Sweden's Laffer Curve: Taxation and the Unobserved Economy

Abstract

Recent research on the unobserved economy suggests that the phenomenon has important implications for both macroeconomic policy and public finance. Attention is focused on the public finance implications by developing a simple macromodel from which it is possible to derive a Laffer curve. The model reveals that the shape and position of the Laffer curve depend upon the strength of supply-side effects, the progressivity of the tax system and the size of the unobserved economy. Using alternative parameterizations of each of these effects, it is possible to obtain rough empirical estimates of the Laffer curve for Sweden. I. Introduction Supply-side economics, the Laffer curve and the unobserved economy are subjects which have captured the interest of economists in their effort to understand and design cures for the growing macroeconomic and public finance malaise which appears to be affecting many of the world's most developed economies. High rates of unemployment and inflation, combined with slower rates of real growth and ever widening government deficits, have focused economists' attention on the interrelated issues of macroeconomic stabilization and public finance policy. The questions raised by the supply side, Laffer curve and unobserved economy literature focus on the effects of tax rates on economic performance and the ability of governments to sustain the ambitious social welfare programs established in the past decade. While there is much controversy about what the Laffer curve looks like and where various economies are on their curves, it is generally accepted that the dependence of tax revenues on tax rates is too oversimplified in