LAFFER TAXATION RATE : ESTIMATIONS FOR RO MANIAS CASE [609265]

LAFFER TAXATION RATE : ESTIMATIONS FOR RO MANIA’S CASE
Elena PĂDUREAN
Centre of Financial and Mone tary Research Victor Slăvescu
Romanian Academy
Bucharest, Romania
[anonimizat]

Andreea STOIAN
Bucharest Academy of Economic Studies
Bucharest, R omania
[anonimizat]

Emilia CÂMPEANU
Bucharest Academy of Economic Studies
Bucharest, Romania
[anonimizat]

Abstract
The relationship between taxation rate and tax revenues for the public budget has generated an
important debate aiming that level of taxation rate that maximizes tax revenues collected for the public
budget. Laffer curve involves the existence of a strong correlation between taxation rate and tax
revenues. The aim of this paper is to estimate a Laffer taxation rate for Romania’s case using annual
data over the period 1990 -2008. The main findings highlight that a taxation rate higher than 28%
could diminish tax revenue for the public budget, in addition, taxation rates were situated slightly on
the prohibitive area o f Laffer curve.

Keywords : Laffer curve, taxation rate, tax evasion, implicit taxation rate
JEL classification : E62

1. INTRODUCTION

Taxes could be considered as „something evil‟ by the contributors, „but necessary‟ by
governments, taking into account t hat they represent the most important financing source of
public budget. Generally, contributors are paying those taxes, but when they exceed a pa r-
ticular amount, they could become a burden and could generate some undesired effects that
could negatively af fect the budget, too. An increase or a decrease of the excess burden i n-
duced by taxes could be related to the economic and social role played by state within an
economy, and to its aim for financing government expenditures. The controversial debates
on exc essive state interference within economy went to a new approach, underlined by
american economist, Arthur Laffer. Considering the representative contributor, Laffer pr o-
posed some guidelines for elaborating a „good‟ taxation policy that would have not harm

184 Elena PĂDUREAN , Andreea STOI AN, Emilia CÂMPEANU
people welfare. Taxation rates have a great influence on contributors‟ decisions related to
income allocation between consumption and savings. According to Laffer‟s theory, high
taxation rate changes contributor‟s behavior in terms of favoring leisure and lowering
productivity, and increasing consumption and decreasing savings.
According to supply -side theory, a progressive income tax will not reward the contri b-
utors‟ willingness to work, but it will generate an increase of the labor cost compared to the
leisure cost (in terms of net income that will not be earned anymore due to high taxes).
Higher taxation rates for income diminish the work supply, and, consequently, the gover n-
ment tax revenue will be much lower. Much more, contributors use to allocate thei r income
between consumption and savings. Income tax increases the cost of future consumption
compared to the current consumption. The effects are an increase of current consumption
and a decrease of savings and investments. Higher taxation rates will not encourage contri b-
utors to save or to invest as long as net income is diminished. Consequently, the
contributors‟ need to assure a proper income before increasing taxation goes to forms of tax
evasion and „black economy‟ is increasing. The effects for the o fficial economy are, as fo l-
lows: reduced number of contributors; reduced tax based; inefficiency of macroeconomic
policies.
The aim of this paper is to estimate the highest taxation rate based on Laffer‟s theory
that could prevent taxation to reach to the prohibitive area. The structure of this paper is as it
follows. In next Section, it will be made a short description of Laffer‟s theory. Se ction 3 will
consist of the methodology used to estimate the Laffer taxation rate for Romania‟s case. The
last sectio n will be dedicated to the main co ncluding remarks of this study.

2. THEORETICAL BACKGROUND OF LAFFER’S THEORY AND
LITERATURE REVIEW

The relationship between taxation rate and tax revenues for the public budget has ge n-
erated an important debate aiming t hat level of taxation rate that maximizes tax revenues
collected for the public budget. Laffer curve is the result of the idea expressed by Laffer at
the early 1980s that involves the existence of a strong correlation between taxation rate and
tax revenues . The interval of variation lies between 0% and 100%; at that point, government
collects no tax revenues due to the refuse of the taxpayers to work or avoid taxes. In this U
curve, it can be identified two areas delimited by the taxation rate that maximize s tax rev e-
nues as presented in the figure below.

