A Tax Reform Analysis of the Laffer Argument

Abstract

This paper shows that tax reform techniques are well-suited to an examination of the Laffer argument, i.e., the possibility that an increase in a tax rate may reduce tax revenues (and vice versa). Our methodology allows us to examine the Laffer argument directly, without deriving the Laffer curve, which in turn allows us to conduct the analysis in a very general setting. Despite the high level of generality, we are able to reach some clear conclusions that provide formal support for the established intuitions that the Laffer effect requires: (i) a 'high' labour-income tax rate, and (ii) a 'large' labour supply response to wage changes. The notions of 'high' and 'large' are made precise in our framework. The analysis also provides indirect support for the intuition that it is never optimal for a government to operate on the downward-sloping segment of the Laffer curve. Finally, we show that our methods provide a theoretical framework for an empirical investigation.Laffer argument, tax reform