The Laffer Curve - Online Tutor, Practice Problems & Exam Prep

The Laffer curve illustrates the relationship between tax rates and tax revenue, showing that higher taxes do not always lead to increased revenue. Initially, as tax rates rise, revenue increases until reaching an optimal point. Beyond this point, further tax increases can decrease revenue due to reduced quantity exchanged. This concept emphasizes the importance of finding a balanced tax rate to maximize government revenue while maintaining economic activity. Understanding this relationship is crucial for effective fiscal policy and economic management.

The Laffer Curve

So the government needs to collect more tax revenue. What do they do? They raise taxes. Right? But that doesn't necessarily lead to more tax revenue. We can actually find a pretty interesting conclusion when we use what's called the Laffer curve to show us how higher taxes do not necessarily mean more tax revenue. Let's check it out. So like I said, this larger tax does not necessarily lead to higher tax revenue. Why is that the case? Well, remember as the size of a tax increases, how do taxes affect our quantity exchanged? As we have more tax, well, that's more cost here, right? So it's going to keep decreasing the quantity exchanged, right? The quantity exchanged is going to decrease as the tax increases. So as we learned here with taxes in our other videos, let's go through three examples here where we'll have a small tax, a medium-sized tax, and a large tax, and let's see how that affects tax revenue.

So as you remember, we can represent the size of the tax by the space between the demand curve and the supply curve. So if this is our demand, our downward demand, upward supply, and let's say this green line right here lets start with extremes. We'll have a very small tax here. So if we have a very small tax here, right, and this would be the size of the tax. So if we were at this point, this would be the quantity exchanged if we had that size tax. So I'll put Q t tax here, right? Where we would originally be at this equilibrium over here, but the tax, it moves us away from equilibrium because the price that the suppliers receive and the price that the buyers pay is now different because of the tax, right? So what's going to happen in this case? Remember how we calculate our tax revenue? Well, it's the amount of tax times the quantity exchanged, right? We're dealing with per unit taxes here. So if we're going to exchange this quantity and there's a certain amount of tax say $1, let's say this is a $1 tax, well, the amount of tax revenue would be represented by this box here, right, because if we go to the demand curve here, this is the price that the buyers pay and this down here is the price the sellers receive. Right? And everything in the middle goes to the government. So what we'll see here is that this space here, just like we saw when we studied taxes originally, this is the amount of tax revenue. So this is our tax revenue in this little box here. Right? So notice, there's a small tax revenue here because we have a small tax.

Now, let's go to the other extreme. Let's go to where we have a really large tax. Okay? Let's start here on this bottom one where we have a really large tax. Let's do the same thing, right? And now, let's say the tax is a big amount over here. Way over here, there's this huge tax. Maybe $15 per item where before it was just $1. Right? So now, we've got this $15 tax per item and notice what's happened to the quantity exchanged. In this case, the quantity exchanged is going to be way down here, this Q t tax . Yeah. Our quantity exchanged has decreased a lot because there's a big tax here. So now the price the buyers pay is way over here. So notice, there are not so many people that want to pay this high price. So there's not going to be that much exchanged. This is our demand curve, our supply curve, and this is the quantity supplied down here because this is the price that the sellers receive and there are not that many sellers that want to supply at such a low price received. Right? So notice what our tax revenue here is. Even though there's this big amount of tax, right, they're getting a lot per exchange. Well, there's not so many exchanges happening now. So what happens to our tax revenue? Well, it's this space again. The space of the tax amount times the quantity exchanged. So again, notice what our box looks like. So our area of the box hasn't increased very much or is pretty much the same as when we had the small tax up here, right? In this case, notice we had a very long box but not very tall. In this case, we have a very tall box but it's not very long. So the area of the box has not changed very much.

So even though this is our kind of example here, you can kind of see where I'm getting at. So our tax revenue there is still not much different than when we had a small tax. Now let's go to the situation where we have maybe a more ideal tax somewhere in the middle. So let's see what happens if we have maybe this tax right here. Maybe this is a better tax for the government right here. So something in the middle. Again, we have a quantity exchanged that's going to be right here with the tax. And what's going to happen with the price the buyers pay and the price the sellers receive? We're going to have this as our demand curve, our supply curve here. So this is the price the buyers pay, the price the sellers receive, and notice what's happened to the area of the box. There's a lot more area here. Right? And that's the idea of a medium-sized tax, the correct-sized tax. Now in every market, this could be a different amount, right? We can't say what the correct tax is that's going to maximize tax revenue, in any market just like this. But this is the idea where there's more tax revenue when there's the correct tax because notice what's happened in this case. There's still quite a lot of quantity being exchanged because we're not in those extremes, but there's also a sizable tax revenue. So the length of the box and the width of the box is greater and that leads to a higher area which leads to higher tax revenue here. So the tax revenue, we're going to say, is the biggest when we have that medium-sized tax.

