Taxation exists for a number of reasons:

  1. To pay for government spending
  2. To manage aggregate demand through fiscal policy
  3. To redistribute income
  4. To correct for market failure

The Laffer Curve

Following the work of the American economist Arthur Laffer, free market economists argue that high rates of tax, especially on income are a disincentive to work and entrepreneurship and will therefore reduce economic growth and output. It also means that tax revenues will actually fall if the tax rate rises beyond a certain level. This is shown in Fig 1 below:

Taxation, figure 1

If the tax rate is 0%, then clearly there will be zero tax revenue. The same applies if the tax rate is 100%, as no one will want to work. It therefore follows as a matter of logic that there must be some tax rate between 0% and 100% where tax revenue is maximised.

Initially, as the tax rate rises above 0%, tax revenue increases, but at a diminishing rate. Beyond 40% however, tax revenues start to fall as the tax rate rises.

The reason for this is to do with the___ income effect and the ___substitution effect of the change in tax rate.

Individuals can choose to divide their time between work and leisure. The more hours they work the less leisure they have. By working more they have more goods and services, so in effect the choice is between goods and leisure.

As tax rates rise the opportunity cost of leisure falls. The substitution effect of a tax rate rise on hours of work is therefore negative, causing the individual to work less. But the tax rise also reduces the amount of goods (s)he can buy, so the individual has to work more hours to obtain the same amount of goods. The income effect is therefore positive.

Free market economists believe that the substitution effect is more important than the income effect. In Fig 1, if the tax rate is above 40%, a tax cut would actually result in an increase in tax revenues as the positive incentive to work of the substitution effect (which is positive for a tax cut) would be greater than the negative incentive of the income effect.

The problem here is that we do not know in practice what rate of tax will maximise work incentives. The UK government thinks it is around 40% (which is why the top rate was reduced from 60% in the 1980s. But this is little more than guesswork. The argument for cutting tax rates to improve incentives also assumes that people have control over the hours they work; in practise most people don’t.

But another aspect of the Laffer curve is about tax avoidance and tax evasion. The former refers to the use of clever accounting techniques that exploit loopholes in the law to reduce the amount of tax paid. The latter means unlawfully hiding income from the tax authorities. It seems reasonable to suppose that both practices are likely to increase at high rates of tax. Also, some wealthy, high earners who are geographically mobile may have a greater incentive to emigrate to a lower tax country.

Progressive, Proportional and Regressive Taxes

A progressive tax is one which takes not only more tax as someone’s income increases, but also takes a higher proportion of someone’s income in tax as income rises. In most countries, income tax is progressive. This is achieved by having increasing marginal rates of tax as people earn more. In the U.K. the first £12,000 of earnings is taxed at 0%. Between £12,000 and £46,000 income is taxed at 20%. Income above £46,000 but below £150,000 is taxed at 40%. Any income above £150,000 is taxed at 45%

A proportional tax is one which takes the same proportion of a person’s income, regardless of how much (or little) they earn. These are sometimes called flat rate taxes. Some eastern European countries, as well as a few of the states in the USA have flat rate income tax.

Taxes on income or wealth are likely to be either progressive or proportional.

A regressive tax is one where the proportion of income paid in tax is higher for those on lower incomes. Generally, indirect taxes (taxes on spending) tend to be regressive. This is because, although two people may pay the same amount in tax when they purchase an item, it represents a bigger % of income for the low earner compared to the high earner.

Tax Changes and the Level of Output, Employment and the Price Level

Changes in tax rates can affect aggregate demand (AD), and or aggregate supply (AS) and will therefore have an impact on the short and long run levels of equilibrium output and employment.

Cuts in any taxes will increase AD, leading to higher equilibrium output and employment. But remember that if the economy is already close to full capacity, it will increase the price level (ie faster inflation) rather than real output. Increases in taxes will correspondingly lead to a fall in AD and a lower level of real output and prices.

Note that the effect on long run equilibrium may be different if we use a Keynesian, rather than neo-classical model.

A rise in indirect taxes (such as VAT) will lead to an upward shift in the short run AS curve. This will cause a fall in the short run equilibrium level of output. A fall in indirect taxes will have the opposite effect.

Cuts in direct taxes may increase the long run AS, resulting in higher equilibrium output and employment.

Tax Changes and the Distribution of Income

In recent years many countries have moved towards raising more revenue from indirect taxes and less from direct taxes. For instance in the U.K. the top rate of income tax has been reduced from 87% in the 1970s to 45% in 2015. The main indirect tax (VAT) has risen from 8% to 20%. One reason for this is that it is much harder to escape paying indirect taxes (you can’t hide spending from the tax authorities). The other reason is to do with the argument about work incentives (discussed above).

A major consequence of this structural reform is that the tax system as a whole is a lot less progressive than it used to be. There is now a wider inequality between rich and poor, as the highest earners now pay a smaller share of their income in tax, whereas low earners now pay a higher share of their income in tax.

Tax Changes and the Trade Balance

Increases in direct or indirect taxes will reduce consumption and investment spending. Some of this reduction in spending will impact on imports, which will therefore reduce, leading to an improvement in the trade balance. But it is possible that if higher taxes lead to lower investment, productive capacity may fall, resulting in higher imports in the long run, as domestic businesses struggle to meet demand.

Tax Changes and Foreign Direct Investment (FDI) Flows

In recent years there has been growing concern about___ tax competition between countries and the so called ‘__race to the bottom_’. Countries can attract inward investment from multi-nationals by offering lower company taxes than in other countries. For instance the Republic of Ireland and Luxembourg have both attracted large amounts of FDI by having low rates of corporation tax. Whether or not this also increases the government’s overall tax revenue depends on the extent to which the tax revenue on new FDI compensates for the loss in revenue that results from having a lower rate of tax, which applies to all existing businesses, as well as newly established foreign owned businesses. It also depends on other countries not reducing their corporate tax rates; otherwise it just results in all countries having lower corporate tax revenues and governments having to increase taxes on incomes and spending instead. This means that national income is redistributed from wages to profits, widening inequality.

Under what circumstances might a reduction in the rate of income tax lead to an increase in tax revenue?
Your answer should include: Laffer curve / income effect / substitution effect / tax avoidance / tax evasion