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Sunday, Jan 11, 2004

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Taxes and Laffer Curve

B. Venkatesh

THE Government has cut taxes on goods. Will this increase or decrease revenue for the Government? The economic relationship between tax rates and tax revenues is captured by the Laffer Curve. What is this curve?

Arthur Laffer introduced this relationship in the 1980s when he was part of the Reagan administration in the US. Suppose tax rate increases from 10 per cent to 15 per cent. The Government may be able to collect more revenue. But suppose the tax rate increases from 40 per cent to 50 per cent. The government may probably collect lower tax revenues. Why?

When the tax rate is high, there is lower incentive for all of us to work harder. You may not want to give 50 per cent of your income to the government as taxes. So, you are likely to spend more time in leisure activity than work harder. If all of us work less, the tax collected will also be lower. So, the government's objective of increasing taxes becomes counter productive.

Increasing tax rate when it is already high results in deadweight loss. This is a jargon used to refer to the loss in the economic activity because people work less when tax rates are high. When you work less, your earnings will be lower. So, your demand for goods will be lower. This lower demand will lead to lower economic activity.

Every government strives to maximise revenue. The Laffer Curve is one of the tools that helps achieve this objective. The optimal tax rate on the Laffer Curve is that rate which maximises revenue.

If the tax rate is lower than the optimal rate on the Laffer Curve, the government can increase tax rates and expect higher revenues.

If the tax rate is already higher than the optimal rate, the government should consider lowering rates to increase revenue.

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