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Big versus Small Government
What is a "sensible" rate of income tax?
In the 1970s a Professor Laffer was studying the effects of tax levels on tax revenues. His findings indicated that tax revenues may be boosted after an increase in the rate of tax, when the "income effect" operates. This is where people's income is affected by the tax rise and their response is to work more hours.
Laffer also suggested, though, that the opposite dynamic could operate, whereby tax revenues fall after a tax hike. This would be due to the 'substitution effect'; with higher income tax cutting the price of leisure, in terms of the lost after-tax income that results.
Decreasing tax revenues would happen here because the substitution effect is stronger than the income effect.
An Optimal Tax Rate? The Laffer Curve
