The Laffer Curve


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.

Nevermind.


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16 Responses to The Laffer Curve

  1. DM says:

    Tax is not just about revenue, but also to encourage or discourage habits. Cigarette tax in CA was set very high to discourage its use. It has been very successful. Use of tobacco in CA is much lower than other states.

    San Francisco voters passed an ordinance that will force stores, grocery and staple stores, to charge for bags for carrying purchases and encourage the use of non-disposable bags. The purpose is to reduce trash.

    • myiq2xu says:

      That’s a practical application of the Laffer curve principle.

    • Lulu says:

      You are talking about using taxes as social policy and behavior modification rather than raising revenue. There are arguments pro and con on that. I always understood that the Laffer curve was a calculation of maximizing revenue and that as soon as any policy was based upon those calculations, the population and business would start adjusting for them and the calculations would start changing. Different taxes have different Laffer curves and different economic cycles have different Laffer curves. This is supposed to be a tool for government policy makers to hit the “sweet spot” to raise enough revenue for government to function as needed without impairing the public welfare.

      When I studied public policy and administration over thirty years ago one of the main tenets was neutrality and fairness. The effects of policy especially taxes were taken into very detailed consideration before implementation. This administration does not consider this nor do I think they care. They use arguments that it is for the public’s own good when it is clearly false, is punitive in nature, and if a little digging is done facts show that it is to punish enemies and enrich friends. The arguments are so warped that the public often does not know what to believe. The best example of this is ObamaTaxCare which has nothing to do with healthcare, and is extremely harmful on its face. The public instinctively understands it is punitive, horrific policy, unfair, hurts the public welfare, was designed to impose some warped sense of morality from Ivory Tower thinkers, and enrich their benefactors. I would like to see a Laffer curve on that.

      • DM says:

        I was simply bringing out the issue that taxes are not just about revenue. It will be interesting to see what happens in SF after the bag tax starts on October 1. I’m expecting people to bring their bags because even though the fee is only ten cents, people don’t like to pay fees if they can avoid it. I suspect many will pay it, but a good number will bring bags that would not have happened without the fee. If the fee went to fifty cents, the number would increase.

    • yttik says:

      Sin taxes do not discourage use. Studies have shown that less than 2% give up things like alcohol and cigs. The other 98% simply suffer the burden those taxes place on the poor and spend less money elsewhere, like on food and medical care.

      I live in the state mecca for sin taxes. We have huge taxes on cigs, alcohol, gas, candy bars, grocery bags, bottled water, soda pop. all for our own good. If sin taxes really discouraged use, the Gov would eventually experience reduced revenue from those things. But that doesn’t happen, Gov’s actually budget in all the future revenue they will be getting. Obamamcare is a good example. Part of the way they plan to fund it is with a sin tax on people who can’t buy insurance. If this tax was really an effective way to encourage people to buy insurance, then people would buy insurance rather than pay the tax. But that’s not what is going to happen. Millions of us will be too rich to qualify for Obamacare and yet too poor to buy insurance. We’ll be paying the sin tax instead, which is actually part of the way they plan to fund the program. Less than 2% will buy insurance simply because of the tax.

      • DM says:

        There are studies, and there’s reality. People either stopped smoking or smoked less in CA after the tax. Though the decrease cannot be totally assigned to the tax because in conjunction with the tax, the revenue received from cigarettes went to ads and other health benefits, there’s no debate about the drop in smoking habits in CA after the tax.

    • bluestate says:

      i read an interesting article about the bag thing a little while ago that said that those reusable bags actually pose a public health risk because people never wash them and they get all kinds of nasty bacteria in them from meat drippings, dirt from produce, etc. discouraging smoking is one thing, but you’ve got to know where to draw the line on the nanny state stuff.

      Memo to greens: Maybe grocery bags should be disposable for a reason « Hot Air

  2. DeniseVB says:

    Update on guy who shot himself in the head on Fox. Sounds like the world is a safer place with him out of it 😦

    http://www.nydailynews.com/news/national/police-id-man-killed-tv-arizona-car-chase-article-1.1171255#ixzz27v6VhXrU

  3. Captain Quark says:

    Why would anyone think that the relationship between tax rates and gross revenue would be expressed by a simple 2nd degree equation?

  4. mcnorman says:

    Minor details when there are such other important things going on (like getting a free phone).

  5. HELENK says:

    funny thing about sin taxes
    the prohibition made some a lot of money and the public loved them

    I can remember people bringing cigarettes from the Carolinas up north and making money

    before state lotteries, people made a lot of money on numbers

    people will always find a way to avoid paying the so called sin taxes, and will not feel guilty about doing so

    • DM says:

      The illegal drugs are right now making lots of money for the drug cartels, and those who benefit will be the first to lobby against legalizing drugs, such as law enforcement, prison industry, and drug dealers.

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