So what is the Laffer curve? How do we translate this all onto a graph to let us know, what the proper tax revenue or what the proper size of the tax is? So the Laffer curve, what it shows us let me get out of the way a little more. What it shows us is that we've got, if we put the size of the tax on the x-axis here and we put the tax revenue, the amount of tax revenue received by the government on the y-axis, well, when we as we increase the tax, right, we're getting more and more revenue up to a point where the tax has gotten too big and the revenue is going to start decreasing again, right? So if we start with the small tax up here, we're going to have a small amount of revenue and it's going to start increasing and increasing as we reach the perfect amount of tax for the maximum tax revenue and then it's going to start and that's here in the medium graph and then it's going to start decreasing again as we get to the large graph, the area of the box gets smaller and smaller again. Right? So notice, our Laffer curve is going to look something like this then. As the size of the tax increases, what we're going to have an increase in tax revenue until it reaches some sort of maximum like that at that ideal maximizing tax revenue tax and then it's going to start decreasing again. Right? So we're going to have this kind of parabolic shape where we're going to have, the tax revenue increasing to a point and then it starts decreasing again. So what does this tell us? That higher taxes do not necessarily lead to more tax revenue because the quantity exchanged is going to keep decreasing as those taxes increase. Okay. So that's what this Laffer curve is depicting. It's depicting the relationship between that size of the tax and the amount of tax revenue and it's named after Arthur Laffer. That's the guy who created this idea, creator of the Laffer curve and he suggested that the USA was already on the downward slope of the curve. So he's saying that the USA was already somewhere, let's say here on the curve. Maybe the USA is right here. So any increase in taxes was actually going to decrease tax revenue. Okay? Now we don't know if he's right or wrong, but the idea is that he was proposing that as we increase taxes, it's actually going to hurt our tax revenue because it's going to hurt the quantity exchanged. So in this situation, what it's saying is that larger taxes are going to have multiple negative effects. First, we're going to have less quantity exchanged which is also going to lead to less tax revenue, right? Just as we saw in our examples there, we're already at that large tax. So if we were to increase the tax even more, that tax revenue, the total tax revenue, would decrease. Cool? So that's about it for the Laffer Curve. That's what you have to remember here: that it's a relationship of larger taxes and the amount of tax revenue. Cool? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the Laffer Curve and how does it relate to tax revenue?

The Laffer Curve illustrates the relationship between tax rates and tax revenue. It shows that initially, as tax rates increase, tax revenue also increases. However, beyond a certain point, further increases in tax rates lead to a decrease in tax revenue. This is because higher taxes can reduce the quantity of goods exchanged, thereby lowering the overall tax revenue. The curve is parabolic, indicating that there is an optimal tax rate that maximizes revenue. Understanding this relationship is crucial for effective fiscal policy and economic management.

Who created the Laffer Curve and what was his main argument?

The Laffer Curve was created by economist Arthur Laffer. His main argument was that the United States was already on the downward slope of the curve, meaning that any further increase in tax rates would actually decrease tax revenue. He suggested that higher taxes would reduce the quantity of goods exchanged, thereby lowering overall tax revenue. Laffer's theory emphasizes the importance of finding an optimal tax rate to maximize government revenue while maintaining economic activity.

How does the Laffer Curve explain the impact of different tax rates on economic activity?

The Laffer Curve explains that different tax rates have varying impacts on economic activity. At low tax rates, increasing taxes can lead to higher revenue without significantly affecting the quantity of goods exchanged. However, as tax rates continue to rise, they reach a point where they start to discourage economic activity, reducing the quantity of goods exchanged. This leads to a decrease in tax revenue. The curve suggests that there is an optimal tax rate that balances revenue generation and economic activity, maximizing tax revenue without overly burdening economic transactions.

What are the implications of the Laffer Curve for fiscal policy?

The Laffer Curve has significant implications for fiscal policy. It suggests that there is an optimal tax rate that maximizes government revenue without discouraging economic activity. Policymakers can use this concept to set tax rates that balance revenue generation and economic growth. If tax rates are too high, they may reduce the quantity of goods exchanged, leading to lower tax revenue. Conversely, if tax rates are too low, the government may not collect enough revenue. Understanding the Laffer Curve helps in designing effective tax policies that promote economic stability and growth.

Can the Laffer Curve be applied to all types of taxes?

While the Laffer Curve is a useful tool for understanding the relationship between tax rates and revenue, it may not apply uniformly to all types of taxes. The curve is most commonly associated with income and corporate taxes, where higher rates can significantly impact economic behavior. However, its applicability to other taxes, such as consumption taxes or property taxes, may vary. Each type of tax has different effects on economic activity, and the optimal tax rate for maximizing revenue can differ. Therefore, while the Laffer Curve provides a general framework, its specific application requires careful consideration of the type of tax and the economic context.