Taxes, incentives and revenue
The Laffer curve, elasticity, tax incidence and disposable income: understand what changes when people and companies respond to rules.
The Laffer curve: does raising the rate always collect more?
Tax revenue depends on the rate and the base to which it applies. The Laffer curve represents how revenue may change when the rate also changes that base. Responses may include economic activity, income reporting, tax planning and evasion. These are not all the same thing.
The idea does not demonstrate that any tax cut will raise revenue. To support that conclusion, tax responses, the starting point, enforcement and the time horizon need to be estimated. An illustrative curve does not identify an optimal rate for Brazil. The rate that maximises revenue is also not necessarily the most desirable for society.
Try a hypothesis
Educational model. The parameters below have not been estimated for any country.
Revenue in hypothetical units, fixed scale from 0 to 100
- Tax base
- 70
- Tax revenue
- 21
How the calculation works: revenue = tax rate × base. In this example, base = 100 × (1 − tax rate)1. The two declining curves use exponents of 1 and 2, chosen to illustrate different curves. With no response, the base remains at 100.
The limitation: the decline in the base and zero revenue at 100% on the declining curves are assumptions of this model. The chart does not recommend tax rates, measure Brazil's tax burden or predict jobs. Maximising revenue is not the same as maximising well-being.
Elasticity: how much does the base respond?
Elasticity describes the size of a response to a change. Taxable income may change without an equivalent change in real production: a person may bring receipts forward or change how they report income. More reported revenue is therefore not automatic proof of greater productivity.
Review of evidence and estimation problems: NBER, Saez, Slemrod and Giertz. (opens in a new tab)
Incidence: does the person remitting the tax bear the cost?
The obligation to remit a tax and its economic cost are different questions. In a simplified competitive market, the division between buyers and sellers depends on how supply and demand respond to prices. In the real world, competition, contracts and the time horizon also need to be examined. Neither full pass-through nor no pass-through should be assumed.
Elasticity and tax incidence: OpenStax, Principles of Economics. (opens in a new tab)
Effective marginal tax rate: how much is left when you earn more?
Alongside tax, higher income may reduce benefits. The effective marginal tax rate considers how much of an additional gain is absorbed by taxes, contributions and benefit withdrawal. It is not the same as the average rate paid on all income.
Hypothetical example: earning R$ 100 more, paying an additional R$ 20 and losing R$ 30 in benefits leaves R$ 50 more available. Over that interval, 50% of the gain was absorbed. Transport and care may reduce the net gain from working, but they should be shown separately from this fiscal measure. The example does not represent a current Brazilian benefit.
Externalities: which costs are left out of the price?
A decision may affect people who do not directly participate in the transaction. Pollution is an example of an external cost. Education may generate benefits for other people. The question is how to recognise these effects and compare instruments without assuming that any public intervention is well designed.
Concept and instruments: IMF, Externalities: Prices Do Not Capture All Costs. (opens in a new tab)
How to use these concepts to evaluate a proposal
- Identify the tax or rule: rate, base, population and period.
- Separate the mechanical calculation from assumptions about behavioural change.
- Ask who remits the tax, who absorbs costs and who receives benefits.
- Compare revenue, well-being, freedom of choice and distribution. They are not synonyms.
- Examine opportunity cost: what will no longer be funded and which alternative was considered.
- Ask for evidence before treating growth or higher future revenue as guaranteed money.
This topic in the model
Financing a project also affects people, businesses and choices. Comparing proposals requires examining who pays, the incentives involved and what the evidence supports.