3.2.4.6  †Constraints on the Amount of Tax that can be Levied

†(This is a current extract from the Patterns of Power Repository.† An archived copy of this page is held at http://www.patternsofpower.org/edition02/3246.htm)

There is a theoretical limit on how much tax can be levied, as illustrated by the 'Laffer curve'.[1] †This shows how total government income from a tax initially increases in proportion to the tax rate applied, but receipts start to level off as people take evasive action or reduce their effort.† The curve then shows that government revenue starts to fall as the tax rate is further increased and the avoidance effects become dominant.† No-one would do any work if the tax rate were 100%, so the government revenue would be nil.†

The Laffer effect, though, only applies if tax rates are set very high.[2]† The more practical limit on how much tax can be raised in total is its effect on growth: if people donít have money to spend there is insufficient demand for wealth to be created and the total tax revenues shrink as the economy contracts.† This is a Keynesian argument,[3] and it applies most directly to taxes on low-paid and middle-income people: tax cuts for these people stimulate growth, whereas tax increases can be used to dampen it and thereby reduce the risk of inflation†(3.3.8.3).

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[1] A simple and amusing explanation of the Laffer curve was available at http://www.youtube.com/watch?v=fIqyCpCPrvU in April 2014.†

[2] An analysis of the Laffer effect can be found in Samuelson and Nordhausís book Economics (pp. 313-316), which argues that American tax rates at the end of the 20th century were set low enough for the Laffer effect to be irrelevant: reductions in tax rates simply reduced revenues almost proportionally, whilst having no detectable impact in generating growth.

[3] Keynesís theory on the impact of demand on economic growth is briefly described in Samuelson and Nordhausís book Economics, p. 603.