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What is the 'Laffer Curve'

The Laffer Curve is a theory developed by supply-side economist Arthur Laffer to show the relationship between tax rates and the amount of tax revenue collected by governments. The curve is used to illustrate Laffer’s main premise that the more an activity — such as production — is taxed, the less of it is generated. Likewise, the less an activity is taxed, the more of it is generated.

BREAKING DOWN 'Laffer Curve'

The Laffer Curve suggests that, as taxes increase from low levels, tax revenue collected by the government also increases. It also shows that tax rates increasing after a certain point (T* on the diagram below) would cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates reached 100 percent, shown as the far right on his curve, all people would choose not to work because everything they earned would go to the government. Governments would like to be at point T* because it is the point at which the government collects maximum amount of tax revenue while people continue to work hard.

 

Laffer Curve

The Laffer Curve Explained

The first presentation of the Laffer Curve was performed on a paper napkin back in 1974 when its author was speaking with senior staff members of President Gerald Ford’s administration about the state of economic malaise that had engulfed the country. At the time, most economists were espousing a Keynesian approach to solving the problem, which advocated more government spending to stimulate demand for products. Laffer countered that the problem isn’t too little demand. Rather, it was the burden of heavy taxes and regulations that created impediments to production, which impacts government revenue.

Laffer argues that the more money was taken from a business in the form of taxes, the less money it has to invest in the business. A business is more likely to find ways to protect its capital from taxation or to relocate all or a part of its operations overseas. Investors are less likely to risk their capital if a larger percentage of their profits are taken. When workers see an increasing portion of their paychecks taken due to increased efforts on their part, they will lose the incentive to work harder. For every type of tax, there is a threshold rate above which the incentive to produce more diminishes, thereby reducing the amount of revenue the government receives.

The theory later became a cornerstone of President Ronald Reagan’s economic policy, which resulted in one of the biggest tax cuts in history. During his time in office, tax revenues received by the government increased from $517 billion in 1980 to $909 billion in 1988.

Is the Laffer Curve Too Simple a Theory?

There are some fundamental problems with the Laffer Curve — notably that it is far too simplistic in its assumptions. While the curve assumes that societies function on a single tax rate and a single supply of labor, that can’t be further from the truth. In reality, public finance structures are much more complex. The curve does not take into account how revenue is affected by multivalued tax rates. Simply, the fact that any increase in the tax rate to a certain percentage may not necessarily equate to the same revenue as a decrease in the tax rate. The curve also does not take into account any avoidance of taxes at any level. 

There is also the assumption that an increase in revenue from tax cuts will likely lead to more jobs. That isn’t necessarily true in today’s environment. More companies are becoming technology-focused and are relying less on human labor. And that means that more and more businesses are likely using these tax reductions to buy computers rather than go on a hiring spree. We also didn’t see that following the 2007-2008 financial crisis. Many of the companies that benefited from government bailouts following the crisis did not use them to create jobs; they saved the money to increase their dividends or make capital investments. 

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