Amid rising public debt, persistent inflation, and expanding public expenditure, many governments are turning once again to tax reforms to strengthen their fiscal positions while maintaining fairness and efficiency.
But designing effective tax reforms is no simple task. Policymakers must find ways to raise sufficient revenue without undermining work incentives, distorting investment, or worsening inequality. In this context, a familiar concept in public finance — the Laffer curve — offers insights into the limits and possibilities of tax policy.
The Laffer curve: A simple but powerful tool
The Laffer curve depicts the relationship between tax rates and total government revenue, see Figure 1. At a 0% tax rate, the government collects no revenue. At a 100% tax rate, taxpayers have no incentive to earn taxable income, so revenue again falls to zero. Between these two extremes lies a revenue-maximising rate — the peak of the curve — beyond which further increases in rates reduce, rather than increase, total revenue.
Although it does not prescribe “optimal” tax rates, the Laffer curve provides an upper bound on the revenue-raising capacity of the tax system. It highlights the trade-off between raising revenue and maintaining incentives — a trade-off at the heart of every tax reform debate.
For policymakers, the curve serves as a reminder that higher statutory rates do not automatically translate into higher receipts. Beyond a certain point, behavioural responses — such as reduced labour supply, changes in savings, or increased avoidance — can erode the tax base.
Figure 1: Laffer curve
Notes: Authors’ elaboration based on simulated data. ME refers to mechanical effects, and BE refers to behavioural effects.
Extending the Laffer curve to real-world tax systems
While the traditional Laffer curve assumes a single, flat tax rate, modern tax systems are much more complex. They feature stepwise rate schedules, exemptions, offsets, and deductions. Governments often implement highly nonlinear reforms, affecting different groups in different ways.
To address these realities, our recent study extends the Laffer curve framework in four key directions:
- Stepwise rate schedules: Real-world systems apply progressive statutory rates, not a single flat rate. The behaviour of the curve under these stepwise structures is less straightforward but essential for realistic policy evaluation.
- Nonlinear reforms: Governments frequently consider reforms that alter the tax schedule in both progressive and regressive ways. A generalised framework is needed to capture such reforms.
- Taxpayer heterogeneity: Individuals differ in income, circumstances, and responsiveness to tax changes. As a result, some taxpayers may lie on the “wrong” side of the Laffer curve, while others remain on the “right” side.
- Average versus marginal tax rates: Distinguishing between these rates clarifies the difference between tax burdens and tax payments — a crucial distinction for understanding distributional outcomes.
When taxpayers fall on the “wrong” side of the curve
Our extended framework introduces the concept of an individual Laffer curve, which helps clarify how different taxpayers experience reforms. A taxpayer lies on the “wrong” side of their curve if an increase in the tax rate raises their tax burden but decreases their actual tax payment because they adjust their taxable income downward. In this case, the taxpayer is on the wrong side because the negative behavioural effect is stronger than the positive mechanical effect, thus reducing their actual tax payment.
Conversely, reducing tax rates can sometimes increase both taxable income and total tax payments. In this case, the positive behavioural effect is stronger than the negative mechanical effect, thus the taxpayer is on the right side of their individual Laffer curve.
This can happen even when behavioural elasticities are modest. The mechanical effect of raising tax rates — higher revenue from a given level of income — can be outweighed by behavioural responses that reduce taxable income, offsetting the expected gains.
The key insight is that Laffer positioning is reform- and taxpayer-specific. Different individuals, with different incomes and incentives, may respond in opposite ways to the same policy change. This heterogeneity explains why aggregate analyses often mask important distributional and behavioural dynamics.
Australia’s Stage 3 tax cuts
These nuances matter for evaluating real reforms. Using the ATO Longitudinal Information Files (ALife), we provide evidence that the 2024 Australian Stage 3 tax cuts exhibited precisely this dynamic. While it lowered statutory rates and appeared to reduce burdens for many taxpayers, it also increased tax payments from them — albeit to a lesser degree than in its original design introduced by the previous Coalition government.
For example, consider a taxpayer earning $50,000. Their pre-reform marginal tax rate is 32.5%. Under the original Stage 3 reform, this would have fallen to 30% above $45,000, while the revised reform lowers it to 16% above $18,201 and 30% above $45,000.
Even with these rate cuts, behavioural responses matter: under standard elasticity assumptions, the mechanical tax reduction is about $125 under the original reform and $929 under the revised reform, but the taxpayer’s behavioural response increases tax by $313 and $315, respectively. This produces a total effect of +$188 under the original reform, placing the taxpayer on the wrong side of their individual Laffer curve, whereas under the revised reform, total payments fall by $614, placing them on the right side.
In particular, we find that:
- Under the original reform, about 15% of taxpayers would have been on the wrong side of the Laffer Curve.
- The revised reform, which redirected benefits toward lower-income brackets, reduced this share to 5%.
Overall, our calculations indicate that the original reform would have resulted in smaller revenue losses than the revised version.
Implications for measuring tax progressivity
Understanding where taxpayers sit on their individual Laffer curves has important implications for how we measure tax progressivity and reform burdens.
Most policy discussions assess who gains or loses from a reform by comparing changes in tax payments across income groups. Yet changes in payments alone can be misleading, especially for reforms that modify marginal tax rates unevenly across the distribution.
A reform can, for instance, lower statutory tax rates while still collecting more revenue from certain taxpayers, if those individuals increase their labour effort or report more taxable income. Conversely, a reform that appears to raise progressivity may fail to raise expected revenue if behavioural responses are strong.
Standard progressivity measures, such as the Kakwani index, rely on observed taxable incomes and tax payments. These measures typically understate behavioural effects, since they do not account for how taxpayers adjust their behaviour in response to rate changes.
To address this, we adjust the Kakwani index to account for the endogeneity of taxable income, providing a clearer picture of who ultimately bears the reform’s burden. In our analysis, we use post-reform income and the total economic cost of the reform (pre-reform tax payments plus the change in tax burdens). We then compare the standard Kakwani index—based on pre-reform income and post-reform tax payments—with our adjusted index to measure the effective progressivity of the 2024 Australian Stage 3 tax cuts.
Our findings show that:
- Both the standard and adjusted Kakwani indices indicate that the original reform was regressive, while the revised reform was progressive.
- However, the adjusted Kakwani index reveals stronger effects: the original reform was more regressive than standard measures suggest, and the revised reform was more progressive than it initially appears.
Moving beyond static analysis
The broader message is clear: tax policy outcomes depend not only on statutory parameters but also on taxpayer behaviour. Static revenue estimates — which assume incomes remain fixed when tax rates change — can overstate both the revenue gains and the progressivity of reforms.
Incorporating behavioural responses into both revenue and distributional analysis allows policymakers to design systems that raise funds more efficiently while avoiding unintended disincentives. The generalised Laffer framework provides a practical way to do so, linking simple, intuitive concepts with economic reasoning.
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