The Laffer curve and economic policy

Last updated: Mar 13, 2021

The Laffer curve indicates that increases in direct taxes may create a disincentive to work to the extent that fewer tax revenues are received by the government. But is the Laffer curve useful as a policy tool?

Statistical models may help determine if it a tax rate creates a disincentive effect.

The Laffer curve and tax policy

For example, with an income tax rate of 60%, and government revenue of $77bn at point z, a policy to reduce tax to 50%, might reasonably expect revenue to rise to $80bn at point t. If the actual gradient is for Curve 2, not Curve 1, then revenues may fall to point x, with no disincentive at z.

Issues with the Laffer curve as a policy tool

Hence, trying to set tax rates based on a theoretical Laffer curve is extremely difficult for several reasons - none the least of which is because there may be imperfect knowledge regarding the specific level of taxation required to maximise revenue and have a largely neutral effect on work and effort.

This problem is compounded by the problem of time lags between the implementation of a policy (say, reducing income tax) and its effect on government revenues.

For the 'Laffer effect' to work it means that reducing income tax rates will create a strong substitution effect between 'work' and 'non-work'. In other words, reducing taxes on work effectively reduces the 'price' of work and increases the opportunity cost of not-working. Hence, as this line of argument goes, rational individuals switch from 'non-work' to 'work' - and tax revenues rise.

However, there is a contradictory effect - the income effect. This suggests that, as income tax rates fall, more income is retained, and individuals can, if these choose, cut back on work but keep the same level of real, post-tax, income and hence can use more of their time on 'non-work' activities.

Hence, if the substitution effect outweighs the income effect, the predictions of the Laffer curve will hold - namely, reducing income tax stimulate more work and effort. However, if the income effect dominates, cutting taxes increases income and less work is required to achieve the same level of real income - hence the predictions of the Laffer curve do not hold.

Research by Tavor et al (2019)1 suggests that there may be three different peaks on three separate Laffer curves - one each for younger workers, adult males, and adult females. Given that these groups may respond different to changes in tax rates, setting general tax rates with the specific purpose of 'hitting the peak' for all groups is impossible, and that tax policy is inevitably a compromise between competing objectives.

It is this uncertainty that has led many to doubt the precision with which the use of the laffer curve can be used as a policy tool.

However, this has not prevented the widespread application of the Laffer curve in shaping the call by supply-side economists to push for lower tax rates as a central element in supply-side policy. This has meant that discussion of the role of taxation is not just limited to fiscal policy, but, since Laffer, is now part of the wider debate about the role of tax policy as an economic tool.

1.Tavor, T., Gonen, L.D. & Spiegel, U. Reservations on the classical Laffer curve. Revue of Austrian Economics (2019). Viewed 3rd March 2021, https://doi.org/10.1007/s11138-019-00483-8


Laffer curve

What does the Laffer curve show?

Laffer curve
Supply-side policy

How effective is supply-side policy?

Fiscal policy
Monetary policy

How effective is supply-side policy?

Supply-side policy

facebook link logo twitter link logo email link logo whatsapp link logo gmail link logo google classroom link logo