Working Paper: NBER ID: w0467
Authors: Don Fullerton
Abstract: When Arthur Laffer or other "supply side advocates" plot total tax revenue as a function of a particular tax rate, he draws an upward sloping segment called the normal range, followed by a downward sloping segment called the prohibitive range. Since a given revenue can be obtained with either of two tax rates, government would minimize total burden by choosing the lower rate of the normal range. A brief literature review indicates that tax rates on the prohibitive range in theoretical and empirical models have been the result of particularly high tax rates, high elasticity parameters, or both. Looking at labor tax rates and total revenue, for example, the tax rate which maximizes revenue will depend on the assumed labor supply elasticity. This paper introduces a new curve which summarizes the tax rate and elasticity combinations that result in maximum revenues, separating the "normal area" from the "prohibitive area." A general-purpose empirical U.S. general equilibrium model is used to plot the Laffer curve for several elasticities, and to plot the newly introduced curve using the labor tax example. Results indicate that the U.S. could conceivably be operating in the prohibitive area, but that the tax wedge and/or labor supply elasticity would have to be much higher than most estimates would suggest.
Keywords: tax rates; government revenues; Laffer curve; elasticity
JEL Codes: H21; H24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher tax rates (H29) | lower revenues (H27) |
| high tax rates or high elasticity parameters (H30) | lower revenues (H27) |
| elasticity of labor supply (J22) | revenue-maximizing tax rate (H21) |
| tax rate maximizing revenue (H21) | elasticity of labor supply (J22) |