Wednesday, 14 September 2011

The Laffer Curve

The curve in this instance is the theoretical curve on a graph. Specifically, a graph that has an x-axis that represents the income tax rate in percent and a y-axis that represents the revenue generated for each possible tax rate. Initially one might expect the graph to be a straight line. Clearly the tax revenue from a 0% tax rate is 0. As the tax rate increases the tax revenue increases until all the income is received as tax thus the graph might look something like this:
However, a moments thought shows that this is not going to be the case. If you are going to be taxed at 100% of your income then you would not bother to work, why would you? You can sit at home doing nothing and be no worse off than working 40 hours a week. We can conclude therefore that the revenue generated from a 100% tax rate would be nothing. This means that we know four things about our graph.

  • It must start at the point (0, 0) since a tax rate of 0% generates no revenue.
  • It must pass through the point (100, 0) since, as has been discussed, a 100% tax rate generates no revenue.
  • It must lie above the x-axis since We know from our own experience that a 20% tax rate raises something.
  • It never goes below the x-axis since the lowest revenue that can be generated is zero.
These four facts mean that we can confidently conclude that the curve looks like this:

Given that the curve is as shown then we can further conclude that there is a point at which the revenue is maximised. In practical terms this is the point at which people decide that there is no point in working overtime or the effort of a partner working full-time isn't worth the income. This is the region where people start to decide that trading on the black market is worth the risk of being caught, the point at which dealing in cash becomes the norm.

This, then, is what is known as the Laffer curve. Unfortunately, the one potentially useful fact that we cannot glean form this theoretical curve is at which value the tax revenue starts to fall. Note then this news article which quotes the Institute for Fiscal Studies who estimate that the 50p tax rate is costing £500 million per year as opposed to the Treasury estimate of an income of £2,700 million per year. By 'costing' they mean that overall tax revenue is down which means that this tax raising revenue has made the country worse off. Let me repeat that, we are worse off. How rubbish must our tax collection service be that it cannot identify this decrease? Or, assuming our leaders were well aware that this would not increase the tax take, is it possible to believe that this tax rate was introduced for any reason other than to satisfy the politics of envy?