switch effort from making money to tax avoidance. This is also plausible, but people are likely to take advantage of any legal tax avoidance they can regardless of the rates. Is the rise beg enough to make more difficult, expensive of elaborate avoidance worthwhile? Are such opportunities available to a high proportion of affected tax payers?

The historical effects of tax rises is also hard to establish because the revenue raised by tax depends on many factors other than the tax rate (regardless of the direction of the Laffer curve) such as the strength of the economy.