6.1.3 The level of tax revenue: Laffer curve

The tax revenue (red square) can be calculated as the product of the level of the tax and the quantity sold. Since sales decrease with increasing tax level, it can be concluded that tax revenue only increases if the decrease in the quantity sold (in percent) is smaller than the percentage increase in tax.
In this graph, the tax is calculated as a quantity tax, i.e. as an additive surcharge on the price. For a constant tax rate, the difference between the gross and net price is always the same, regardless of the price.
This can be seen from the red rectangle that represents the tax revenue. If the tax is very low, the rectangle area is small (and the tax revenue is low), because the height of the rectangle (tax level) is small. If the tax is very high, the rectangle area is small (and the tax revenue is low), because the width of the rectangle (quantity sold) is small.
If the tax level is medium, the tax revenue is at its maximum. If the tax level rises above this point, the tax revenue decreases. The tobacco tax increase of 2004 had exactly this effect. So many smokers stopped smoking, reduced their consumption or switched to smuggled goods that the revenue from tobacco tax fell noticeably. A similar effect, which is used to argue for a reduction in income tax, is called the Laffer curve.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de