Effect of the tax rate on output: an empirical approximation using the Laffer curve for Ecuador

Abstract

In recent years, tax revenue has increased significantly. The tax rate increased from 7.3% in 2007 to 18.00% in 2014. This research analyzes the relationship between production and the tax rate and social security during the period 1990-2015. We use the theoretical relationship proposed by Laffer (1974) to find the optimal tax rate where production reaches its peak before it begins to decline and become negative. First, we find that for the Ecuadorian economy, an aggregate tax rate of 20.7% allows production to peak. If the percentage of the tax rate is higher than this level, the GDP would tend to decrease progressively until it is negative. Second, we find that GDP has a strong short-term and long-term relationship with the tax rate and the percentage of people affiliated to general social insurance. A policy implication derived from this research is to direct towards tax policies until reaching the optimum level towards progressive taxes and towards the reduction of tax evasion. This would maximize production while reducing inequality.