Laffer curve

The direct taxes code bill, recently tabled in the Lok Sabha, proposes to bring down the effective tax rates for individuals and corporates. The government hopes this will increase tax collections. In the developed world, it is being debated if tax rates should be increased to cut high deficits. The UK has already raised rates. The economic principle that drives the debate is Laffer Curve. ET takes a look at the concept.

What is Laffer curve?

The Laffer curve is the graphical representation of the relationship between tax rates and absolute revenue these rates generate for the government. The principle thought behind the Laffer curve is that a zero tax rate would produce zero revenue and a 100% tax rate would also generate zero revenue, as there would be no incentive to work. This means there must be an optimal tax rate that will yield maximum revenue for the government.

Economist Arthur Laffer discovered this relationship that came be known as the Laffer curve. It is based on the idea that at a particular tax rate evasion will make no sense as the cost, in terms of the money and time going into it, would be higher than benefits.

How does the Laffer curve work?

There are two effects that come into play whenever the tax rates are changed — the arithmetic and the economic effect. Simple mathematics says that other things being equal, if tax rates are lowered, tax revenues will drop in the same proportion.

Any increase should also make collections grow, but this happens only up to a point. Economic effect works at a more subtle level and recognises that an unduly high tax rate will mean people will be less inclined to work or will look for ways to avoid taxes. For instance, individuals and companies could think of moving their assets and business to a less taxing jurisdiction. Therefore, arithmetic logic of higher rate leading to greater collections is countered by be adverse economic effects.

What is the revenue maximising rate?

t is difficult to give a rate as it would vary from country to country. Research has shown different tax rates to be optimal under different circumstances. A country with good compliance machinery and re-strictions on moving assets to other jurisdictions can push the rate high. It would also vary with respect to time. In the short term, tax revenues can be boosted through higher rates, as the visible income will be taxed at higher rate. But over a long term, the high rates would discourage economic activity.

A recent paper of the European Central Bank says that the US could increase tax revenues by as much as 30% by raising labour taxes or tax on income and 6% by raising capital income taxes or tax on business. For a select 14 countries of the EU, the benefit from rate hike can be only 8% and 1%, respectively. The study notes that Denmark and Sweden are on the wrong side of the Laffer curve for capital income taxation.

What is the case in India?

Although the current rate of taxes in India is considered moderate, it is felt that lowering the tax rate will increase compliance further, particularly in the case of individuals.