Laffer curve suggests that increasing the tax rate beyond a threshold, does not fructify the thirst to mobilize higher revenues.
What’s a Laffer curve?
Laffer curve portrays tax revenue in relation to tax rates. Visualize a miniature crack in greater heights of a reservoir filled until its brim. As the miniature crack develops, the reservoir breaks, ambushing its neighbourhood with a tsunami wave. The catastrophe would have been avoided had the reservoir been optimally filled & not till its brim (as the crack was at greater heights). Lets juxtapose the same with the constituents of Laffer curve. Raising the water level until the brim can be compared with the government’s lust for rising tax rates.The crack at greater heights is the compliance issues arising at higher tax rates. The catastrophe is akin to falling tax revenues. So lets fix it, rising tax rates beyond the optimal level reduces the tax revenue.
Laffer curve specifically deals with the branch of taxation which is direct. Higher tax rates shall ostensibly fetch high revenues, as compliance turns out to be a major question then. A stellar instance of it, is India. A meagre 8.45 crore annual returns were filed in FY (financial year) 2018-19 from the world’s second most populous nation. A former union minister & economist opined that its time for India to nullify direct taxes and shore up the revenue from indirect taxes standalone. Indirect taxes are inevitable in most instances but for “Duty-free” shops at airports, Special Economic Zones etc. With due respects to the federal system adopted in India, the question of sharing tax revenue has eternally been a bone of contention between the union and states. The problem got further accentuated post GST era, as states were bereft of tax levying powers except on crude & liquor. Commodities of necessity more often than not ain’t charged at extortionate rates, even if they are – their demand ought to stay put. Eventually, the coffers get filled. There’s an optimal income tax rate which garner’s the highest possible tax revenue for the government. The optimal oscillates between 10%-15% in the case of most countries. Let’s dream about Indian tax rates falling under this ballpark!
During times of economic slowdown, the treasury is pumped out till its base. Presume the government’s treasury akin a coffer, once its absolutely drained out, the base of it is being tampered in a phased-ceaseless manner. And as a mark of culmination, the coffer goes under the hammer!! The act of tampering the coffers base is nothing but fiscal deficit. To put it unembellished, your spends surpass revenue. The period for which you prolong your deficit and at what pace, decides when the coffer will fall under the hammer. The coffer is under the custody of GoI (Government of India) & the RBI (Reserve Bank of India) bears the onus of filling the coffer.
The “Fiscal Responsibility & Budget Management (FRBM) Act, 2003” brought in by the NDA (National Democratic Alliance – anchored by BJP), stimulates fiscal discipline by imposing caveats on fiscal deficit limits. Since promulgation of this act, the annual budgets presented in the country are bound its provision. The “Escape clause” of the FRBM act permits a breach of 0.5% of the fiscal deficit target in circumstances necessitating the same. The same was exercised by the current finance minster Ms.Nirmala in her second budget.
Any Sovereign nation, bears the onus to strike the right balance between direct & indirect taxation and fix the optimal rates, thereby maintaining fiscal discipline. Optimum tax rates seldom augur well from revenue mobilizing perspective, but shoulder economic prosperity & fiscal discipline over an elongated period.