Econ 101, Part 10: Public Economics Deep Dive
The Laffer Curve
Why raising tax rates beyond a point can reduce revenue, what evidence says about where that point lies, and how the idea has been used and misused.
The Laffer curve illustrates a simple idea: tax revenue depends on both the tax rate and the tax base.
The idea
- At a 0 percent tax rate, revenue is zero.
- At a 100 percent rate, revenue is also near zero, because nobody would bother earning taxable income.
- Somewhere in between, revenue is maximised.
If rates are above the revenue-maximising point, cutting them could raise revenue, because people would work, invest and report more.
The curve is named after economist Arthur Laffer, who reportedly sketched it on a napkin in 1974, though the idea is much older; Ibn Khaldun wrote about it centuries earlier.
Where is the peak?
That’s the key question. Research suggests that for income taxes in rich countries, the revenue-maximising top rate is fairly high, often estimated at 60 to 70 percent or more when including all taxes, though estimates vary.
Uses and misuses
- In the 1980s, US tax cuts were promoted partly with Laffer arguments. Most economists found that the cuts reduced revenue, because US rates weren’t above the peak for most taxpayers.
- For very high rates or certain taxes, cuts can increase revenue by reducing avoidance.
India’s experience
India’s cuts in very high income tax rates after 1991 and the corporate tax cut in 2019 were accompanied by debates about revenue. Improvements in compliance and a broader tax base helped revenue grow over time, though many factors were involved.
The lesson
Tax rates affect behaviour, so revenue doesn’t rise proportionally with rates. But claims that tax cuts “pay for themselves” should be tested with evidence.
In the 1970s, some Indian taxpayers faced marginal income tax rates of up to 97.75 percent including surcharges. Such rates encouraged evasion and black money. Cutting them helped bring income back into the tax net.
Only when rates are above the revenue-maximising point do cuts increase revenue.
- The Laffer curve shows revenue is zero at both 0 and 100 percent tax rates.
- Revenue peaks somewhere in between.
- Evidence suggests the peak for top income tax rates is fairly high.
- Claims that tax cuts pay for themselves often don't hold.
No recording for this one yet - EconReader can read it aloud for you.