Cambridge International as and a level Economics Ebook

Laff er curve
may be considered to be linked to 
government failure in two ways. One is that it shows 
that when tax rates are high, raising them further will be 
counterproductive.
Laff er curve: 
a curve showing tax revenue rising at first 
as the tax rate is increasing and then falling beyond a 
certain rate.
KEY TERM
Th
e Laff er curve was fi rst drawn by an American 
economist and advisor to President Ronald Reagan, 
Arthur Laff er, in the early 1970s. He drew it to support his 
view that a cut in tax rates may increase tax revenue by 
stimulating both total economic activity, because of the 
greater incentive eff ect, and declared economic activity. 
Figure 10.4
 shows the Laff er curve.
At a tax rate of 0% there will obviously be no tax 
revenue. Th
ere will also be no tax revenue at a rate of 100% 
as workers will not be prepared to work if all their income 
goes in tax. Th
e curve suggests there is a tax rate that will 
generate the most tax revenue. Raising the tax rate beyond 
this point would reduce tax revenue as it will discourage 
work and encourage tax evasion.
 Figure 10.4
 indicates that 
a cut in the tax rate from 50% to 40% would increase tax 
revenue.
Th
e curve also suggests that, apart from where tax 
revenue is maximised, tax revenue is associated with two 
tax rates. Economists, however, question the usefulness and 
validity of the Laff er curve. Th
ey argue that it is debatable 
what the shape of the ‘curve’ actually is. Th
ey suggest it may 
be linear over part of its length and any shape is likely to 
vary over time and between countries.
Empirical evidence also suggests that belief in the 
Laff er curve can result in government failure. For example, 
soon aft er it was shown to Ronald Reagan, the American 
government introduced tax cuts that actually reduced tax 
revenue.
TOP TIP
Always indicate the 0% and 100% tax rates on a Laff er 
curve as well as the ‘optimum’ rate.