Source: Image of Laffer Curve created by Kate Eskra
Hi, welcome to economics. This is Kate. This tutorial is on the Laffer Curve. As always, my key terms are in red and my examples are in green.
So in this tutorial I'll discuss with you and show you a Laffer Curve and you'll be able to interpret it. You'll understand what this implies about tax rates. And finally we'll talk about how the Laffer Curve is debated among economists.
I don't know anyone who likes paying taxes. But most people agree that at least to some extent it's necessary for the government to be able to do anything. However, just how high should taxes be? And how would the government actually maximize the amount of revenue that they collect? Would it be by charging extremely high tax rates? Or would it be actually by charging slightly lower rates?
Our income tax rates have really varied over the decades. Republicans and Democrats, we know, have very different views on taxation. At one time the wealthiest, actually, paid over 90% in taxes on their earnings above a certain level.
Arthur Laffer was an American economist who sat on Reagan's Economic Advisory Board. And he became very famous for what he had to say about the relationship between tax rates and the revenue that the government collects from them.
So the Laffer Curve was developed to show this relationship between tax rates and government revenue. It's a key term. Here is the Laffer Curve definition. It's a graphical representation of the relationship between rates of taxation and government revenue collected.
Here's what the Laffer Curve looks like. And it's exactly what we just defined. If this is the amount of revenue that the government is taking in in taxes, and this is the tax rate-- and that's usually expressed as a percentage, obviously, this is the Laffer Curve. And it has some sort of shape that looks like this.
So at a rate of 0%, obviously, if the government is not taxing us at all, they are taxing us at 0%, they would, obviously, take in zero dollars in tax revenue. Well, wouldn't it be logical that as they begin to raise tax rates, obviously, they start generating some amount of tax revenue. So tax revenue will rise.
Wait, but why does it start to fall at some point? Hm? Well, let's go to the extreme. Think about it. If tax rates were actually 100%, meaning that people did not get to keep any of their money from going to work, would you go to work if you didn't get to keep your money? If you had to pay all of it back to the government? No, so, actually, this is suggesting that at extremely high tax rates, that gives people a disincentive to work. And, in fact, then tax revenue begins to fall off because people are not working as much.
So the idea is that somewhere in the middle, more than likely at some intermediate level of taxes, tax revenue will actually be the highest.
Now just how high is that? The specifics of this curve are really debated among economists. And it really can only be estimated for any given economy in any given time.
So where is this ideal tax rate? Is it somewhere around 35%? That's what a lot of people in our country believe it might be. Is it higher than that? Is it lower than that? There's actually been studies that over time this ideal rate has varied a lot. Again, just to reiterate the point, the idea is that raising taxes at some point will become counterproductive, and that would be after this maximum revenue is being collected.
Raising taxes anymore is going to be counterproductive because people won't be happy about it. They're paying more to the federal government. And the federal government's not benefiting at all. In fact, they're benefiting less and less and less because it takes away people's incentive to work.
And so, like I said, this has been debated. Studies have shown that the revenue maximizing tax rates have really varied. And even if economists could agree on exactly what the curve would look like, does that even necessarily mean that we should raise taxes to generate more revenue for the government. That's certainly not agreed upon by everybody. And this is going to depend on a variety of factors only one of which would be elasticity.
In this tutorial we talked about how the Laffer Curve shows the relationship between tax rates and the tax revenue collected by the government. And this implies that there is an intermediate level of taxation that will maximize revenue collection. And as we discussed, this is really debated among economists. Thank you so much for listening. Have a great day.
(01:06-01:38) Arthur Laffer / Laffer Curve
(01:39-03:02) Graphical Depiction of Laffer Curve
(03:03-04:23) Debate on the Laffer Curve
Terms to Know
Graphical representation of the relationship between rates of taxation and government revenue collected.