Fiscal Policy - The Laffer Curve

The Laffer Curve is a relationship which suggests there is an optimum tax rate which maximises total tax revenue.

The Laffer Curve is a useful idea to bring into analysis and evaluation when looking at the impact of tax changes on government finances. Whilst plausible, there is limited empirical evidence that an optimum tax rate for maximising tax revenue actually exists.

The Laffer Curve concept infers that a tax rate cut could lead to an increase in tax revenue, or a decrease in tax revenue, depending whether you have already passed the ‘optimal tax rate’ (whatever % that may be)

Tax rate T3 might be considered optimal if the objective is to maximise total tax revenues

Under certain circumstances, lifting the tax rate to T4 might lead to a reduction in tax revenues

Why might total tax revenues fall if the tax rate increases?

1. Increased rates of tax avoidance – greater incentive to seek out tax relief, make max use of tax allowances
2. Greater incentive to evade taxes (illegal) – i.e. non–declaration of income and wealth
3. Possible disincentive effects in the labour market – depending on which taxes have been increased
4. Possible “brain drain” effects – loss of highly skilled, high income taxpayers

Evaluating the Laffer Curve

• Supporters of the Laffer Curve are often those pushing for lower tax rates on higher income earners
• Lower top rate taxes might increase income inequality
• Little strong evidence that top rate income tax is a major barrier to inward migration of skilled labour
• Many people are on fixed hours / zero hours contracts – so tax rates have little bearing on work incentives
• Tax rates not the only factor affecting work incentives – we must also consider the impact of the benefits system
• For some people, tax cuts will cause them to take more leisure time instead of work – a backward bending labour supply curve effect – especially at higher wages/ earnings
• There is a solid Keynesian explanation for some aspects of the Laffer Curve – cuts in direct and indirect taxes increase real disposable income and therefore lead to higher consumer spending and aggregate demand