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Paper Review: Tax Rate Cuts and Tax Compliance—The Laffer Curve Revisited September 1, 2009

Posted by maskokilima in Sekolah, Tax.

As a tax auditor in a country which is generally assumed to have high tax rates, I was curious to read Tax Rate Cuts and Tax Compliance—The Laffer Curve Revisited , a working paper by Tamás K. Papp and Előd Takáts, two of the IMF researchers. Can tax rate cuts cause an increase in tax revenues? Papp and Takáts answer this question by using a theoretical model.
Papp and Takáts are motivated by the Russian experience and build a theoretical model to explain how tax rate cuts can increase tax revenues. Russia introduced a new flat tax rate and effective PIT rate cuts but gained substantial increase in their tax revenues almost immediately. To explain the theory behind the success story in Russia, the authors build a general equilibrium model. From the model, the authors conclude that a reduction in effective tax rates leads to a fall in tax evaders. The same result also occurs when the tax authority’s time endowment is increased.
Papp and Takáts also illustrate tax revenue as a function of the official tax rate chart based on their model. This chart shows a Laffer curve where a tax rate increase increases tax revenues until the tax rate reaches 12%. They believe that the Laffer effect comes from increased compliance and not from labor supply responses, because in this chart, there is a dramatic fall in the percentage of honest taxpayer when the tax rate exceeds 12%. This is consistent with what happened in Russia.
One of the benefits is that Tax Rate Cuts and Tax Compliance—The Laffer Curve Revisited explains the connection between the changes in tax rate, tax compliances and tax revenues easily. Although there are many mathematical equations, readers who do not have any mathematic or economic background can understand it without so many difficulties. Papp and Takáts give a logical and adequate explanation for all of mathematical operations in their paper.
It is convincing and very useful for tax policy makers to “identify the theoretical conditions under which tax rate cuts can increase compliance sufficiently to increase tax revenues”. Indonesia (which has similar problems to Russia such as: it was suffered from 1998 financial crisis; was very dependent on IMF, but then refused to extend the cooperation; has a high tax rate and other similar problems) can use this model to increase their tax revenues by cutting tax rate. Moreover, Indonesia which is considered has a weak level of tax authority strength and high official tax rate may take benefit from tax rate cuts policy.
However, Papp and Takáts are too rashly in concluding that the Laffer effect occurs because of the tax compliance only and not because of labor supply responses. They are stuck in the effort to provide an explanation why tax revenues increase when tax rate cuts from the tax compliance side, because of the lack of literature. They seem to forget the fact that tax compliance is also the result of the labor supply decision. Tax evaders who realize that the cost incurred to avoid the tax is equal to or greater than the amount of tax that they could avoid will be motivated to become honest taxpayers. Taxpayer who decide to evade tax end up will paying more than their actual tax because there is potential penalties (in terms of fine or prison sentences) if they are caught.
Overall, Tax Rate Cuts and Tax Compliance—The Laffer Curve Revisited is recommended for people who are interested in fiscal policies and macro economics. It is useful to understand the impact of a government decision and which decision should they choose theoretically.

Papp, Tamás K., & Takáts, Előd. 2008, Rate Cuts and Tax Compliance—The Laffer Curve Revisited, IMF Working Paper, International Monetary Fund, Washington, DC., retrieved 23 June 2009, .


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