Laffer Curve - Tax Rates Vs. Government Tax Revenue

in LeoFinancelast year

Hi there. In this post, I would like to highlight the Laffer curve. Laffer does sound laugher as a person who is laughing but this Laffer curve is a bit of an interesting model. This curve is named after Arthur Laffer. The Laffer curve is a model which compares the relationship between tax rates (in %) versus tax revenue for governments.

The motivation behind this post is based on this video from the Coin Bureau at the 18:30 mark.

Pixabay Image Source

Laffer Curve

The Laffer curve shows that as tax rate increases tax revenue for the government does increase. This increase in both tax rates and tax revenue continues until a certain tax rate denoted by r. When tax rates are above the this certain tax rate r then the government tax revenue actually decreases. Tax rates that are too high will be seen as unattractive as after-tax income decreases and costs of goods & services after taxes goes up. In extreme cases, people may leave the country if tax rates get too high.

The shape of the Laffer curve is a downwards facing parabola. For non technical people, it looks like a symmetrical frown. The shape and curvature may vary. I showcase a few parabolas through screenshots and with Desmos.

These increases and decreases in government tax revenue as tax rates change are not always the same. If the changes were the same you would see lines instead of curves.

All Models Are Wrong But Some Are Useful

This Laffer curve is not a perfect model. It is not known what is the pivotal tax rate that gives the maximum tax revenue. In reality there are more variables at play than just tax rate. People do different things with different reasons in an economy. Not everyone has that much money to leave a country if a tax rate goes really high. Also the shape of the Laffer curve may not be symmretric.

Statistician George Box has a quote that says

"Essentially, all models are wrong, but some models are useful.

I would classify this Laffer curve as a useful model. I do agree with the idea that increasing tax rates does bring in tax revenue only up to a certain point. Too much taxes would have the opposite effect in the form of diminished tax revenues.

The shape of the Laffer curve can be apply to other things. Scenarios such as drinking water. Drinking water is good but drinking too much water is bad for you. It is about balance.

For more details on the Laffer curve from an economics and finance perspective there is this article from Investopedia.