Does the Laffer curve still apply?

Laffer curve explanation: how does it work?

The Laffer curve describes the relationship between the tax rate and tax revenue. This was named after the economist Arthur B. Laffer and is said to have been painted on a napkin for the first time at a dinner in 1974.

According to the Laffer curve, there is a point for every state at which higher taxes no longer lead to increasing but rather to decreasing tax revenues. Thus, true to the curve, lower taxes encourage investment and job creation. So in the event of a tax cut, government revenues would not decrease, but actually increase.

Why is it theoretically possible to lower taxes, but at the same time increase tax yield?

At a tax rate of zero percent, the state's tax return is zero.

But if the tax rate is 100 percent, for example on work, no one would offer their labor anymore because the entire income would have to be ceded to the tax.

At this point, too, the state's tax return is still zero. So there has to be a point where the government's tax return can be maximized. From this point on, the tax return falls on both sides. If the tax rate is increased continuously, starting from a rate of zero, the tax revenue increases.

However, as already mentioned, this increase only happens up to a certain point, at which the taxed people evade. If the tax rate is increased further towards 100 percent beyond this point, tax revenue will decrease again.

This phenomenon can be explained by the fact that higher tax rates can lead to a decrease in turnover and this can be attributed, for example, to reduced labor input.

It is important to note that the course and the apex of the Laffer curve at which the tax return would be maximum cannot be specified precisely. Also, it is not possible for a tax to indicate whether it is to the left or right of the vertex.

With the Laffer curve, it is only possible to show the connection that if a tax rate or a tax rate is increased above a certain point, this leads to decreasing tax revenues due to the reactions of the taxed persons.

Laffer curve: a simplified example

With a view to the tobacco tax increase in Germany, it is possible to illustrate the theory of the Laffer curve described above.

Tax revenues fell in the first half of 2005, although they should have increased after the tax increases on tobacco products.

Because of the tax hike, many people are consuming alternative, lower-taxed tobacco products.

Such a state is visualized by a point on the Laffer curve to the right of the vertex.


© Verlag für die Deutsche Wirtschaft AG, all rights reserved