The Laffer Curve, made popular in the 1980s as one of the premises behind supply-side economics and espoused by proponents of government tax cuts, has a long and interesting history, and not surprisingly, is also of interest in the modern era, as debate over tax increases and cuts continues to rage. The term ‘Laffer Curve’ itself is said to have been coined by Jude Wanniski, a writer for the Wall Street Journal, but is primarily the work of Arthur Laffer, the economist who brought the concept to the attention of Wanniski and other government officials, that included Dick Cheney and Donald Rumsfeld. Laffer himself was quick to point out that the idea behind his idea on taxation was not original, but had been referenced as early as the 14th century, and then again by renowned economist John Maynard Keynes.
The theory is elegant in its simplicity, though there is still debate as to how useful it is in determining tax policy. At its heart, the curve is a representation of the relationship between government revenue raised via taxation, and each rate of taxation that can be instituted. The curve itself illustrates―or purports to illustrate, say its detractors―the vague concept of taxable income elasticity. While that concept may sound esoteric, it is actually very simple. In short, the curve seeks to measure the effect on total revenue generated as tax rates increase, and works on the assumption that as tax rates increase, the workforce, or in government parlance, the tax base, will work less, and therefore earn less. This is based on the assumption that workers will be fully cognizant of the amount of money they are permitted to keep versus what they must pay to the government.
As a starting point, the curve illustrates the amount of tax revenue that would be collected at tax rates of 0% and 100%. The assumption, of course, is that tax revenue would be zero in both instances, as a 0% taxation rate would create no revenue, and 100% taxation would cause rational people to simply stop working, therefore earning no money and paying no taxes. Thereafter, the next posited theory is that there must exist some rate between 0 and 100, that maximizes tax revenue.
Laffer’s important distinction in the theory involves what he referred to as an ‘arithmetic effect’ versus an ‘economic effect’. Simply stated, he explained that from a pure numbers perspective, a 100% tax rate would create the maximum possible tax revenue, but that such a policy fails to recognize the likely result of such legislation. The ‘economic effect’ of the 100% tax rate would lead to zero revenue, he argued, because workers would change their behavior in response to the tax rate. In short, they would either stop working altogether, or would find a means of earning money without paying taxes.
In the 1980s, economists and many politicians opposed to tax increases used this theory as a means of arguing for tax cuts, though it was clear that most politicians had nothing more than a rudimentary understanding of economics in general, much less the specifics of the Laffer model. Many have argued against the use of these principles on these grounds alone, while still others have pointed out that the assumption of rationality creates a disconnect in the theory itself. Regardless, the Laffer Curve is quite an ingenious bit of theory, and certainly has its place in economic theory. Divorcing it from reelection-minded politicians, however, would likely allow the theory to function as intended, and to potentially shape tax policy. In the modern-day, even as Congress continues to debate the merits of tax cuts or increases, it can at least serve as a history lesson for legislators, as they form their own opinions and put forth their own policy suggestions.