Laffer curve
The
Laffer curve, developed by
economist Arthur Laffer and often used to justify
tax cuts, is intended to show that government can maximize revenue (taxes) by setting an optimal tax rate. The curve is clearly accurate at both extremes of taxation --zero percent and one-hundred percent-- where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other, where there is a 100% tax rate, the government collects zero revenue because taxpayers have no incentive to work or earn. Somewhere between 0% and 100%, therefore, lies a tax percentage rate that will maximize revenue, an idea central to the
supply side economics.
Figure 1: t* represents the rate of taxation at which maximal revenue is generated
Context in US History
The Laffer curve and supply side economics inspired the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more revenue because government was operating on the right-hand side of the curve. Conventional economic paradigms acknowledge the basic notion of the Laffer curve, but argue that government was operating on the left-hand side of the curve, so a tax cut would thus lower revenue. The central question is the elasticity of work with respect to tax rates.
In the United States, some claimed that both tax cuts and government spending policies of the 1980s were the cause of large budget deficits. Others claim that the data actually shows United States government revenues increased during that period, suggesting that deficits were unrelated to tax cuts, and should be attributed to increased spending alone. The counter-argument is that the income only increased along with growth in GNP at a rate roughly consistent with other 20th century decades. At the same time the federal government commitments to services such as Social Security rose along with population growth. During the Clinton administration government revenues and GNP increased at an even higher rate despite increases in taxes.
David Stockman, Reagan's budget director during his first administration and one of the early proponents of supply-side economics, maintained that the Laffer curve was not to be taken literally - at least not in the economic environment of the 1980's United States. In "The Triumph of Politics" he writes:
"[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve."
Rumor suggests the Laffer Curve was originally sketched on a restaurant napkin in the late 1970s as Art Laffer and Robert Mundell described the concept to Jude Wanniski.
Precendents to the Laffer Curve
The idea inherient in the laffer curve has been described many times prior to Laffer, including:
See also
\n* Supply-side economics\n* Macroeconomics\n* List of economics topics
\n
