On the possibility of an inverse relationship between tax rates and government revenues

When Arthur Laffer and other 'supply side advocates' plot total tax revenue as a function of a particular tax rate, they draw an upward-sloping segment called the normal range, followed by a downward-sloping segment called the prohibitive range. A brief literature review indicates that tax rates on the prohibitive range in theoretical and empirical models have been the result of particularly high tax rates, high elasticity parameters, or both. The labor tax rate which maximizes total revenue, for example, will depend on the assumed labor supply elasticity. This paper introduces a new curve which summarizes the tax rate and elasticity combinations that result in maximum revenues, separating the 'normal area' from the 'prohibitive area'. A general- purpose empirical U.S. general equilibrium model is used to plot the Laffer curve for several elasticities, and to plot the newly introduced curve using the labor tax example. Results indicate that the U.S. could conceivably be operating in the prohibitive area, but that the tax wedge or labor supply elasticity would have to be much higher than most estimates would suggest.