What Does the Laffer Curve Show?
Learn what the Laffer curve shows about tax rates, tax revenue and incentives, including its limitations and the key A Level exam misconception.
The Laffer curve shows the theoretical relationship between the rate of taxation and the total tax revenue received by the government. It suggests that raising tax rates can eventually reduce tax revenue if it weakens incentives to work, invest or declare taxable income.
Specification focus: A Level Economics,
10.3.1, Effectiveness of policy options to meet all macroeconomic objectives — specifically fiscal policy including Laffer curve analysis.
How the curve works
The vertical axis shows government tax revenue, while the horizontal axis shows the tax rate.
At a tax rate of 0%0\%0%, the government receives no tax revenue. As the tax rate rises, revenue initially increases. However, beyond the revenue-maximising tax rate, further increases may reduce the tax base—the income, spending or profits on which tax is charged.
Very high tax rates may:
- discourage people from working additional hours;
- reduce entrepreneurship and investment;
- encourage tax avoidance or tax evasion;
- cause workers or firms to move elsewhere.
The curve is therefore usually drawn as an inverted UUU-shape. In its simplest theoretical form, revenue is also zero at a tax rate of 100%100\%100%, because people have no incentive to earn taxable income.
Worked example
Tax revenue can be represented simply as:
tax revenue=tax rate×tax base\text{tax revenue}=\text{tax rate}\times\text{tax base}tax revenue=tax rate×tax baseSuppose a tax rate of 30%30\%30% applies to a tax base of 100100100 billion units:
0.30×100=30 billion units0.30\times100=30\text{ billion units}0.30×100=30 billion unitsIf the rate rises to 50%50\%50%, but the tax base falls to 505050 billion units, revenue becomes:
0.50×50=25 billion units0.50\times50=25\text{ billion units}0.50×50=25 billion unitsThe higher rate has produced lower revenue.
Evaluation and exam mistake
The curve does not prove that every tax cut increases revenue. That depends on the economy’s starting position and how strongly taxpayers change their behaviour. The revenue-maximising rate is also difficult to identify and may differ between taxes and countries.
A common exam mistake is claiming that the curve shows taxes should always be reduced. Its real message is that, beyond some uncertain point, higher tax rates may lower tax revenue.
