Last updated: Mar 13, 2021
The rate of ‘direct’ tax may affect decisions to choose work rather than pursue leisure activities. For example, an increase in the rate of income tax may encourage an individual worker to choose to have additional leisure time - as the opportunity cost of working has increased - and hence work less.
Any change in take-home pay will create both an income and a substitution effect. Higher taxes (and less pay) will encourage workers to switch from work to leisure - a substitution effect. However, less pay reduces real income and may force individuals to work more (rather than less) to re-establish their previous level of real income.
Hence, the effect of a rise in income tax depends upon the relative strength of the income effect in relation to the substitution effect.
We assume that working and leisure activities are substitutes - though not perfect ones. Hence, as tax rates change, choosing more work or more leisure may be the effect - that is, the substitution effect.
At tax rates of zero and 100%, the government gets no tax revenue. At a rate of 100% no one will work, and, again, the government gets no revenue. Between zero and 100% the government gains more, and then less revenue.
According to the Laffer curve (after American economist, Arthur Laffer), a strong substitution effect (disincentive effect) will kick-in - beyond ‘t’ tax rate, caused by workers substituting leisure for work. In the example, increasing tax rates from 50% to 70% causes revenue to fall (from $80bn to $70bn.)
There are a number of criticisms that can be made regarding the accuracy and usefulness of the Laffer curve, including:
Having said this, the Laffer curve has under-pinned several political perspectives that favour a smaller state, with lower tax rates.
Is the Laffer curve useful for policy?
Further reading - articles from the New York Times, The NewYorker, and from The Guardian.