Business, Legal & Accounting Glossary
Laffer curve in economics refers to exemplify the idea that an increase in taxation rate may result in a decrease in revenues from taxes.
The Laffer Curve is a mathematical shape that shows the relationship between tax rates and the revenue governments collect from those taxes. The Laffer Curve is shaped like an upside-down U. The Laffer Curve is not fixed, however. The Laffer Curve shows that as tax rates rise, tax revenues increase. They reach a critical high point, called T*, where the maximum amount of tax revenue is reached for the maximum tax rates possible. After this point, both tax rates and revenue drop. The T* location suggests that at this point, people become increasingly unwilling to pay taxes. The location of the T* point along the Laffer Curve varies according to economic conditions. Economist Arthur Laffer invented the Laffer Curve.
The curve illustrates that, with tax being increased from lower levels, government revenues from taxes also increases. It also displays that after-tax rates are increased beyond a certain point (T*) revenues from taxes would be reduced. If tax rates reached 100% then people would desist from work as all their earnings would go to government coffers.
Governments would prefer to be at point T* as they can extract maximum quantum of revenue. People would also work hard at this point of the Laffer curve.
Point T* is subject to considerable theoretical speculation. This point is dependent on the elasticity of supply of labour and a number of external factors. Laffer curve is distinct for each country economy. Problems in drawing this curve are created when there is progressive taxation. The curve may also change with the legal creation of tax shelters and loop-holes.
Laffer curve is mainly used by interest groups who prefer the government to decrease the tax rate. These groups also forward the opinion that the current rate of tax is above the optimum tax rate. They believe that a decrease in tax rates will lead to an increase in revenues collected by the government.
Income tax is a tax that governments enforce on financial income produced by all applicable entities in their jurisdiction. Businesses and individuals are compulsorily required to file an income tax return every year. The return determines whether they owe any taxes or are eligible for tax refunds. Income tax is a principal source of funds for government-funded activities.
Most countries impose a progressive tax system where persons earning higher incomes pay higher taxes compared to their peers who earn less.
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This glossary post was last updated: 29th March, 2020