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May 1981

Tax Rates, Factor Employment, and Market Production

by Victor A. Canto, Douglas H. Joines, and Arthur B. Laffer

Victor Canto, Douglas Joines, and Arthur Laffer develop a simple, static, one-good, two-factor general equilibrium model in which taxes on factor incomes drive a wedge between gross factor payments and net factor incomes. The authors then derive the response of factor supplies, output, and tax revenue to changes in tax rates. They demonstrate that the framework is consistent with the existence of the so-called “Laffer curve,” according to which increases in tax rates initially increase government revenue up to some revenue maximizing tax rate but decrease tax revenue beyond this point. The authors note that the theoretical analysis only suggests the possibility that tax rate reductions may raise tax revenue. Empirical evidence is required to demonstrate whether tax rates are in the prohibitive range of the Laffer curve. In the second half of their paper, the authors therefore employ a time-series analysis of tax revenues to estimate the effects of the Kennedy tax cuts in 1962 and 1964 on tax revenues. They conclude that the cumulative revenue change induced by the tax cuts is approximately zero, with an equal chance that the tax cuts increased revenue as that they reduced it.