Question

8. In the figure below a hypothetical Laffer curve is drawn. Answer the follow- ing questions about the curve. 1,000 600 0 80 50 30 Tax Rate (percent) a. What is the Laffer curve argument about the association between tax rates and tax revenues? b. At what tax rate do revenues reach a maximum? c. Why are there two tax rates (30 percent, 80 percent) that yield the same revenue? d. What causes tax revenues to decline beyond point Y? e. What are the principal problems with using the Laffer curve as a basis for tax policy? Tax Revenue (billi ons of dollars)

Answer 1

a. Laffer curve shows thr relationship between tax rate and tax revenue. It shows us that sometimes decreasing tax rate can raise the tax revenue.

b. At point Y, with 50% tax rate , the revenues are maximum.

c. When taxes are raised beyond a certain tax rate, people are discouraged to work or invest so tax revenue keeps on falling. Hence at both 0% and 100% revenue is zero. Similarly at 30% and 80% tax revenue is same because tax rate of 80% discourages the workers to work more and earn. So the revenue is same as that of at 30%.

d. Beyond the threshold level of Y, reducing the tax rate actually raises the tax revenue. This happens because at very high tax rate, people are discouraged to work or invest. So the tax revenue also starts falling.

e. Problems with laffer curve-

1. Laffer curve is too simplistic in it's assumption like Y is stable or unique and the shape of laffer curve is fixed.

2. Maximizing the tax revenue is not the only goal of the policy.

3. The laffer curve might change it's shape and multiple Y can exist. Therefore it is not easy to observe the shape of the laffer curve.