Laffer Curve
The Laffer curve is a theoretical relationship between tax rates and tax revenue that illustrates the idea that, beyond a certain point, raising tax rates reduces total tax revenue. It is named after the economist Arthur Laffer and is often cited in debates about taxation and tax policy.[1]
The relationship
The Laffer curve posits that for a given economy there is a tax rate that maximises total tax revenue:
- At a tax rate of 0%, revenue is zero because no tax is collected.
- At a tax rate of 100%, revenue is also zero because there is no incentive to work or produce, so the tax base disappears.
- Between these extremes, revenue rises and then falls, producing a hump-shaped curve.
The tax rate that maximises revenue—the revenue-maximising rate—is unknown in practice and is the subject of ongoing debate.[1]
Interpretation
| Position | Effect of a tax increase |
|---|---|
| Below the peak | Revenue rises. |
| At the peak | Revenue is maximised. |
| Above the peak | Revenue falls, because the tax base shrinks as activity is discouraged. |
Criticisms
The Laffer curve is often criticised for being difficult to apply in practice. The location of the peak is not known, and the shape of the curve depends on the responsiveness of the tax base to tax rates—that is, on elasticities. Critics note that the theory is sometimes used to argue for tax cuts without evidence that rates are on the downward-sloping portion of the curve. Nonetheless, the curve illustrates an important principle: taxes can dampen the activity they are levied on, so higher rates do not necessarily yield higher revenue.[1]