Question

What is the Laffer Curve, and how does it relate to supply-side economics? Why is determining the economy’s location on the curve so important in assessing tax policy?

Short answer

The Laffer curve depicts a link between tax rate and tax revenue. It is related to supply-side economics because taxation generates tax revenue for the government and affects the aggregate productivity of the economy.

The policymakers need to determine the economy’s location on the Laffer curve to design an appropriate tax policy for the economy.

Step-by-step solution

The definition of the Laffer curve and relation with supply-side economics 

The Laffer curve establishes a link between tax rates and tax revenue. The curve is inverted U-shaped which shows that for lower tax rates, tax revenue rises with a rise in tax rate up to a certain threshold or maximum limit, and then both tax rate and tax revenue become inversely related.

Taxation is an integral part of supply-side economics. A rise in tax rate reduces the disposable income of the households and, therefore, provides less incentive for work. Thus, people earn less, which reduces savings and investment. So, the aggregate productivity of the economy drops, leading to a leftward shift in the aggregate supply curve.

Just like productivity, taxes also affect the tax revenue of the government. Lower tax rates raise tax revenue, while higher tax rates tend to reduce it. The Laffer curve explains this relationship. Thus, this is how the Laffer curve is related to supply-side economics.

Importance of the location on the Laffer curve 

The Laffer curve is inverted U-shaped. It implies a particular level of the tax rate maximizes the tax revenue, and two tax rates (lower and higher) yield the same revenue to the government. So, policymakers need to determine the point on the curve where the economy lies.

For instance, if the economy lies to the right of the threshold point (at which tax revenue is maximum), the economy can earn higher tax revenue by lowering tax rates. However, if the economy lies to the left of the threshold point, policymakers can maximize tax revenue by increasing tax rates. Therefore, a point on the Laffer curve helps policymakers select an appropriate tax policy based on the current economic state.