Laffer Curve: History and Critique

Laffer Curve

Investopedia / Michela Buttignol

What Is the Laffer Curve?

The Laffer Curve is based on a theory by supply-side economist Arthur Laffer. Created in 1974, it visually shows the relationship between tax rates and the amount of tax revenue collected by governments.

The curve is often used to illustrate the argument that cutting tax rates can result in increased total tax revenue.

Key Takeaways

  • American economist Arthur Laffer developed a bell-curve analysis in 1974 known as the Laffer Curve.
  • The Laffer Curve shows the relationship between tax rates and total tax revenue.
  • The Laffer Curve states that total tax revenue is most likely not maximize when tax rates are at 100%, as this disincentives workers from earning wages.
  • The Laffer Curve was used as a basis for tax cuts in the 1980s during the Reagan Administration.
  • Critics argue that the Laffer curve is too simplistic and uses a single tax rate.
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Laffer Curve

Understanding the Laffer Curve

American economist Arthur Laffer developed a bell-curve analysis that plotted the relationship between changes in the government tax rate and tax receipts, known as the Laffer Curve. It suggests that taxes could be too low or too high to produce maximum revenue and both a 0% income tax rate and a 100% income tax rate generate $0 in receipts.

Arthur Laffer argued that tax cuts have two effects on the federal budget, both arithmetic and economic.

Arithmetic

The arithmetic effect is immediate and every dollar in tax cuts translates directly to one less dollar in government revenue as well as decreases the stimulative effect of government spending by exactly one dollar.

Economic

The economic effect is longer-term and has a multiplier effect. As a tax cut increases income for taxpayers, they will spend it. The increase in demand creates more business activity, spurring an increase in production and employment.

Charting the Curve

Laffer Curve
Image by Julie Bang © Investopedia 2019 

Tax revenue reaches an optimum point, represented by T* on the graph.

To the left of T*, an increase in tax rate raises more revenue than is lost to offsetting worker and investor behavior. Increasing rates beyond T*, however, cause people not to work as much or not at all, thereby reducing total tax revenue.

If the current tax rate is to the right of T*, lowering the tax rate will stimulate economic growth by increasing incentives to work and invest and increasing government revenue.

Laffer Curve and the Tax Rate

The Laffer Curve follows certain logic, as tax revenue does not always increase whenever the tax rate increases. Of course, when the tax rate is 0%, the government collects no income. However, imagine a situation where the government collects 100% tax revenue.

Though all earnings will then be remit to the government, there is no incentive for workers to be employed. In this case, though the rate is highest (i.e. further along the x-axis), total revenue actual falls as shown by the diminishing portion of the curve. Therefore, though it may feel counterintuitive, tax revenue is most often not maximized when tax rates are highest due to extenuating circumstances.

The Laffer Curve's theory is that it is more efficient and most ideal for a government to set a rate somewhere between 0% and 100%. Though this may seem simplistic, finding the exact point where total revenue is maximized is subject to great political debate. Though the graphical depiction above shows it somewhere in the middle, the true ideal rate may be skewed one direction or the other. In addition, different circumstances for different countries will yield different outcomes.

History of the Laffer Curve

Arthur Laffer presented his ideas in 1974 to staff members of President Gerald Ford’s administration. At the time, most believed that an increase in tax rates would increase tax revenue.

Laffer countered that taking more money from a business in the form of taxes, the less money it will be willing to invest and a business will find ways to protect its capital from taxation or to relocate all or a part of its operations overseas. When workers see a greater portion of their paychecks taken for taxation, they lose the incentive to work harder.

Laffer argued that this means less total revenue as tax rates rise and that the economic effects of reducing incentives to work and invest by raising tax rates would damage an economy.

Laffer's findings influenced President Ronald Reagan’s economic policy known as Reaganomics, based on supply-side and trickle-down economics, resulting in one of the biggest tax cuts in history. During his time in office, annual federal government current tax receipts grew from $344 billion in 1980 to $550 billion in 1988, and the economy boomed.

Reagonomics

In the economic policy under President Reagan, marginal tax rates decreased, tax revenues increased, inflation decreased, and the unemployment rate fell.

Use of the Laffer Curve in U.S. Economics and Political Discourse

Politicians heavily debate the best way to change the effective tax rate. Republicans tend to lean towards lower corporate and high-earner taxes with the argument that these parties create jobs for the less wealthy. They often lean towards shedding public policy for low-income individuals, including minimizing or eliminating tax credits or rates for the lowest earners.

Democrats tend to lean towards redistributing wealth from high-earners to low-earners. In either case, each party strives to reach peak efficiency along the Laffer Curve, though they use very different methods. This is done by increasing tax rates for higher tax brackets and establishing tax breaks for lower tax brackets.

Regardless of which policies prevail, each side of the aisle is attempting to do what they think is best for their country. However, each have a different approach regarding the Laffer Curve. Republicans most often believe governments should have minimal interference with business, thus their ideal Laffer Curve often has a smaller peak. Democrats most often believe governments play a crucial part in generating programs that benefit low-earners, thus their ideal Laffer Curve is higher.

Criticisms of the Laffer Curve

The Single Tax Rate. The tax system is complex and raising the rate of one tax can impact or offset the benefits or negatives of reducing another. The Laffer curve overly simplifies the relationship between taxes by allocating a simplistic single tax rate.

The T* or Ideal Tax Rate Changes. The Laffer Curve sets the ideal tax rate anywhere between 0 and 100. However, this rate may change due to economic circumstances.

Tax Cuts Required for the Rich. The Laffer curve assumes an exact T* for maximizing government revenue and requires tax cuts for the rich.

• Assumptions of Individuals and Businesses. The Laffer curve assumes that higher taxes result in lower revenues because corporations may leave and employees will work fewer hours. However, employees may work harder or longer for career progression. Businesses do not rely solely on the tax rate for decision-making but also look for a skilled workforce and infrastructure, both of which offset an increased tax rate.

What Can Prevent Tax Cuts from Stimulating Economic Growth?

Tax cuts and their effect on the economy depend on the timeline for growth, availability of an underground economy, availability of tax loopholes, and the economy's productivity level.


What Is Trickle-Down Economics?

Arthur Laffer's idea that tax cuts could boost growth and tax revenue was quickly labeled “trickle-down.” Both President Herbert Hoover’s stimulus efforts during the Great Depression and President Ronald Reagan's use of income tax cuts were described as "trickle-down," where tax breaks and benefits for corporations and the wealthy will trickle down to individuals and boost the economy.

What Is Lacking in the Laffer Curve?

Actual numbers are missing from the curve, so the actual suggested tax rates and the percentage increase in revenue generated are missing, leaving policymakers to guess which rates work and support Laffer's theory.


The Bottom Line

The Laffer Curve displays the relationship between tax rates and tax revenue collected by governments and is often used to illustrate the argument that cutting tax rates can result in increased total tax revenue. Arthur Laffer claimed that tax cuts have arithmetic and economic effects on the federal budget, however, the curve assumes both a single tax rate and the behavior of businesses and individuals.

Article Sources
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  1. Boyce Wire. "Laffer Curve Definition."

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