Source : own represe ntation
Figure no. 1 Laffer Curve A
E
0
tR

0tR

0
tR

Prohibitive area
0
1t
*t
2t 100% taxation

r
a
t
e

(
t
)
Tax revenues
(R)

*
rR

1rR

B

Laffer Taxation Rate: Estimations for Romania‟s Case 185
The taxation rate that maximizes the tax revenues varies form country to country, e s-
pecially due to the taxpayers‟ reactions to different le vel of taxation. This taxation rate is
important to all the governments, taking into consideration the need for more and more re v-
enues to finance increasing budgetary expenditure.
The initial Laffer curve involves only a taxation rate that maximizes tax re venues. But,
there are authors that highlight the lack of a continuous curve or a maximum tax revenues
for a particular taxation rate [Fullerton, 1982 ; Malcolmson, 1986 ] or the existence of many
taxation rates that maximize tax revenues [Novales and Ruiz, 2002 ] . The different forms of
Laffer curve could be the result of the governments‟ reaction in order to sustain economic
growth according to Mitchell (2002) who defined a so called “Growth Laffer Curve” (GLC).
GLC is the results of the negative correlati on between taxation rate and economic growth
because higher taxes might: (i) assure more financial resources for public investment that
may sustain economic growth; and (ii) affect the private capital accumulation and economic
growth.
The optimal taxation rate according to Laffer curve is difficult to be estimated for a
group of countries. For instance, this taxation rate varies between 35% [ Hsing, 1996 ], and
60% [ Trabandt and Uhlig, 2006 ] .
The taxation rate should be established in order to avoid tax evas ion and the „black
economy‟. Feige, Edgar, and McGee (1983) showed that recent research on „black econ o-
my‟ suggests that the phenomenon has important implications for both macroeconomic
policy and public finance. The authors focused on the public finance i mplications by deve l-
oping a simple macro -model that makes it possible to derive a Laffer curve. This model
reveals that the shape and position of the Laffer curve for Sweden depend upon the strength
of supply -side effects, the progressivity of the tax syst em and the size of the unobserved
economy. They also simulated the UK Laffer curve (1983).
The dynamic Laffer curve was studied by Ireland (1994), (1995), Agell and Persson
(2000), and Novales and Ruiz (2002). Ireland (1994) considered a single tax on out put, and
found a non -trivial range of feasible tax cuts. Agell and Persson (2000) analyzed the
government budget balance within a simple model of endogenous growth by performing an
empirical study of the transfer -adjusted taxation rates of the OECD countri es to see which
country has the highest potential for fiscal improvements. Novales and Ruiz (2002) analyzed
the possible welfare gains from substituting debt for taxes in deficit management.
Laffer curve had been studied in correlation with the situation o f the delay retirement
by Hairault, Langot, and Sopraseuth (2004). The authors investigated the situation that the
taxation on continued work should be removed by implementing actuarially fair schemes
and they proposed to give individuals only a fraction o f the marginal actuarially fair
incentives in the case of postponed retirement. This will make a tradeoff between giving
enough incentives to make individuals actually delay retirement and giving little increase in
pensions in order to help finance its exp ected deficit that can be captured by a Laffer curve
using the French data.
Laffer curve quantitatively was examined using a simple neoclassical growth model by
by Trabandt and Uhlig (2006, 2010) for the US, EU -14 and individual European countries
based on data during 1995 -2007. They showed that the relationship between taxation rates
and tax revenues depends on the type of the taxation system (for instance, in a country it are
used more taxes on capital, labor or consumption with a flat tax or a progressiv e taxation).
Also, they revealed that US and the EU -14 area are located on the left side of their labor and
capital tax Laffer curves, but the Denmark and Sweden are on the wrong side of the Laffer

186 Elena PĂDUREAN , Andreea STOI AN, Emilia CÂMPEANU
curve for capital income taxation. EU -14 economy is much c loser to the slippery slopes than
the US. The slope of the Laffer curve in the EU -14 economy was much flatter than in the
US which documents a much higher degree of distortions in the EU -14 area. Also, the a u-
thors highlighted that the US can increase tax r evenues by 30% by raising labor taxes and
6% by raising capital income taxes, and for the EU -14 they find 8% and 1%.

