14--The Notes "Laffer Curve" See the text on this. The point is that an increase in tax rates is not necessarily the same as an increase in tax revenues. Raising rates can cause taxpayers to avoid taxes (reduce their taxes by legal means) by using tax shelters to take advantage of deductions (remember, one man's loophole is another man's write-off), shifting income around to take advantage of more favorable rates, and simply working and hence earning less. Higher rates also encourage evasion. Hence, as rates rise, (1) the government collects more of each dollar of income earned, which raises revenues, but also (2) the amount of income which can be taxed declines, which reduces revenues. Up to a point, (1) dominates (2) and revenues rise, but beyond some percentage tax rate--probably 40 to 50 percent--(2) dominates (1), and revenues fall. So, it is possible to cut tax rates but increase tax revenues, as appears to have happened for high income earners in the US as a result of the 1981 tax law, which greatly reduced the marginal tax rates on that group. The Laffer curve is a simple logical proposition (but no less clever for that). At a tax rate of 0%, the government will collect $0 in tax revenues, because 0% of any amount of income earned is still zero. At a tax rate of 100% (i.e., your Form 1040 consists of two lines: Line 1How much did you make last year? Line 2Send it in.), the government will collect all income earned in tax revenue. But this will be equal tonothing! Why? Because no one will work for free, which is what this amounts to. (Well, maybe some people will. Theyre probably Democrats.) But we know that, at tax rates between 0% and 100%, the government does collect positive amounts of tax revenue, hence the curve must look roughly like Figure 4-3. Let's take a look at Figure 1. The marginal tax rate in percenttis shown on the vertical axis, and the tax revenue collected, in dollarsTis on shown the horizontal axis. At tax rate t1, tax revenue collected by the government is equal to T1. As the tax rate is raised to t2*, revenue rises to T2; the * indicates that this is the maximum amount of revenue the government can collect. If the government gets greedy and raises the rate further, to t3, it kills the golden goose, and tax revenue falls to T3, which is even less than the revenue collected when the tax rate was at its initial level. What matters here is really something that can be called the keep rate. People do not work so that they can pay taxes. They work so that they can keep something for themselves. The percentage of their income that they get to keep--the keep rate-is what determines their behavior, not the tax rate. The little table below shows why the distinction is important. Consider case A first, shown by the first two lines in the table. To start with (A1), the marginal tax rate is set at 10%, leaving the worker with a keep rate of 100% - 10% = 90%. Then the tax rate is raised (A2) to 15%. This is only a 5 percentage point increase, but in relative termsstay with me herethe rise is really quite big; an increase from 10 to 15, the increase of 5, is a 50% increase ([15-10] 10 = 50%). But this big tax hike won't have much effect on people's behavior, because their keep rate falls from a high 90% only to 85%, a fall of about 6% ([85-90] 90 = approx. -6%). People won't much miss the extra pay, because their paycheck hasn't fallen much. A worker earning $3,000 gross pay per month would find his take-home (net) pay reduced from $2,700 to $2,550. Now let's look at case B. Here, the tax rate starts (B1) at a whopping 80% and rises to 85%. This is a rise of only about 6%, in relative terms. But the keep your eye on the keep rate; it falls from 20% to 15%; that's a fall of 25%. ([15-20]/20 = -25%). Our worker's take-home pay would fall from $600 to $450. Ouch! Figure 1.