The Laffer Curve is a theory that describes the tradeoff between tax cuts and tax revenues.
Tax cuts have an arithmetic effect on government revenue and spending. They have an economic effect on long-term revenue and economic growth. The total impact depends on the tax rate before the cut, among other considerations.
What Is the Laffer Curve?
The Laffer Curve is an economic theory that describes the potential impacts of tax cuts on government spending, revenue, and long-term growth.
Economist Arthur Laffer developed it in 1974. He argued that tax cuts have two effects on the federal budget: arithmetic and economic.
The arithmetic effect is immediate and on a 1-for-1 basis. Every dollar in tax cuts translates directly to one less dollar in government revenue. It also decreases the stimulative effect of government spending by exactly one dollar.
The Laffer Curve describes how changes in tax rates affect government revenues in two ways.
The economic effect is longer-term and has a multiplier effect. Its impact may be more or less than the tax dollar cut.
A tax cut puts money into the hands of taxpayers, who then spend it. The increase in demand creates more business activity. For this, companies hire more workers, who then spend their additional income.
A cut in a high tax rate may stimulate the economy by more than a dollar. The same cut to a low tax rate may stimulate less than a dollar.
A tax cut's impact on the economy also depends on four other components:
- The time period being considered
- How easy it is to switch to an underground economy
- The availability of tax loopholes
- The economy's productivity level
Any of these factors can prevent tax cuts from stimulating economic growth. If all these circumstances lined up right, the tax cut could generate enough economic growth to generate a larger tax base. Eventually, it could replace any revenue lost from the tax cut.
Laffer Curve Chart
The Laffer Curve chart shows how, at the bottom of the curve, zero taxes results in no government income and, thus, no government.
Of course, increasing taxes from zero boosts government revenue right away. In the beginning, raising taxes still does a good job of increasing total revenue, as shown by the flatness of the curve. As the government keeps raising taxes, the payoff in additional revenue becomes less, causing the curve to steepen.
At some point, higher taxes place a heavy burden on economic growth.
The high tax burden takes money out of consumers' pockets. Demand falls so much that the long-term decline in the tax base more than offsets the immediate increase in tax revenue. That's where the curve boomerangs backward. This is the shaded section on the chart, which Laffer calls the "Prohibitive Range." Beyond this point, additional taxes result in reduced government revenue.
At the top of the curve, when tax rates are 100%, government revenue is zero. If the government takes all personal income and business profit, then no one works or produces goods. This results in the disappearance of the tax base.
Laffer Curve Debunked
What's missing from the chart? Numbers! In other words, the actual tax rates and the percentage increase in revenue generated are the missing factors. If Laffer had put numbers on the diagram, the government could say, "Hmm, let's increase the tax rate from 24% to 25% to get a 2% increase in the tax base."
If you look at the chart, it appears that the "Prohibitive Range" starts at about a 50% tax rate. If that were the case, then the chart would no longer be relevant today. Why? The federal government hasn't taxed anyone at 50% or higher since 1986.
Tax Cuts Work Best in the Prohibitive Range
Tax cuts work in the "Prohibitive Range" because the economic effect outweighs the arithmetic effect. It increases consumer spending and demand. It encourages business growth and hiring. This results in increased government revenues in the long-run.
Laffer mentions another benefit of a faster-growing economy. It helps reduce government spending on unemployment benefits and other social welfare programs.
In fact, tax cuts during a recession or a period of slow growth harm the economy. During recessions, government-funded unemployment benefits, social welfare programs, and jobs boost the economy enough to keep it from going into a depression. If revenues are curtailed even further with tax cuts, demand drops and businesses suffer from too few customers.
To Work, Tax Cuts Must Lead to More U.S. Jobs
The Laffer Curve assumes that companies will respond to increased revenue from tax cuts by creating jobs. Economic research shows this hasn't been true since 2000.
The 2001 and 2003 Bush tax cuts didn't offset their costs with increased job creation. The top 1% of households gained an after-tax income increase of 6.7%, while those in the lowest fifth made gains of just 1%.
Research shows no evidence that tax cuts have any impact on the spending habits of upper-income taxpayers. The Bush tax cuts only increased growth enough to make up 10% of their long-run cost. Maintaining the cuts has been estimated to cost $4.6 trillion from 2012 to 2021.
The 2017 Tax Cuts and Jobs Act lowered the top individual tax rate from 39.6% to 37%. It cut the corporate tax rate from a maximum rate of 35% to a flat rate of 21%. The Act is estimated to increase the deficit by $1 trillion to $2 trillion from 2018 to 2025. It was projected to increase growth by 0.7% annually.
Instead of spending extra income from tax cuts, high-income households saved or invested it.
Businesses sent it out to stockholders as dividends, repurchased their stocks, or invested overseas. None of those activities created the U.S. jobs needed to give the economic boost Laffer described.
Impact of Monetary Policy
Another consideration is monetary policy. During a recession, the Federal Reserve uses expansionary monetary policy. Often, lower interest rates are the real stimulator of the economy. For example, some say the Bush tax cuts worked because the economy improved. At the same time, the Federal Open Market Committee lowered the fed funds rate from 6% in January 2001 to a low of 1% by June 2003.
Dr. Laffer admits that "The Laffer Curve itself does not say whether a tax cut will raise or lower revenues." Instead, it shows that if taxes are already low, then further cuts reduce revenues without boosting growth. Politicians who claim tax cuts always raise revenues in the long-term misinterpret the Laffer Curve.