Tax and incentives - the Laffer curve

The rate of ‘direct’ tax may affect decisions to choose work rather than leisure activities. For example, an increase in the rate of income tax may encourage an individual worker to choose additional leisure, and 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.

The Laffer curve

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.)

The increased tax revenue (in theory) could also come about as a result of increased participation in the formal labour market - at high marginal tax rates individuals may be encouraged to work in the informal economy, and hence not pay any income tax at all.

video on the Laffer curve

Criticisms of the Laffer curve

There are a number of criticisms that can be made regarding the accuracy and usefulness of the Laffer curve, including:

  1. The assumption that individuals act rationally 'in their own interest' can be questioned.
  2. It can be argued that individuals have a longer term planning horizon in terms of how much work they are prepared to do - and short run changes in tax rates may have little effect on this.
  3. Many individuals are on fixed contracts and cannot alter their hours of work in response to tax changes.
  4. Even if it is accepted that there might be a Laffer effect, it could be very weak, and not a sound justification for tax cuts.

Having said this, the Laffer curve has under-pinned several political perspectives that favour a smaller state, with lower tax rates.

Further reading - articles from the New York Times, The NewYorker, and from The Guardian.

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