Laffer Curve

Imagine you woke up today as the president of the United States. It is a challenging time post-pandemic, and the country is hit by rising prices. Your government urgently needs tax revenue to be able to fund some of its activities. What are some of the revenue sources that come to mind? Would you choose to increase taxes for the already struggling individuals, or would you tax large companies instead? Turns out, the relationship between the tax rate and tax revenue is not as clear-cut.

Before you make your decision as the new president, why don't you dive into this article to understand the economics of the Laffer Curve, which will, inevitably, influence your decision!

Arthur Laffer Curve

Arthur Laffer is an economist who, in 1974, came up with the idea of the curve, later named after him, that shows the relationship between the tax rate and tax revenue. The initial idea seemed valid as a theory but didn't get much support for its practical implementation. Arthur Laffer suggested that the taxes in the US at the time were so high that reducing them could actually increase tax revenue.But wait, you say, isn't it contradictory? Assuming that everyone pays their taxes, to get more tax revenue, tax rates should increase! And you are not wrong to think that. However, the assumption that everyone pays their taxes is what Arthur Laffer challenged. He argued that individuals' incentives would change if the tax rate was too high. In particular, he argued that too high of a tax rate would discourage work, while a lower tax rate would encourage work. How is this possible?

The same idea dominated at the time among the working class and the self-employed. They found the tax rates to be too high. They decided to move to the countryside and sustain themselves by growing food instead of being in the business of trading.Consider Tables 1 and 2 below. They show some of the federal income tax brackets for single filers in 1974 vs. 2022.

Given the numbers in Tables 1 and 2, you can notice how high the tax rates were back in 1974. Of course, the incomes in the tax brackets are stated in nominal terms. Nevertheless, they gave the idea of the tax rates at the time when Laffer came up with his theory.

Laffer Curve vs. Supply Side Economics

How is the Laffer Curve connected to supply side economics, if at all? Well, the answer lies in history! Let's look at some of its historical backgrounds and examples.

Laffer Curve Examples and History

Ronald Reagan, the US president then, became interested in Laffer's ideas. He and his administration decided to follow with a series of tax cuts. In 1981, he passed the Economic Recovery Tax Act cutting the individual tax rate in the highest bracket from 70% to 50%.³ This resulted in the tax revenues coming from income taxes rising by 40% by 1986.⁴But Ronald Reagan's reforms did not stop there. In 1986, he proposed the Tax Reform Act. Yet another cut for individual income tax in the highest bracket has occurred, but this time from 50% to 33%.³ You probably wouldn't believe it, but tax revenues increased by 34% by 1990! ⁴ This period has marked the start of the new era of economic interventions known as supply side economics!

It is worth noting that the effects of Reagan's tax cuts are debated among economists. In other words, we cannot be 100% sure of the causal impact of the tax cuts on tax revenues as many other factors were at play there. To be certain, we would need to go back in time and repeat all the events in the exact same way but with different tax rates to be able to discern causal effects. As economists love to say: 'there is no counterfactual' that these events can be compared against as we can't relive history.

Laffer Curve Definition

Let's jump straight into the definition of the Laffer Curve! Laffer Curve depicts the relationship between the tax rate and tax revenue. It shows that as tax rates increase from 0%, tax revenue increases; however, after a specific tax rate, tax revenue begins to fall, reaching zero at a 100% tax rate.The Laffer Curve is shown in Figure 1 below.

Fig. 1 - The Laffer Curve

Figure 1 shows the relationship between the tax rate and tax revenue. The tax rate is plotted on the horizontal axis, while the tax revenue is plotted on the vertical axis. At the tax rate of 0%, tax revenue is zero. An increase in the tax rate up to the maximum tax rate point M leads to increased tax revenue. Tax revenue is maximized at point M. As the tax rate climbs past the maximum tax rate point M, tax revenue begins to fall until reaching zero at a 100% tax rate.

Laffer Curve Criticism

What is the criticism of the Laffer Curve that would discourage country leaders from outright taking it as a rule in today's economy? The answer is there is no consensus on how the behavior of individuals would change in response to tax cuts.

Laffer Curve Effect

Let's revisit the Laffer Curve effect again and then see how today's economists view individual work incentives with the help of income and substitution effects.Take a look at Figure 2 below.

Fig. 2 - The Laffer Curve Effect

Figure 2 shows that as the tax rate increases, tax revenue increases initially. But, beyond the tax revenue-maximizing point, higher tax rates lead to a reduction in revenue.

What does the curve tell us? It tells us that there are two forces at work - a higher tax rate and a lower tax base (people working less in response). Before we reach the revenue-maximizing point (M), the effect of a higher tax rate will dominate the reduction in the tax base. After point M, the effect of a reduction in the tax base will outweigh the effect of a higher tax rate.

However, economists today describe individual incentives to work in terms of income and substitution effects.

Work and leisure activities are considered substitutes. Individuals decide how many hours to dedicate to work and how many to leisure, depending on their preferences.

These effects imply that the labor supply curve is non-linear. Therefore a decrease in the tax rate may not necessarily lead to an increase in labor supply. How individuals respond based on their varying desired income levels may be far more complicated than the Laffer Curve predicts.

Apart from individuals' behavioral changes, it is practically impossible to calculate the effects of the tax revenues increase resulting from a tax cut. This is because elasticities of demand and supply in the labor market are the factors that would determine the extent of distortions to the behavior of individuals, and their values remain unknown.