3. ESTIMATING LAFFER TAXATION RATE: EMPIRICAL EVIDENCES
FOR ROMANIA’S CASE

For Romania‟s case there are only few studies that considered the taxation issues based
on Laffer‟s theory. In that sense, the studies conducted by Pădurean and Cataramă (2004)
and Pădurean (2006) over the period 1990 -2002 showed that a simple projection of overall
taxation rate and government revenues has not revealed a Laffer, but it could be observed a
trend that indicates a positive relationship s ituated on the „accepted zone‟ of the Laffer
curve. Also, the study highlighted the short periods when taxation rate situated on the „pr o-
hibitive area‟. For instance, for the years 1992, 2001, and 2002 empirical evidence indicated
a negative relationship b etween tax revenues and overall taxation rate, while for the year
1997, the correlation was negative.
Moșteanu and Stoian (2005) proposed an alternative app roach for Laffer taxation rate
consider ing that the median could be a relevant proxy for that taxation rate, taking into a c-
count that the original Laffer‟s work, based on an graphical illustration, splits the taxation
area on two even sub areas: a „non -prohibitive‟ one and a „prohibitive one‟. The a u-
thors‟ estimation for Laffer overall taxation rate indicated a value around 28% of GDP.
Stoian (2008) estimated a Laffer taxation rate on annual data over the p eriod 1990 –
2009 and reached to the conclusion that a taxation rate higher than 31% will place taxation
on the „prohibitive‟ area of Laffer curve. For an overall taxation rate of 31% of GDP it was
recorder the largest amount of tax revenue for the public bu dget. One shortcoming of that
study is represented by data used for estimation. Some of the data were projections and did
not capture the situation after the financial crisis. In addition, Stoian (2009) found that over
the period 1990 -2006 taxation rates w ere situated on „non -prohibitive area‟ of Laffer curve.
The aim of this paper is to estimate Laffer taxation rate for Romania‟s case using a n-
nual data over 1990 -2009 for tax revenues as ratio to GDP, considered as proxy for overall
taxation rate, and for t ax revenues at constant price (1990=100).

Table no. 1 Laffer taxation rate
Year Overall taxation rate (%) Tax revenues at constant price (mil.RON)
1990 33.8 29.0
1991 32.4 26.4
1992 33.5 24.1
1993 31.3 21.0
1994 28.2 19.9
1995 28.8 22.2
1996 26.9 22.5
1997 26.5 20.3
1998 27.8 19.8
1999 30.1 21.4
2000 29.2 21.0

Laffer Taxation Rate: Estimations for Romania‟s Case 187
Year Overall taxation rate (%) Tax revenues at constant price (mil.RON)
2001 28.0 21.7
2002 27.6 22.7
2003 27.0 25.1
2004 27.1 28.0
2005 31.0 30.2
2006 22.7 23.1
2007 28.7 40.1
2008 28.3 46.5
2009 27.5 42.9
Legend:
Overall taxation rate : was estimated as ratio of tax revenues (social contributions included) to GDP and is a
proxy for the taxation rates according to Laffer‟s theory.
Tax revenues at constant price: was estimate d based on tax revenue (social contributions included) and Co n-
sumer Price Index at constant price 1990=100.
Source: Data were available from Ministry of Finance (tax revenues), National Institute of Statistics (for
GDP and CPI).

The Laffer taxation rate f or Romani‟s case lies around 28% of GDP that generates the
largest tax revenue for public budget. It is to some interest to see if taxation rates over the
period considered were situated on „non -prohibitive‟ area of Laffer‟s curve. Based on the
previous re sults, it was graphically illustrated for the case of Romania (see figure b elow):

Source : own representation.
Figure no. 2 Laffer Curve for Romania’s case, 1990 -2009

Compared to the results obtained by Stoian (2009) for the period 1990 -2006, addin g
the last three years moved taxation slightly to the „prohibitive‟ area of Laffer curve. That
means that the much higher taxation goes, tax revenues for the public budget are decreasing.
In addition, using the same methodology applied for a smaller sampl e over the period 2000 –
2008, it was estimated the Laffer taxation rate for consumption. The results are presented
below:

188 Elena PĂDUREAN , Andreea STOI AN, Emilia CÂMPEANU
Table no. 2 Comparing the results
Anul Implicit tax rate on consumption (%) Value Added Tax at constant price (mil.RON)
2000 17 4,5
2001 15.6 4,9
2002 16.2 5,7
2003 17.7 6,4
2004 16.4 7,0
2005 17.9 8,7
2006 17.8 10,1
2007 18 10,8
2008 17.7 13,3
Legend:
Implicit taxation rate on consumption (%) : proxy for the taxation rate on consumption as average.
Value Added Tax at consta nt price: was estimated based on VAT revenue and Consumer Price Index at co n-
stant price 1990=100.
Source: Data were available from Ministry of Finance (VAT revenues), European Commission (implicit
taxation rate of consumption).

Laffer taxation rate on con sumption lies around 17%, and is situated on the „non –
prohibitive‟ area on Laffers curve, as shows the figure below:

Source : own representation.
Figure no. 3 Laffer taxation rate on consumption

4. CONCLUDING REMARKS

Laffer‟s theory about the taxa tion rate could represent o benchmark in establishing that
particular taxation rate that maximizes the tax revenue for the public budget and avoids tax
evasion. The Laffer taxation rate for Romania‟s case estimated for annual data over the p e-
riod 1990 -2009 lies around 28%, while taxation situates slightly on the „prohibitive‟ area of
Laffer‟s curve. That finding implies that higher taxation rate than the Laffer one could d i-
minish the tax revenue.

Laffer Taxation Rate: Estimations for Romania‟s Case 189
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