Reduce Tax Rates To Increase Collection

The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate.

Direct taxes are an important source of revenue for any nation. Every government faces the dilemma of increasing tax collection and at the same time not upsetting the electorate. Many a  government has been known to desist from imposing taxes, revenues from which the country is in dire need of, lest they lose the taxpayers’ votes.

This is, of course, based on an incorrect premise that to increase tax collection, tax rates must also increase. However the reverse is true.

The theory, enunciated by Ibn Khaldun, a 14th century Muslim philosopher,  and many years later by the 20th century British economist John Maynard Keynes, and which was illustrated in December 1974 by Arthur Laffer on a paper napkin while having dinner at a restaurant, (now famously called the Laffer Curve) states that  tax revenues would be zero if tax rates were either 0% or 100%, and somewhere in between 0% and 100% is a tax rate which maximizes total revenue. The Laffer curve illustrates the concept that taxable income will change in response to changes in the rate of taxation. It postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100% and that there must be at least one rate where tax revenue would be a non-zero maximum.

The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. However, the actual existence and shape of the curve is uncertain and disputed. One potential result of the Laffer curve is that increasing tax rates beyond a certain point will be counter-productive for raising further tax revenue

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Laffer’s curve:
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The curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100% then all people would choose not to work because everything they earned would go to the government.

At a 0% tax rate, the model assumes that no tax revenue is raised. At the extreme of a 100% tax rate, the government theoretically collects zero revenue because taxpayers change their behavior in response to the tax rate: either they have no incentive to work or they find a way to avoid paying taxes.

Conversely as tax rates come down, initially tax collection decreases. But as rates are further decreased tax collections actually start rising since there is less incentive to evade and the consequences of not paying appear more severe than the pain of paying.

The committee on Direct Tax Reforms appointed in 1991 and headed by Dr Raja Chelliah in its report had strongly recommended sending a clear signal to the population of India that we are entering a low tax regime and that the tax rates will be successively reduced from the existing 60% (in certain cases) to 30%.

Dr Manmohan Singh, in his budget for 1992-93, accepted Dr Chelliah’s recommendations in toto, and started the tax reduction process, which, with a few hiccups, gradually did bring the rates down to the current 30%.

Contrary to doomsayers, the tax collection in the country has actually risen, year after year.

I think it is time to now take this to the next level. Encouraged by its experience the government should announce a new round of slashing of tax rates and a simultaneous withdrawal of exemptions to bring down the highest rate to maybe 15% over the next 3 to 5 years.

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