What is the Laffer curve?
The Laffer curve is a theory developed by the 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 argument that lowering tax rates can sometimes increase total tax revenue.
Key points to remember
- The Laffer curve describes the relationship between tax rates and total tax revenue, with an optimal tax rate that maximizes total government tax revenue.
- If taxes are too high along the Laffer curve, they will discourage taxed activities, such as labor and investment, enough to actually reduce total tax revenue. In this case, lowering tax rates will boost economic incentives and increase tax revenues.
- The Laffer curve was used as the basis for tax cuts in the 1980s with apparent success, but criticized for practical reasons on the basis of its simplistic assumptions and for economic reasons that increased government revenues may not always be optimal.
Understanding the Laffer curve
The Laffer curve is based on the economic idea that people will adjust their behavior when faced with the incentives created by tax rates. Higher tax rates reduce the incentive to work and invest compared to lower rates. If this effect is large enough, it means that at a certain tax rate, a further increase in the rate will actually decrease total tax revenue. For each type of tax, there is a threshold rate above which the incentive to produce more decreases, thereby reducing the amount of revenue collected by the government.
At a 0% tax rate, tax revenue would obviously be zero. As tax rates rise from low levels, government tax revenues also increase. Finally, if tax rates were to reach 100%, shown as the far right on the Laffer curve, everyone would choose not to work because everything they earned would go to government. It is therefore necessarily true that at some point in the range where tax revenues are positive, they must reach a maximum point. This is represented by T * on the graph below. To the left of T *, an increase in the tax rate generates more income than what is lost to compensate for the behavior of workers and investors. Raising rates above T *, however, would keep people from working as much or not at all, thereby reducing total tax revenue.
Therefore, at any tax rate to the right of T *, a reduction in the tax rate will actually increase total revenue. The shape of the Laffer curve, and therefore the location of T *, depends on the preferences of workers and investors for work, leisure and income, as well as technology and other economic factors. Governments would like to be at point T * because this is the time when the government collects the maximum amount of tax revenue while people continue to work hard. 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 will increase government revenue because more work and investment means a broader tax base.
Laffer’s curve explained
The first presentation of the Laffer curve was done on a paper napkin in 1974 when its author met with senior officials in the administration of President Gerald Ford about a proposed increase in the tax rate in the middle of a period of economic unrest that had engulfed the country. . At the time, most believed that raising tax rates would increase tax revenues.
Laffer replied that the more a company takes out of every dollar of additional income in the form of taxes, the less willing it is to invest. A business is more likely to find ways to protect its capital from taxation or to outsource all or part of its operations abroad. Investors are less likely to risk their capital if a higher percentage of their profits are taken. When workers see an increasing share of their paychecks taken up because of their increased efforts, they will lose the incentive to work harder. Bringing these together could all mean less total incoming income if tax rates were increased.
Laffer further argued that the economic effects of reducing the incentives to work and invest by raising tax rates would be detrimental at best and worse still in the midst of a stagnant economy. This theory, the supply-side economy, later became the cornerstone of President Ronald Reagan’s economic policy, which resulted in one of the largest tax cuts in history. During his tenure, the federal government’s annual tax revenues increased from $ 344 billion in 1980 to $ 550 billion in 1988, and the economy exploded.
Is Laffer’s curve too simple?
There are some fundamental problems with the Laffer curve – notably that it is far too simplistic in its assumptions. First, that the optimal tax revenues maximizing the T * tax rate are unique and static, or at least stable. Second, the shape of the Laffer curve, at least close to the current tax rate and T *, is known, even known to policy makers. Finally, maximizing or even increasing tax revenues is a desirable political objective.
In the first case, the existence and the position of T * depend entirely on the shape of the Laffer curve. The underlying concept of the Laffer curve only requires that tax revenues be 0% and 100% zero, and positive in between. It says nothing about the specific shape of the curve at points between 0% and 100% or about the position of T *. The shape of the actual Laffer curve may be radically different from the commonly described single peak single curve. If the curve has several peaks, flat points or discontinuities, several T * can exist. If the curve is tilted deeply to the left or right, T * could occur at extreme tax rates like a 1% tax rate or a 99% tax rate, which could put the policy maximizing tax revenues in serious conflict with social equity or other political objectives. Furthermore, just as the basic concept does not necessarily imply a curve of simple shape, it does not imply that a Laffer curve of any shape is static. The Laffer curve could easily change and change shape over time, which would mean that to maximize income, or simply avoid falling, policymakers would have to constantly adjust tax rates.
This leads to the second criticism, namely that the decision makers would not be able in practice to observe the shape of the Laffer curve, the location of the T *, if there are several T *, or if and how the Laffer’s curve could change over time. The only thing that decision makers can reliably observe is the current tax rate and associated revenues (and past combinations of rates and revenues). Economists can guess what the shape could be, but only trial and error could actually reveal the true shape of the curve, and only at the tax rates actually applied. Raising or lowering tax rates may or may not move the rate to T *. In addition, if the Laffer curve has a shape other than the simple parabola assumed to be a single peak, tax revenue at the points between the current tax rate and T * could have any range of values greater or less than revenue at current and the same or less than T *. An increase in tax revenue after a rate change would not necessarily mean that the new rate is closer to T * (or a decrease in revenue signaling that it is more distant). Worse still, given that changes in tax policy are made and applied over time, the shape of the Laffer curve could change; policy makers could never know whether an increase in tax revenue in response to a change in tax rate represented a movement along the Laffer curve toward T *, or a change in the Laffer curve itself, with a new T *. Policymakers trying to reach T * would indeed fumble in the dark after a moving target.
Finally, it is not clear, for economic reasons, that maximizing or increasing government revenues (by moving towards T * on the Laffer curve) is even an appropriate objective for choosing tax rates . It could easily happen that a government can meet the otherwise unmet needs of its citizens and provide all the public goods necessary for a certain level of income below the maximum that it can potentially extract from the economy, perhaps much more low depending on the position of T *. If this is the case, then given the well-documented problems of the lead attorney, rent-seeking and knowledge issues that arise with the allocation of resources for political ends, placing additional funds in public coffers beyond this socially optimal level could simply produce additional unnecessary social costs, inefficiencies, and deadweight loss. Maximizing government tax revenue by taxing T * would also maximize these costs. A more appropriate goal could be to achieve minimum tax revenue necessary to achieve only the socially necessary political objectives, which would seem to be almost exactly the opposite of the objective of the Laffer curve.