Question

14 Suppose the average income tax rate is currently 40%, which results in a tax revenue of $400,000. A new policy is implemented to decrease the tax rate to 30% which causes the tax revenue to increase to $500,000. Briefly explain why this is possible. (1 pt)

Answer 1

There is a relationship between the income tax rate and revenue generation which was developed by Arthur Laffer to find the reason behind increased revenue generation with lower tax rates. He simply formulated a model where one extreme has a 0% tax rate and the other extreme has a 100% tax rate. This can be better explained with the following diagram where the y-axis represents the tax revenue and x-axis represents tax rate, where P is the point of maximum revenue that can be generated and T is the rate of tax at the point of maximization. So we can see in the diagram, until we reach point P, in the LT curve, the increase in tax rate is generating a higher revenue from 0 to point T on the x-axis, after point T while going towards right, we can see that with the increase in tax rate beyond point P on the y-axis, the revenue generated will decrease as the curve is sloping downwards. So in our example when the tax rate was 40% the government was generating a revenue of $ 400,000 but this rate falls rightward to point P and this is not the optimal rate of taxation. Whereas at 30% rate of tax the government is generating $ 500,000 as it falls towards the left side of point P where there is still scope for an increase in tax rate till point P. But if we go further than P it will gradually decrease the revenue as it happens when the tax rate is 40%.

R2 $500,000 R1 400,000 Tax Revenue LT 0% 30% T 40% 100% Tax Rate Relationship between tax rate and tax revenue by Laffer's Curve

So from the above diagram, we saw that with increased tax rate the revenue collection was decreasing, i.e., taxpayers were not ready to pay the taxes at such a higher rate. The reason for such behavior of the taxpayers can be, while considering individual or households, they will prefer not to work while paying such heavy taxes and they will be left with less money for their own consumption while paying much higher taxes, so few will try to evade the tax incidents, and few will stop working due to lack of incentives, so this will lead to a decrease in tax revenue collected from individual income earners. With higher tax rates the businesses will reduce investments as the profit percentage is getting utilized for paying taxes and capital accumulation will reduce which will decrease investments in the economy. The investors will think of relocating their operations to foreign countries and protect its assets from being taxed. This will lead to a falsification of financial statements by understatement of incomes and gains to reduce the tax burden. The price of the products will also increase due to increased taxation, and the producers will reduce production as the demand will fall due to higher prices because of the increased tax rate. So the individuals and investors will lose interest in earning due to such tax increase and the tax revenue will fall down eventually due to such turnovers. Tax cuts motivate investors and individuals to work more to increase their consumption and investment while paying lesser taxes. And the savings will also be increased due to higher disposable income in the hands of the taxpayers which will eventually get invested in new businesses by the producers. This will increase the business opportunities and there will be more productivity in the economy, and this increased production will generate higher tax revenue for the government. So the government should keep the tax rate as such so that it falls within the point of revenue maximization rather than going beyond this point because higher tax rates will decrease the revenue generation beyond the point of maximization.