Laffer Curve: Key Takeaways

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 argument that sometimes cutting tax rates can increase total
tax revenue.
Key Takeaways
 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, then they will discourage the taxed activities,
such as work and investment, enough to actually reduce total tax revenue. In this case,
cutting tax rates will both stimulate economic incentives and increase tax revenue.
 The Laffer curve was used as a basis for tax cuts in the 1980's with apparent success, but
criticized on practical grounds on the basis of its simplistic assumptions, and on
economic grounds that increasing government revenue might not always be optimal.
Understanding the Laffer curve
The Laffer curve is based on the economic assumption that people’s behavior will adjust in the
face of the incentives created by income tax rates. Higher income tax rates decrease the incentive
to work and invest compared to lower rates. If this effect is large enough, it means that at some
tax rate, and further increase in the rate will actually lead to decrease in total tax revenue. 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.
At a 0% tax rate, tax revenue would obviously be zero. As tax rates increase from low levels, tax
revenue collected by the government also increases. Eventually, if tax rates reached 100 percent,
shown as the far right on the Laffer curve, all people would choose not to work because
everything they earned would go to the government. Therefore it is necessarily true that at some
point in the range where tax revenue is positive, it must reach a maximum point. This is
represented by T* on the graph below. To the left of T* an increase in tax rate raises more
revenue than is lost to equalizing worker and investor behavior. Increasing rates beyond T*
however would cause people not to work as much or not at all, thereby reducing total tax
revenue.
The shape of the Laffer curve, and thus the location of T* is dependent on worker and investor
preferences for work, leisure, and income, as well as technology and other economic factors.
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. If the current tax
rate is to the right of T*, then lowering the tax rate will both stimulate economic growth by
increasing incentives to work and invest, and increase government revenue because more work
and investment means a larger tax base.
The famous Laffer curve was first presented on a paper napkin back in 1974 when its author was
speaking about a proposed tax rate increase in the midst of a period of economic disorder that
had engulfed the country. At the time, most believed that an increase in tax rates would increase
tax revenue.
Laffer countered that the more money was taken from a business out of each additional dollar of
income in the form of taxes, the less money it will be willing to invest. 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. Put together these could all mean less
total revenue coming in if tax rates were raised.
Laffer further argued that the economic effects of reducing incentives to work and invest by
raising tax rates would be damaging in the best of times and even worse in the midst of a
stagnant economy. This theory, supply-side economics, 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, annual federal government current tax receipts from $344 billion in
1980 to $550 billion in 1988, and the economy boomed.

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