Tax Behavior

A Lesson from the Laffer Curve

Click here to view online magazine Discussions aimed at curing our recent economic fiascos have often led to proposals to raise taxes (income, sales, capital gains, etc.). While raising taxes might sound like a viable way to increase revenue and get the economy back on track, the Laffer curve (named for the economist, Dr. Arthur Laffer, who popularized the curve in the 1980s) shows us that this may not be the best approach. The Laffer curve above illustrates how taxpayers’ behavior changes as tax rates change. The curve shows that when tax rates are zero, government revenue is, as you’d expect, zero. But even when tax rates are 100 percent, government revenue is still zero. Why? At that rate, taxpayers would no longer have an incentive to earn income, thus government revenue zeroes out. So, as the curve implies, as tax rates rise progressively with income, the incentive to earn each incremental dollar decreases until the tax rates become too onerous. This can lead to corruption, deception, and extreme declines in tax revenues collected.

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