Home
Economy-notes
Economy-UPSC notes

Laffer Curve – Economy UPSC Notes

Laffer Curve is an economic theory that shows the relationship between the tax rate (%) and the tax revenue collected by the government.
Amith

✅ Laffer Curve – Complete UPSC Notes

➤ Definition

The Laffer Curve is an economic theory that shows the relationship between the tax rate (%) and the tax revenue collected by the government.
It explains that:

  • At 0% tax rate → Tax revenue = ₹0 (because no tax is collected).

  • At 100% tax rate → Tax revenue = ₹0 (because people stop earning or hide income).

  • There is an optimal tax rate where tax revenue is maximum.

The Laffer Curve is an economic theory that illustrates the relationship between the tax rate and the tax revenue collected by the government. It shows that as the tax rate increases from 0%, tax revenue increases up to a certain point (the optimal tax rate). Beyond this point, further increases in tax rate cause tax revenue to decline, because high taxes discourage work, investment, and reporting of income, leading to tax avoidance or evasion. The curve highlights the importance of setting a balanced tax rate to maximize revenue without harming economic activity.

➤ Shape of the Curve

  • The graph looks like a hill.

  • Initially, as tax rate increases, revenue increases.

  • After a point, further tax increases lead to less revenue.

➤ Easy Example

Tax Rate People’s Motivation Tax Revenue
0% People work as usual ₹0
10% People work happily → Government collects some tax.
50% Still good revenue collected.
90% People hide income or don’t work → Less tax revenue.
100% No incentive to earn → Tax revenue = ₹0.

👉 At some middle tax rate (e.g., 30%-50%), the government collects the maximum revenue.

➤ Key Terms

  • Tax Rate: The percentage of income or sales taken as tax.

  • Tax Revenue: Total money collected by the government from tax.

  • Optimal Tax Rate: The tax rate where the government earns maximum revenue without discouraging people from working.

➤ Why Does the Revenue Decrease After a Point?

  • Higher tax makes people feel it’s not worth working hard.

  • People start hiding income, avoiding or evading tax.

  • Businesses may invest less or reduce production.

➤ Real-Life Analogy

  • Think of a lemonade stall:

    • If the owner keeps the price too low (₹1 per glass), they sell a lot but don’t earn much (small revenue).

    • If the price is too high (₹100 per glass), no one buys → Revenue drops.

    • There is a perfect price (e.g., ₹10 per glass) where revenue is highest.

Similarly, for tax:
There is a perfect tax rate where revenue is maximum.

➤ Importance in Policy Making

  • Helps governments decide the right tax rate.

  • Prevents imposing too high tax rates that reduce revenue and harm the economy.

  • Balances economic growth and revenue generation.

➤ Key Point to Remember

  • Very low tax → Less revenue.

  • Very high tax → People avoid paying, work less → Less revenue.

  • A balanced rate is best.

Post a Comment