HISTORIAS Manuel Espejo
Laffer Curve
Arthur Laffer, an American economist, is renowned for popularizing a fundamental concept: the connection between the income of economic agents and their willingness to pay taxes. This economic phenomenon, though strikingly straightforward, has sparked extensive debates among economists with varying perspectives. The essence of the Laffer curve can be succinctly conveyed through the following graphical representation:
How do we interpret the graph above? Let's consider the economic agent known as the Tax Payer. Tax Payer represents the multitude of individual economic agents who, independently, make decisions regarding engaging in economic activities subject to taxation. According to the graph above, if Tax Payer has zero income, the taxes they will pay (tax revenue for the tax administration) will also be zero. Similarly, if the economic agent is burdened with a tax rate of 100% of their income, Tax Payer will have no incentive to partake in any economic activity, resulting in zero income for the tax administration. It is not contentious to comprehend what transpires when Tax Payer has no income or when the tax rate reaches 100%; the debate arises in the realm that lies between these two extremes.
According to the Laffer curve, when Tax Payer possesses income, they are obliged to pay taxes as per the applicable tax rate. Tax Payer will willingly continue to pay taxes until the point at which they realize that the economic activities they engage in are no longer worthwhile due to the taxes incurred. At this juncture, they will cease these economic activities, subsequently discontinuing tax payments.
As Tax Payer is defined as an amalgamation of autonomous market operators, when one among them, having income, is subject to taxation based on the prevailing tax rate, these diverse economic agents must decide whether to continue their market operations or withdraw. As the tax rate escalates, fewer operators will find it feasible to engage in market activities. For each economic agent, a tipping point will emerge where further increases in taxes will lead to a reduction in the number of operators constituting Tax Payer, and consequently, a decrease in tax revenue. This tipping point is represented as point C in the graph.
To the left of point C on the graph, tax authorities can augment tax rates, resulting in an increase in tax revenue. Conversely, to the right of point C, elevating the tax rate doesn't yield more tax revenue; instead, it diminishes it. The tax administration will generate equivalent revenue with either tax rates A and E (R2) or B and D (R1). Nonetheless, lower tax rates foster more substantial economic growth and enhance societal well-being. In simpler terms, tax rates D and E are inferior to tax rates B and A, as they contribute to greater prosperity within society. This is because higher taxes discourage economic activities.
Certain economists contend that if a country finds itself at point C on the graph (the pinnacle of tax revenue, which is challenging to pinpoint precisely), an escalation in tax rates will trigger an economic slowdown and set in motion a process of economic deterioration, ultimately leading to a decline in future tax revenue. This decline in economic activity will result in increased unemployment. Conversely, reducing tax rates from C to B will produce an immediate reduction in tax revenue to R1. However, this tax rate reduction will stimulate economic growth and increased economic activity, ultimately enabling the tax administration to garner higher revenues in the future. Lower tax rates will provide citizens with more disposable income, leading to increased spending and heightened well-being. The economy will expand, and unemployment will decrease.
The model presented here is quite elementary. The consequences of tax adjustments can vary considerably depending on the type of tax, whether it is direct or indirect. Consequently, the Laffer Curve yields distinct outcomes contingent on the specific tax under consideration.
