WP Global Economy 2018.11.28
Recent studies on Laffer curves (tax revenue curves) find that the Laffer curve for consumption tax might not be hump-shaped, but monotonically increasing, whereas the Laffer curve for labor income tax is hump-shaped. This study investigates the cause of this difference in the shapes of two Laffer curves, by decomposing the effects of an increase in a tax rate on the tax base as a product of two parts: (i) the effects on the relative price of leisure (RPL), and (ii) the substitution and income effects. It is shown that the first effect with respect to the consumption tax rate is completely different from that with respect to the labor income tax rate, while the second effect is common among the taxes and depends on the functional form of the utility. The elasticity of the RPL from an increasing consumption tax rate is at most 1, whereas it can be infinity as the tax rate increases in the case of labor income tax.