Answer to Question #102330 in Macroeconomics for Jorge Ferreira

Question

Whats the macroeconomic logic for the existence of a Laffer curve for seignorage and the limits it imposes on monetary and fiscal policy?

Answer 1

The Laffer Curve is a graphical and robust display of the relationship between tax revenue and tax rates. The concept of the curve implies the existence of an optimal level of taxation at which tax revenues reach a maximum, the curve shows the relationship between state budget revenues and the dynamics of tax rates. The points of tangency of the Laffer curve show that if, for example, the level of taxation is zero, then the state loses revenue. If it intends to take away all the revenues, then the economic process stops and the state budget remains without revenues.

Attempts to raise the tax rate will lead to a decrease in state revenues. Raising tax rates to a certain level leads to an increase in budget revenues. Such a positive impact is possible only to a certain limit, and behind it begins the so-called “restricted area” of the taxation scale. Taxes levied on the basis of high rates lead to a significant reduction in budget revenues. This is because high taxes suppress private initiative and undermine the desire for new investments.

A. Laffer concluded that tax rates have reached a level that holds back the pace of economic development and suggests lowering tax rates, and especially for profits.

But, increasing taxes does not always help in the fight against the budget deficit. In order to cover the budget deficit, the state can borrow from the population or in the world market. The use of this method is also limited, since an increase in the share of debt in GDP can lead to a loss of state solvency and default. The state may sell part of its assets.Naturally, the possibilities of financing public spending through privatization revenues are not unlimited, moreover, privatization means a decrease in state assets. Thus, if all of the above methods of financing the state budget deficit are exhausted, the state can simply print the money. How wide are the possibilities of covering the budget deficit with the help of income received by the state from money issue? It is clear that real income is needed for such coverage. The income received by the state from monetary emission is called seigniorage. By issuing an emission, the state increases the supply of money, which leads to inflation.

Rising prices reduces the purchasing power of money. As a result of the depreciation of money, consumers suffer losses, called inflationary taxes. Note that, according to the quantitative theory of money, in a state of long-term equilibrium in the absence of economic growth, the inflation rate is equal to the growth rate of the money supply, which means that the inflation tax is equal to the seigniorage. It is logical to assume that the ideas in accordance with which the Laffer curve was proposed are also true for real state revenues from emissions. The magnitude of seigniorage, like tax revenues, does not increase indefinitely with the growth of monetary emissions.There is a rate of inflation at which budget revenues from emissions reach a maximum. Increasing inflation above this “optimal” rate leads to a significant reduction in the tax base and a decrease in seigniorage. Naturally, from the point of view of public finances, the inflation rate, which allows to achieve the maximum of real income from emissions, is optimal.