During the Reagan administration, economist Arthur Laffer argued in favor of lowering income tax rates in order to increase tax revenues. Like most economists, he believed that at tax rates above a certain level, tax revenue would fall because high taxes would discourage some people from working and that people would refuse to work at all if they received no income after paying taxes. This relationship between tax rates and tax revenue is graphically summarized in what is widely known as the Laffer curve. Plot the Laffer curve relationship assuming that it has the shape of a nonlinear curve. The following questions will help you construct the graph.
a. Which is the independent variable? Which is the dependent variable? On which axis do you therefore measure the income tax rate? On which axis do you measure income tax revenue?
b. What would tax revenue be at a 0% income tax rate?
c. The maximum possible income tax rate is 100%. What would tax revenue be at a 100% income tax rate?
d. Estimates now show that the maximum point on the Laffer curve is (approximately) at a tax rate of 80%. For tax rates less than 80%, how would you describe the relationship between the tax rate and tax revenue, and how is this relationship reflected in the slope? For tax rates higher than 80%, how would you describe the relationship between the tax rate and tax revenue, and how is this relationship reflected in the slope?