What is the Laffer Curve?

The Laffer Curve is like describing how you feel eating candy…

If you could graph your happiness, you could illustrate how your mood changes as you eat more and more candy. At first, you get a shot of sugar and a good feeling. So, as you eat the first few pieces of candy, your mood gets better and better. But, at some point, too much candy makes you feel a little queasy. If you keep gorging yourself, you might even make yourself sick. This fact implies that there is some piece of candy (tax rate) that provides you (the government) the maximum happiness (tax revenue). If you try to push past that point, it ends up doing more harm than good.

The Laffer Curve is a simple representation of the relationship between tax rates and government revenues. It shows that it is possible for lower tax rates to increase tax revenues. The idea behind the curve rests on the assumption that people are willing to supply labor and capital just like they are any other good or service. Because taxes reduce the amount of money that a person keeps, increasing taxes has the same effect as lowering income. Because the reduced income level decreases the incentive to go to work or invest in a business, there is less money subject to the tax.

In its purest form, the Laffer Curve suggests that increasing tax rates might not always be the best way to increase tax revenues. In some cases, it might even be possible that decreasing income tax rates can result in increased tax revenues. Proponents of tax reductions use the Laffer Curve to suggest that tax cuts can “pay for themselves” and are a responsible thing for a government to do. However, opponents of this idea call it “voodoo economics,” which does nothing more than increase the national debt and income inequality.

The Laffer Curve relates directly to taxation. It demonstrates the relationship between tax rates and tax revenues. Most people that rely on the Laffer Curve to bolster their position on taxes focus on the idea that a tax burden can weigh down economic activity.

Because taxes reduce the incentive to work or invest, at a certain level they may force people out of the labor force or entrepreneurship. With fewer people willing to work or put money into business opportunities, a country can experience a reduction in gross domestic product (the value of the things produced in an economy). A smaller economy generates less taxable income, which implies that tax revenues may fall.

Even in instances where economic growth doesn’t fall, it might shift to avoid the higher tax rate. Consequently, the change in the composition of the economy can also reduce total revenues. In some cases, this could mean changing production to lower-taxed products. It could create an incentive for corporations to move their operations overseas. Or it might drive economic activity onto the black market to evade taxes. Regardless of whether the increased taxes drive companies out of business, or toward ways to avoid the taxes, the government may get fewer tax dollars.

To plot the Laffer Curve, begin by drawing two axes. Label the vertical axis “tax revenue” and the horizontal axis “tax rate.” The horizontal axis has a range from 0% percent to 100%.

Next, plot the two extreme tax rates at the ends of the spectrum. If the tax rate is zero, the government collects zero tax revenue (zero percent of anything is zero). At the other end, consider the amount of tax revenue that the government receives at a 100% tax rate. Dr. Laffer argued that if employees and investors received none of the benefits from their efforts, they would not provide their labor or capital. Therefore, tax revenue at a 100% tax rate is also zero (100% of nothing is zero).

Now, plot the current tax revenue and tax rate on the graph. For instance, the United States Federal government collected about $1.7T in income tax receipts during 2019. During 2019, Americans earned about $18.6T of personal income. Therefore, you could plot the point at 9.1% and $1.7T on the graph.

Because there is equal tax revenue at lower points on the curve to either side of it (at 0% and 100%), Rolle’s Theorem states that there must be a maximum point between those points. This fact implies that there must be a portion of the curve that increases from 0% and then decreases back to zero revenue when you reach 100%.

The Laffer Curve entered the mainstream when Laffer reportedly drew the equation on a napkin during dinner with Jude Wanniski, Dick Cheney, and Donald Rumsfeld in 1974. Supposedly, Laffer used it to argue against proposed tax increases by President Gerald Ford.

The concept itself dates back much further in history, but Laffer is commonly given credit for its introduction to the general public. This idea became a cornerstone of President Ronald Reagan’s economic policy, which took the names supply-side economics, Reaganomics, and trickle-down economics. Republicans leaned on this theory to support a series of tax cuts and deregulation policies over the next several decades. One could argue that the Laffer Curve is at least partially responsible for many of the economic policies that were enacted over the last 40 years.

While most economists agree that there is a point at which an increase in taxes would decrease tax revenue, there is little agreement about where that point exists.

Some believe that even around 35%, the tax rate would be beyond the maximum revenue level. Others believe that revenues would continue to increase at rates up to 70%. The shape of the Laffer Curve is critical in the interpretations that are derived from it.

Opponents of the Laffer Curve also argue that there’s no proven connection between cutting taxes and economic growth. For instance, during relatively high-tax periods — such as after World War II — America has seen significant economic growth.

Finally, it’s unclear whether tax rates and revenues behave in a predictable fashion, as assumed by the Laffer Curve. Tax avoidance by the rich and corporations, among other factors, makes the relationship between the two far more complex than the Laffer Curve’s assumptions, critics argue.

In general, the current major party platforms follow opposing philosophies on taxation. The Republican party of today tends to promote smaller government and lower taxes. In 2017, the Republican party passed the Tax Cuts and Jobs Act, which significantly reduced corporate income taxes and reformed individual income tax policy. The bill passed mostly on party lines in the Republican Congress and was signed by President Trump.

To garner support from the general public, proponents of the tax reform effort leaned heavily on the Laffer Curve to suggest that the tax cuts would generate so much additional economic activity that federal revenues would not decrease. In the years since the Tax Cuts and Jobs Act of 2017, the real world evidence does not suggest those statements came true. Revenue collections in 2018 and 2019 fell short of expectations, pushing the national debt to over $24T.