Understanding the Laffer Curve

There are several things the great Laffer Curve can teach us – things normally overlooked or missed. The Laffer Curve shows us the relationship between tax rates and tax revenues based on how people react to tax rates. The curve does not show us that lower taxes always lead to higher revenues, instead it shows us that lower tax rates can actually lead to fewer revenues. The curve shows us more about human nature and how humans react to incentives and disincentives created by tax rates. So what does the Laffer Curve show us? Well one of the most striking features of the Laffer Curve is that there are two points in which zero revenues can be collected by the government. The first point in which no revenues can be collected is at the 0% tax rate. This is a simple no brainer – if the government isn’t taking your money, it will be broke. The only money government would get would come from charity – which wouldn’t count for much (It depends on the society.). At such a tax rate, the incentive to work would skyrocket, the incentive to invest, save, and take risks would also skyrocket. People, businesses, and capital would flock from other areas into the area with the 0% tax rate (Income Tax.). The incentive to open a business would skyrocket and the incentive to avoid taxation would be zero, since there would be no taxes to avoid. Economic productivity would skyrocket and the standard of living would grow at an amazing rate. The economy would expand, thus expanding the tax base – but that wouldn’t matter because the government would be taking no taxes.

The second point we see, where zero revenues are collected, is at the 100% tax rate. According to common stupidity, if taxes are doubled revenues would also be doubled. That is a false belief. At a 100% tax rate, the government would receive no revenues because no one would be working. The incentive to work, save, invest, and take risks would be near zero. People would work to sustain themselves, but they wouldn’t report their income to the government – most of their activities would go underground. People, businesses, and capital would flee from the area and the lack of economic productivity would lead to a shrinking economy and tax base. The incentive to avoid taxation would skyrocket, also reducing the size of the tax base. As you can see, this becomes something very common in the Laffer Curve – a large tax base with a small tax rate can collect the same amount of revenues a small tax base could with a high tax rate. Do I seem to be speaking in tongues?

Let’s dig deeper into the subject and let’s examine the shaded area of the Laffer Curve, also known as the Prohibitive Range. In this area of the Laffer Curve, tax rates become extremely harmful to economic growth and productivity. The incentive to work, save, invest, and take risks goes down while the incentive to avoid taxation goes up. People, businesses, and capital begin to flee the area and the economy begins to shrink, along with the tax base. The end result is a weaker economy and a much smaller tax base. The area below the Prohibitive Range is what I call the Optimal Range, or the best area to keep the tax rate at. In the Optimal Range the tax rates are not harmful to the economy to the point where they retard and impede economic growth and productivity. Instead with the tax rates in the Optimal Range, the incentive to work, invest, save, and take risks is higher and the incentive to avoid taxation is lower. People, businesses, and capital will flock to the area with tax rates in the Optimal Range. Over all, tax rates in the Optimal Range would increase economic growth and productivity, expand the economy, and lead to a larger tax base – thus allowing a large tax base with a low tax rate to have the same amount of revenues as a small tax base with a high tax rate. In short, tax rates in the Prohibitive Range lead to a weaker, shrinking economy and a smaller tax base – while tax rates in the Optimal Range lead to a stronger, expanding economy and a larger tax base. Depending on where you are on the curve, a tax cut in the prohibitive range will lead to more revenues, while a tax hike in the optimal range will lead to more revenues.

Then there’s the Optimal Tax Rate (Equilibrium Point), or the exact tax rate which maximizes revenues without harming the economy too much. Of course it is impossible to find such a rate, which separates the Prohibitive and Optimal Ranges. But in theory, this is the tax rate in which revenues can be maximized. A tax rate higher than the Optimal Rate will lead to a fall in revenues. And before you ask – NO, the Optimal Tax Rate is not at 50%. One must know that revenue responses to a change in the tax rate will depend on the tax system itself, the timing of the tax change, the size of the tax change, the level of the tax rates themselves, the amount of loopholes and legal tax shelters, and the ease of moving into underground activities. With that said, the Laffer Curve is an incredibly simple concept to understand.

Extra Notes on the Laffer Curve.

The Laffer Curve was created by former Reagan Chief Economic Advisor and the Father of Supply-Side Economics, Arthur B. Laffer.

The Father or Modern Macroeconomics and Keynesian Economics, John Maynard Keynes once said:

“When, on the contrary, I show, a little elaborately, as in the ensuing chapter, that to create wealth will increase the national income and that a large proportion of any increase in the national income will accrue to an Exchequer, amongst whose largest outgoings is the payment of incomes to those who are unemployed and whose receipts are a proportion of the incomes of those who are occupied…

Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget. For to take the opposite view today is to resemble a manufacturer who, running at a loss, decides to raise his price, and when his declining sales increase the loss, wrapping himself in the rectitude of plain arithmetic, decides that prudence requires him to raise the price still more–and who, when at last his account is balanced with nought on both sides, is still found righteously declaring that it would have been the act of a gambler to reduce the price when you were already making a loss.”

In the quote above, John Maynard Keynes makes the case for the Laffer Curve effect, or how lower taxes can lead to more revenues and how higher taxes can lead to fewer revenues. Keynes makes this argument before Arthur Laffer himself created the Laffer Curve.

Recommended Reading:

Laffer, Arthur B. - The Laffer Curve: Past, Present, Future, The Heritage Foundation: http://www.heritage.org/Research/Reports/2004/06/The-Laffer-Curve-Past-Present-and-Future

Laffer, Arthur B., et al. The End of Prosperity: How Higher Taxes Will Doom the Economy – If We Let it Happen. New York City: Threshold Editions , 2008. Print.

Laffer, Arthur B., et al. Return to Prosperity: How America can Regain its Economic Superpower Status . New York City: Threshold Editions , 2010. Print.