A general equilibrium analysis of the Laffer argument

Abstract

This paper examines the Laffer argument (i.e., the possibility that an increase in a tax rate may reduce tax revenues, and vice versa) in a general equilibrium model and using tax reform techniques. Our methodology allows us to examine the Laffer argument in a very general setting. Despite the high level of generality, we are able to reach some clear conclusions that happen to provide some support for the intuition that the Laffer effect requires: (1) a “ high” labour-income tax rate, and (2) a “ large” labour supply response to wage changes. However, the notions of “high” and “large” in our framework are quite different to the interpretations given them in conventional wisdom about the Laffer argument. The analysis also provides indirect support for the intuition that it is not optimal for a government to operate on the downward-sloping segment of the Laffer curve.