The Laffer Curve

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The Laffer curve, named after the economist Arthur Laffer, is a curve that demonstrates the trade-off between tax-rates and tax-revenues (Wanniski 1978). It is used to illustrate the concept of taxable income elasticity, the idea that a government can maximise the revenue by setting the tax rates at an optimum point. This curve can be traced back as far as 1844 to a French economist Jules Dupit who in 1844 found similar effects as Laffer did (Laffer 2004). Dupit also saw tax revenues rising from zero with a small increase in the rate, reaching a maximum PMTQ at rate pM, then falling with further rate increase and eventually returning to zero when the rate becomes prohibitive (Humphrey 1992: 9). In fact in 1844, Dupuit wrote: If a tax is gradually increased from zero upto the point where it becomes prohibitive, its yield is at first nil, then increases by small stages until it reaches a maximum, after which it gradually declines until it becomes zero again.

Figure 1 Dupuit’s Tax Theorems (Humphrey 1992: 8)

Adam Smith in his book, Wealth of Nations (Smith 1776: 414), outlined that high taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue than what might be drawn from more moderate taxes. The Laffer curve assumes the existence of two points where state tax revenues amount for zero. At these two points, the Aggregate Average Tax (AAT) amounts either for 0% (t=0) or 100% (t=1). At a certain point in between these two points on the curve is t*, where the AAT (tmax) lies, tax revenue reaches its maximum point T (Papava 2002: 66-70). At t=0 the reason why the state does not earn any revenue is clear as the tax rate amounts for zero. At t=1, corresponding to a rate of 100%, all production ceases because people will not work in the money economy if all fruits of their labours are confiscated by the government (Wanniski 1978: 3).

The Laffer curve, however, does not tell us whether or not a tax cut will increase or lower revenues as this depends on the tax rate system in place, the legal system as well as the ease of moving into underground or barter activities to avoid being taxed. If taxes are in the prohibitive area, then a tax cut will result in increased tax revenues. Arithmetically, lowering of the tax rate results in lowered tax revenues by the amount of the decrease in the rate however the economic effect identifies a positive effect of lower tax rates on work, output and employment and therefore gives incentives to increase these activities. A decrease of a tax rate currently in the prohibitive range has therefore an economic effect which far outweighs the arithmetic effect such that despite losing arithmetically, the economy will be better off with tax cuts (Laffer 1981, Canto/Joines/Laffer 1978, Canto/Joines/Laffer 1981).

In his model, Arthur Laffer assumed a static one-sector, two factor model, with labour and capital being the only two factors. The market sector production consists of one simple good, called market output. This model does not, as it is static, analyse the process of capital formation and therefore assumes that at “any point there exist fixed stocks of capital and labour and that these stocks must be allocated either to household production or to market sector production” (Canto/Joines/Laffer 1981: 3). Within this model it is assumed that the supply of factors of production to the market sector is partly determined by the net-of-tax factor rewards. The demand for the factors is affected by their marginal products. The optimal factor mix will depend on relative factor rewards and people in this model work in part for after-tax income. A reduction of tax-rates on an activity inevitably increases the after-tax profitability of that activity and as a result more of that activity will be done which will increase the tax base (Laffer 1981: 2-10). In his model derivation, Laffer found out the...
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