Taxes - incentives

Undoubtedly, there is a strong relationship between Taxes - incentives which affect consumption, savings and investement. How tax incentives influence investment.

An increase on taxes reduces the available income that is to be consumed or saved. This is what we define as income effect.

However, such an increase on taxes will also influence (in a negative way) the working hours for individuals. Thus they may decide to substitute one thing for another, i.e. free time for work. This is what we define as substitution effect.

As a result from the income effect, we will be forced to increase our attempt in order to gain back what we lost from our income reduction. On the other hand, since we are facing a higher tax rates, meaning a reduced available income and consequently less consumption, due to the substitution effect we may finally prefer leisure than additional working time.

Finally, it is the relative strength of the each one of the aforementioned efforts (that are pulling in opposite direction) that will allocate the closing impact of the tax.

The Laffer curve

The above is illustrated by the Laffer [1] curve (figure T1), which shows the relationship between tax income and tax rate.

Figure T1 (The Laffer curve)

There is an optimum tax rate that leads to the maximization of tax revenues

Laffer suggested that as the tax rate increases (zone 0 - 40 [2] ), the tax income also increases (from 0 to X), but up to a maximum point (A) that represents the optimum tax rate where the maximum amount of tax income could be collected. After said point, should continue the tax rate to increase (zone 40 –100), the tax revenue will start to decrease (from maximum X to 0).

In other words, emerge of the substitution effect - individuals will start to substitute leisure time for additional income since they will be unwilling to work harder than before. Said lack of incentives would lead to a fall in income and therefore a fall in tax income. The end – point is undoubtedly a tax rate of 100 % where no one would be willing to work and so tax income would become zero.

Author: Manolis Anastopoulos. Assignment (part) in Public Finance, University of Leicester.

[1] Dr. Arthur Laffer was an advisor to President Reagan of USA in the early 1980s but despite that, he become quite well known through his ‘curve’ Time magazine included him among ‘The Century’s Greatest Minds’ (Greater Talent Network Inc, 1999-2002)

[2] A 40 % is a randomly price of the tax rate

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