What Is the Laffer Curve? Explanation

Why Tax Cuts No Longer Work

Laffer Curve
Laffer Curve. (Source: Arthur Laffer)

Definition: The Laffer Curve is the theory that says lower tax rates boost economic growth. It underpins supply-side economics, Reaganomics, and the Tea Party economic policies. Economist Arthur Laffer developed it in 1979.

The Laffer curve describes how changes in tax rates affect government revenues in two ways. One is immediate, which Laffer describes as "arithmetic." Every dollar in tax cuts translates directly to one less dollar in government revenue.

 The other effect is longer-term, which Laffer describes as the "economic" effect. It works in the opposite direction. Lower tax rates put money into the hands of taxpayers, who then spend it. That creates more business activity to meet consumer demand. Then, companies hire more workers, who spend their additional income. This boost to economic growth generates a larger tax base. That eventually replaces any revenue lost from the tax cut.

Laffer Curve Explained

The 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 immediately boosts government revenue. 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, and the curve steepens.

At some point, higher taxes create a heavy burden on economic growth.

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. It's 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%, then government revenue is zero. If the government takes all personal income and business profit, then no one works or produces goods, so the tax base disappears.

If Only Life Were as Simple the Laffer Curve

What's missing from the chart? Numbers! In other words, the actual tax rates and the percent increase revenue generated. If Laffer had put numbers on the diagram, the government could say, "Hmm, let's increase the tax rate from 24 percent to 25 percent to get a 2 percent increase in the tax base." If you look at that chart, it appears that the "Prohibitive Range" starts at about a 50 percent tax rate. But if that were the case, the chart would be useless today. Why? The federal government hasn't taxed anyone at 50 percent (or higher) since 1986. (Source: "Historical Tax Rates," Tax Foundation.)

Laffer avoided being more specific. Whether tax cuts stimulate the economy (where you are on the curve) depends on six factors:

  1. The type of tax system in place.
  2. How fast the economy is growing.
  3. How high taxes are already.
  4. Tax loopholes.
  5. The ease of entry into non-taxable, underground activities.
  6. The economy's productivity level.

Any one of these factors can prevent tax cuts from stimulating economic growth.

Tax Cuts Only Work in the Prohibitive Range

Tax cuts work in the "Prohibitive Range" by increasing consumer spending and demand. That encourages business growth and hiring. It results in increased government revenues in the long-run. That's because the economic effect of the tax cut outweighs the arithmetic effect of the tax cut. Laffer mentions another benefit of a faster-growing economy. It reduces government spending on unemployment benefits and other social welfare programs.

But lowering taxes outside of the "Prohibitive Range" does not stimulate the economy enough to offset reduced revenues. 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 Jobs

The Laffer Curve also assumes that companies will respond to increased revenue from tax cuts by creating jobs. Several other factors have emerged since the 2008 financial crisis that reveal this isn't always true. Businesses haven't used money from the Bush tax cuts and the TARP bailouts to create jobs. Instead, they saved it, 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.

Also, the economy has become more capital- and technology-intensive, and less labor intensive. Businesses are more likely to use tax cuts to buy computers and other labor-saving equipment than to hire new workers.

Conclusion

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 say tax cuts always raise revenues in the long-term misinterpret the Laffer Curve.

For example, President Bush cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). The economy grew, and revenues increased. Supply-siders, including the President, said that was because of the tax cuts. Other economists point to lower interest rates as the real stimulator of the economy. The FOMC lowered the Fed Funds rate from 6 percent at the beginning of 2001 to a low of 1 percent by June 2003. (Source: "Historical Fed Funds Rate," New York Federal Reserve.)