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Why is the shape of the Laffer curve for consumption tax different from that for labor income tax?

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  • Kazuki Hiraga
  • Kengo Nutahara

Abstract

Recent studies on Laffer curves (tax revenue curves) find that the Laffer curve for consumption tax might not be hump-shaped, but monotonically increasing, whereas the Laffer curve for labor income tax is hump-shaped. This study investigates the cause of this difference in the shapes of two Laffer curves, by decomposing the effects of an increase in a tax rate on the tax base as a product of two parts: (i) the effects on the relative price of leisure (RPL), and (ii) the substitution and income effects. It is shown that the first effect with respect to the consumption tax rate is completely different from that with respect to the labor income tax rate, while the second effect is common among the taxes and depends on the functional form of the utility. The elasticity of the RPL from an increasing consumption tax rate is at most 1, whereas it can be infinity as the tax rate increases in the case of labor income tax.

Suggested Citation

  • Kazuki Hiraga & Kengo Nutahara, 2018. "Why is the shape of the Laffer curve for consumption tax different from that for labor income tax?," CIGS Working Paper Series 18-004E, The Canon Institute for Global Studies.
  • Handle: RePEc:cnn:wpaper:18-004e
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    File URL: http://www.canon-igs.org/workingpapers/180913_nutahara.pdf
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    2. repec:eee:jjieco:v:48:y:2018:i:c:p:15-28 is not listed on IDEAS
    3. Holter, Hans A. & Krueger, Dirk & Stepanchuk, Serhiy, 2014. "How does tax progressivity and household heterogeneity affect Laffer curves?," CFS Working Paper Series 490, Center for Financial Studies (CFS).
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    6. Shinichi Nishiyama & Kent Smetters, 2005. "Consumption Taxes and Economic Efficiency with Idiosyncratic Wage Shocks," Journal of Political Economy, University of Chicago Press, vol. 113(5), pages 1088-1115, October.
    7. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production II: Tax Rules," American Economic Review, American Economic Association, vol. 61(3), pages 261-278, June.
    8. Diamond, Peter A & Mirrlees, James A, 1971. "Optimal Taxation and Public Production: I--Production Efficiency," American Economic Review, American Economic Association, vol. 61(1), pages 8-27, March.
    9. Kneller, Richard & Bleaney, Michael F. & Gemmell, Norman, 1999. "Fiscal policy and growth: evidence from OECD countries," Journal of Public Economics, Elsevier, vol. 74(2), pages 171-190, November.
    10. ├ůsa Johansson & Chistopher Heady & Jens Arnold & Bert Brys & Laura Vartia, 2008. "Taxation and Economic Growth," OECD Economics Department Working Papers 620, OECD Publishing.
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