Laffer Curve
Source D. Ohmans
Date 04/09/27/22:04


The idea behind tax cuts is very simple: Lower the burden on such good things as productive investment, work and risk-taking and you will wind up receiving more tax receipts. Kerry and his fellows are blind to the fact that the resulting prosperity always means more government revenue.



Legend has it that in November 1974 Arthur Laffer, a young economist, drew a curve on a napkin in a Washington bar, linking AVERAGE tax rates to total tax revenue. Initially, higher tax rates would increase revenue, but at some point further increases in tax rates would cause revenue to fall, for instance by discouraging people from working. The curve became an icon of supply-side ECONOMICS. Some economists said that it proved that most governments could raise more revenue by cutting tax rates, an argument that was often cited in the 1980s by the tax-cutting governments of Ronald Reagan and Margaret Thatcher. Other economists reckoned that most countries were still at a point on the curve at which raising tax rates would increase revenue. The lack of empirical evidence meant that nobody could really be sure where the United States and other countries were on the Laffer curve. However, after the Reagan administration cut tax rates revenue fell at first. American tax rates were already low compared with some countries, especially in continental Europe, and it remains possible that these countries are at a point on the Laffer curve where cutting tax rates would pay.


For us to gain a rudimentary understanding of the ideas incorporated into the Laffer Curve, we must understand a tiny bit about economics. Economics is really just basic human psychology as applied to money and business affairs. We assume that people will react to the realities of the world of money and business more or less like they react to any other set of stimuli. They tend to act in their own and their family and friends' best interests, as they see them. The Laffer Curve results from our assumptions about how people will react to varying rates of income taxation.

Now we must put our understanding of human nature to work. We must ask ourselves two questions, the answer to the first being obvious, and the answer to the second being not so obvious, but just as certain. The first question is, "If the income tax rate is zero %, how much income tax revenue will be raised?" The answer is, of course, "None."

Now, here is where it gets a bit tougher. The second question is, "If the income tax rate is 100%, how much income tax revenue will be raised?" To answer this question, we must place ourselves in the position of an income earner who faces a tax rate of 100% on every extra dollar he earns. Will he have any reason whatsoever to earn any more money? The answer is, "No, he won't." He will refrain from any activities likely to result in taxable income. So the income tax revenue from a 100% income tax will be zero, or nearly zero. There will always be a few suckers who go ahead and earn some money, only to have it taxed away. But the number of people willing to do so must be exceedingly small. For all practical purposes, the number is zero.

Okay, now we get to the nub of the "infamous" Laffer Curve. We must take the ideas discussed above and reach some conclusions. The reasoning goes like this: If a zero % income tax rate brings in zero revenue, and if a 100% income tax rate brings in zero revenue, the tax rate which will bring in the most revenue must be somewhere between zero % and 100%. It necessarily follows that in a given economy, there is some optimal income tax rate which will bring in the most revenue possible. In that economy, a lower than optimal rate will bring less revenue, and a higher than optimal rate also will bring in less revenue. Are we all still together here? Did you get that? If not, go back and do it again. Keep doing it until you get it.

Okay, that is all the Laffer Curve claims. Let's all say this together, "In any given economy, it is possible that the income tax rates are already too high, and if the authorities wish to bring in more income tax revenue, they must lower the tax rates." Do we all understand that? Even the Democrats amongst us?


Whether a decrease in tax rates would increase tax revenues depends to a large extent on the elasticity of labor supply, that is, on how much workers respond to increased incentives.... They would do so only if their labor supply elasticity were 1.25, which is higher than the average labor supply elasticity found by virtually all economists who have studied the issue.... There are many other good reasons for cutting taxes.... A better strategy for reducing taxation would be and has been to cut taxes first and let the legislators and special interests bicker over who gets what.... But the argument for tax cuts on the basis of the Laffer curve is a castle made of sand.

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