On the Irrelevance of the Laffer Curve
When discussing the magnitude of marginal tax rates, we do not consider the Laffer curve to be particularly helpful. The change in tax revenues due to a change in marginal tax rates is a misleading measure of the benefits or losses to society. In designing a tax system one cannot avoid the fact that a dollar of tax revenues costs the taxpayer a dollar. This is the income effect of taxation. If taxes alter relative prices by discriminating between different activities, they introduce incentives to shift private activities from heavily taxed to less heavily taxed activities. This is the substitution effect. The substitution effect leads the taxpayers to persue a combination of activities with lower social returns. Although this reaction is privately advantageous at the new after-tax prices, society suffers a welfare loss. In designing a suitable tax system, one must be concerned with minimizing welfare costs or excess burden of taxation.
KeywordsWelfare Loss Substitution Effect Welfare Cost Excess Burden Misleading Measure
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