From American Thinker:
For those who are familiar with the “Laffer Curve,” the name generally brings on an immediate and politically charged opinion related to the inherent implications the curve has historically had on the topic of the government’s tax rate policies. However, the underlying points illustrated by the curve deserve serious and independent consideration. In fact, to evaluate the Laffer Curve without bias will undoubtedly yield a better understanding of one of the key political issues facing America today.
The name “Laffer Curve” originated in 1974 and was given by a writer for the Wall Street Journal in honor of Arthur Laffer, an economist who later served on President Ronald Reagan’s Economic Policy Advisory Board. It was originally used as part of the argument against the tax increases Gerald Ford was contemplating with an aim to reduce the federal deficit. But the concept was not at all new. The nonlinear relationship between tax rates and government revenues depicted in the curve is something that has been discussed and written about for at least several centuries. In fact, Laffer explains that he himself learned of the concept from reading works by other economists, including Keynes.
Simply stated, the “Laffer Curve” is a theoretical curve showing the relationship between an applied income tax rate and the resulting government revenue. Generally, the tax revenue is indicated on the vertical “y” axis and the tax rate on the horizontal “x” axis. The fundamental concepts are as follows:
1) A tax rate of zero results in zero government revenue.
2) A tax rate of 100% will also result in zero government revenue.
3) As the tax rate increases above zero, there is a resultant increase in government revenue.
4) As the tax rate continues to increase, the resultant increase in government revenue begins to slow.
5) There is a point at which the curve peaks and turns back toward the horizontal “x” axis.
The factors that go into determining where you are on the curve are many. And this is where politicians and pundits generally rely on the fact that the overwhelming majority of the citizenry do not have the knowledge, understanding, patience, or inclination to dig into the details. In truth, most of them don’t.
First, the curve is different for different types of taxation and is not the same for each income bracket. For example, the curve is not the same for the Personal Income Tax as it is for the Corporate Income Tax or for the Capital Gains Tax. The curve is not the same for the personal income tax applied to a person making $40,000 per year as it is for someone making $1,000,000 per year.
The curves for these different taxes and tax rates will begin and end at the same place. But the area between the slope and point of diminishing return is certainly not the same. Secondly, the economic climate at any given point in time introduces countless variables such as the general economic growth rate, banking practices, loan interest rates, employment rates, consumer confidence, inflation rates and many others, all of which contribute to the shape of the curve. The curve is not the same for the same tax at different points in time because economic conditions are constantly shifting. Thirdly, it is impossible to quantitatively “measure” the relationship with any exactness because of the inherent time lag involved between changes to the tax rate and the resulting impact on government revenue. Other factors always come into play during this lag period and to some degree contribute to the resulting government revenue.
There is no single “Laffer Curve”; there is no set-in-stone point at which increased tax rates cease to generate government returns. But we can be reasonably certain that during the last century we in America have at different times found ourselves on both sides of the curve. There have been occasions where increased tax rates clearly resulted in increased government revenue. There have been occasions where decreased tax rates clearly resulted in increased government revenue. When it comes to the argument of whether tax rates should be raised or lowered, at different points in time and in different economic circumstances, each side of the political aisle has been correct. At different points in time and in different economic circumstances, each side has been wrong.
I first heard of the Laffer curve way back in 1980, but it wasn’t until recently that I understood what it really meant.
Let’s take the tobacco tax. If there is no tax on tobacco, there is no revenue. On the other hand if you raise the tax to $100 for each pack of cigarettes, people will either quit smoking or they’ll buy bootleg cigarettes, either way producing no revenue. The question is what tax rate would produce maximum revenue?
That’s really all the Laffer curve means. It doesn’t tell you what tax rates should be or whether current rates are too high or too low.
And they say economics is boring.
Oh wait! It is boring.