The Optimal Income Tax Rate in Spain: A Nonlinear Approach using Laffer Curve and Economic Crises Dummies

Abstract

This study explores the nonlinear relationship between income tax rates and fiscal revenues in Spain through the lens of the Laffer Curve, which proposes that beyond a certain threshold, higher taxation can reduce government income by discouraging economic activity. The primary aim is to identify the tax rate that maximizes fiscal revenues and to analyze how major economic crises, the 2008 Global Financial Crisis, the 2012–2013 European recession, and the COVID-19 pandemic, have shaped this relationship. Using annual data from 1995 to 2022 obtained from the Spanish Tax Agency, the World Bank, and the National Statistics Institute, we calculate the effective tax rate as the ratio of total tax revenues to GDP. A cubic spline regression approach is applied, allowing for flexible estimation of the tax-revenue function across different rate intervals. The model incorporates GDP, inflation, and dummy variables for each crisis period to control for macroeconomic conditions and structural breaks. Results reveal a clear nonlinear pattern consistent with the Laffer hypothesis, with an optimal effective tax rate estimated at approximately 13%, slightly below the observed 13.94% in 2022. The inclusion of crisis indicators substantially increases model fit, indicating that fiscal stimulus and supportive policies during downturns can offset, or even reverse, negative revenue impacts. The controlled model explains over 95% of revenue variation, with GDP growth emerging as the dominant driver, while inflation shows no statistically significant effect. Findings suggest that Spain may currently operate above the revenue-maximizing threshold, implying that a moderate tax reduction could yield higher revenues, improve compliance, and reduce economic distortions. The study underscores the policy relevance of maintaining flexible, countercyclical tax frameworks that respond to changing economic conditions, thereby enhancing both fiscal sustainability and economic efficiency, particularly in economies exposed to recurrent macroeconomic shocks.