Increases in income-tax rates beyond some level will decrease rather
than increase tax revenues. The curve relates the government’s tax
revenue to the tax rate. As drawn, revenue reaches a maximum level of
at the tax rate. If the tax rate were , then reducing it to would
increase the government’s tax revenue.
The reasoning behind the general shape of the Laffer curve is as follows.
At a zero tax rate, no revenue would be collected. As rates are raised
above zero, some revenue will be generated. But as rates continue to rise,
revenue will eventually fall because the very high tax rates will lead
people to work less and less. At a tax rate of 100 percent, they will not
bother to work at all (because all of their income would go to the
government) and so tax revenue will again be zero. It follows that there
must be some tax rate, greater than zero and less than 100 percent, at
which tax revenue reaches a maximum.
Figure 18-4 is drawn under the assumption that there is a steady
increase in tax revenue as tax rates rise to , and a steady decrease in tax
revenues as tax rates continue to rise toward 100 percent. This particular
shape—with a single peak in tax revenues—is not necessary. But the
precise shape is beside the point. The key point is that there is some tax
rate like that maximizes total tax revenue. And therefore tax rates
above or below will generate less tax revenue than the amount raised
at.
In Canada and the United States, it is not uncommon to hear heated
debates regarding the appropriate level of income-tax rates. In such
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