Laffer curve

In economics, the Laffer curve is a representation of the relationship between rates of taxation and the resulting levels of government revenue. Proponents of the Laffer curve claim that it illustrates the concept of taxable income elasticity—i.e., taxable income will change in response to changes in the rate of taxation.

The Laffer curve postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100% and that there must be at least one rate which maximizes government taxation revenue. The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. The shape of the curve is uncertain and disputed.

One implication of the Laffer curve is that increasing tax rates beyond a certain point will be counter-productive for raising further tax revenue. A hypothetical Laffer curve for any given economy can only be estimated and such estimates are controversial. The New Palgrave Dictionary of Economics reports that estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%. Generally, economists have found little support for the claim that tax cuts from current rates increase tax revenues or that most taxes are on the side of the Laffer curve where additional cuts could increase government revenue.

Although economist Arthur Laffer does not claim to have invented the Laffer curve concept, it was popularized in the United States with policymakers following an afternoon meeting with Ford Administration officials Dick Cheney and Donald Rumsfeld in 1974 in which he reportedly sketched the curve on a napkin to illustrate his argument. The term "Laffer curve" was coined by Jude Wanniski, who was also present at the meeting. The basic concept was not new; Laffer himself notes antecedents in the writings of the 14th-century social philosopher Ibn Khaldun.

Laffer explains the model in terms of two interacting effects of taxation: an "arithmetic effect" and an "economic effect." The "arithmetic effect" assumes that tax revenue raised is the tax rate multiplied by the revenue available for taxation (or tax base). Thus revenue R is equal to t×B where t is the tax rate and B is the taxable base (R=t×B). At a 0% tax rate, the model assumes that no tax revenue is raised. The "economic effect" assumes that the tax rate will affect the tax base itself. At the extreme of a 100% tax rate, the government theoretically collects zero revenue because taxpayers change their behavior in response to the tax rate: either they lose their incentive to work, or they find a way to avoid paying taxes. Thus, the "economic effect" of a 100% tax rate is to decrease the tax base to zero. If this is the case, then somewhere between 0% and 100% lies a tax rate that will maximize revenue.

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