On the possibility of an inverse relationship between tax rates and government revenues
When Arthur Laffer or other "supply side advocates" plot total tax revenue as a function of a particular tax rate, he draws an upward sloping segment called the normal range, followed by a downward sloping segment called the prohibitive range. Since a given revenue can be obtained with either of two tax rates, government would minimize total burden by choosing the lower rate of the normal range. A brief literature review indicates that tax rates on the prohibitive range in theoretical and empirical models have been the result of particularly high tax rates, high elasticity parameters, or both. Looking at labor tax rates and total revenue, for example, the tax rate which maximizes revenue will depend on the assumed labor supply elasticity. This paper introduces a new curve which summarizes the tax rate and elasticity combinations that result in maximum revenues, separating the "normal area" from the "prohibitive area." A general-purpose empirical U.S. general equilibrium model is used to plot the Laffer curve for several elasticities, and to plot the newly introduced curve using the labor tax example. Results indicate that the U.S. could conceivably be operating in the prohibitive area, but that the tax wedge and/or labor supply elasticity would have to be much higher than most estimates would suggest.
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- T. Aldrich Finegan, 1962. "Hours of Work in the United States: A Cross-Sectional Analysis," Journal of Political Economy, University of Chicago Press, vol. 70, pages 452.
- Jane H. Leuthold, 1968. "An Empirical Study of Formula Income Transfers and the Work Decision of the Poor," Journal of Human Resources, University of Wisconsin Press, vol. 3(3), pages 312-323.
- Grieson, Ronald E. & Hamovitch, William & Levenson, Albert M. & Morgenstern, Richard D., 1977. "The effect of business taxation on the location of industry," Journal of Urban Economics, Elsevier, vol. 4(2), pages 170-185, April.
- George J. Borjas & James J. Heckman, 1978. "Labor Supply Estimates For Public Policy Evaluation," NBER Working Papers 0299, National Bureau of Economic Research, Inc.
- Rosen, Sherwin, 1969. "On the Interindustry Wage and Hours Structure," Journal of Political Economy, University of Chicago Press, vol. 77(2), pages 249-73, March/Apr.
- Canto, Victor A. & Joines, Douglas H. & Laffer, Arthur B., 1978. "An income expenditure version of the wedge model," Proceedings, Federal Reserve Bank of San Francisco, issue 2, pages 27-62.
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