The Laffer Curve
The Laffer Curve
The Laffer Curve is the illustration of the tradeoff of tax rates and the total tax revenue that is collected by the government. It starts at 0%, where the government collects no tax revenue, and goes up to 100%. The government also doesn’t collect any tax revenue at 100% because people will not work for nothing. The Laffer Curve does not guarantee or predict whether or not a tax cut will raise or lower tax revenue. It was only meant to show that tax reductions result in a smaller loss in tax revenue. It also shows that the higher the tax rate, the more the economy will be stimulated with a tax cut. Maximizing government revenue is not always what is sought after. Tax cuts lead to growth and prosperity in the economy, and that is what the people desire more than government revenue (The Laffer Center, 2012).
The name Laffer Curve was coined in 1978 by Jude Wanniski. Wanniski published an article recounting a dinner that he had with Arthur Laffer, Donald Runsfeld, and Dick Cheney. The dinner discussion turned toward President Ford’s WIN (Whip Inflation Now) proposal to raise taxes. Arthur Laffer was said to have grabbed his napkin and drew the curve showing the tradeoff between tax rates and tax revenue. Wanniski coined the term Laffer Curve after this dinner. Laffer can’t recall the details of the dinner, but fully backs Wanniski’s story. Arthur Laffer did not invent the Laffer Curve, the idea has been around for centuries. The 14th century Muslim philosopher, Ibn Khaldun, wrote in his work Muqaddimah: “It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.” (Laffer, 2004).
There are two reasons why the Laffer Curve shows the illustration of tax cuts that it does: one is the arithmetic effect, and the other is the economic effect. The arithmetic effect is static, meaning that if tax rates are lowered then tax revenues will also lower and vice versa if they are increased. In other words, hypothetically if a tax rate of 1% brings in 1 million dollars in revenue, then a 2% tax rate would bring in 2 million dollars. The economic effect is the effect that tax rates have on work output and employment. Lower tax rates increases work output and employment because companies are able to offer more to their employees with lower tax rates. In contrast, if tax rates are increased then work output and employment decrease because people are penalized for the increase in taxes. The arithmetic effect always works in the opposite direction from the economic effect (Laffer, 2004).
The Laffer Curve doesn’t say if a tax cut will increase or lower revenue, it was just meant to show that tax cuts will result in smaller revenue losses than most would think (The Laffer Center, 2012). How revenue responds to a tax cuts depends on