Laffer curve: history and criticism

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What is the Laffer Curve?

The Laffer curve is based on a theory by supply-side economist Arthur Laffer. Created in 1974, it visually shows the relationship between tax rates and the amount of tax revenue collected by governments.

The curve is often used to illustrate the argument that reducing tax rates can lead to an increase in total tax revenue.

Key points to remember

  • American economist Arthur Laffer developed an analysis of the bell curve in 1974 known as the Laffer curve.
  • The Laffer curve shows the relationship between tax rates and total tax revenue.
  • The Laffer curve was used as the basis for tax cuts in the 1980s under the Reagan administration.
  • Critics argue that the Laffer curve is too simplistic and uses a single tax rate.

Understanding the Laffer Curve

American economist Arthur Laffer developed a bell curve analysis that plotted the relationship between changes in the government tax rate and tax revenue, known as the Laffer curve. This suggests that taxes might be too low or too high to produce maximum income and that an income tax rate of 0% and an income tax rate of 100% generate $0 in revenue.

Arthur Laffer has argued that tax cuts have two effects on the federal budget, both arithmetic and economic.

Arithmetic

The arithmetic effect is immediate and each dollar of tax reduction translates directly into one dollar less in public revenue and reduces the stimulating effect of public spending by exactly one dollar.

Economic

The economic effect is longer term and has a multiplier effect. Since a tax cut increases taxpayers’ income, they will spend it. The increase in demand creates more business activity, stimulating an increase in production and employment.

Draw the curve

Image by Julie Bang © Investopedia 2019

Tax revenue reaches an optimal point, represented by T* on the graph.

To the left of T*, an increase in the tax rate generates more revenue than is lost to compensate for the behavior of workers and investors. However, increasing rates beyond T* results in people not working as much or at all, reducing total tax revenue.

If the current tax rate is to the right of T*, lowering the tax rate will stimulate economic growth by increasing incentives to work and invest and increasing government revenue.

History of the Laffer Curve

Arthur Laffer presented his ideas in 1974 to members of President Gerald Ford’s administration staff. At the time, most believed that an increase in tax rates would increase tax revenue.

Laffer countered that the more money a company receives in the form of taxes, the less it will be willing to invest and a company will find ways to protect its capital from taxation or relocate some or all of its operations offshore. . When workers see more of their paychecks taken for tax, they lose the incentive to work harder.

Laffer argued that this means less total income as tax rates rise and that the economic effects of reducing incentives to work and invest by raising tax rates would harm an economy.

Laffer’s discoveries influenced President Ronald Reagan’s economic policy known as Reaganomics, based on supply-side and spillover economics, resulting in one of the largest tax cuts in history. During his tenure, current annual federal tax revenues rose from $344 billion in 1980 to $550 billion in 1988, and the economy boomed.

reagonomic

In economic policy under President Reagan, marginal tax rates have fallen, tax revenues have increased, inflation has fallen, and the unemployment rate has fallen.

Criticisms of the Laffer Curve

The single tax rate. The tax system is complex and increasing the rate of one tax can impact or negate the advantages or disadvantages of reducing another. The Laffer curve oversimplifies the relationship between taxes by assigning a single simplistic tax rate.

The T* or ideal tax rate changes. The Laffer curve sets the ideal tax rate between 0 and 100. However, this rate can change due to economic circumstances.

Tax cuts needed for the wealthy. The Laffer Curve assumes an exact T* to maximize government revenue and requires tax cuts for the wealthy.

Personal and business assumptions. The Laffer curve assumes that higher taxes lead to lower incomes because businesses can leave and employees will work fewer hours. However, employees may work harder or longer to advance in their careers. Businesses do not rely solely on the tax rate to make decisions, but also seek skilled labor and infrastructure, both of which compensate for an increase in the tax rate.

What can prevent tax cuts from stimulating economic growth?

Tax cuts and their effects on the economy depend on the timing of growth, the availability of an underground economy, the availability of tax loopholes, and the level of productivity in the economy.

What is the trickle down economy?

Arthur Laffer’s idea that tax cuts could boost growth and tax revenue was quickly dubbed a “trickle down”. President Herbert Hoover’s stimulus efforts during the Great Depression and President Ronald Reagan’s use of income tax cuts have been described as “spillovers”, where tax breaks and benefits for businesses and rich will trickle down to individuals and stimulate the economy.

What is the Laffer curve missing?

Actual numbers are missing from the curve, so suggested actual tax rates and the percentage increase in revenue generated are missing, leaving policymakers guessing which rates work and supporting Laffer’s theory.

The essential

The Laffer curve shows the relationship between tax rates and the tax revenue collected by governments and is often used to illustrate the argument that reducing tax rates can lead to an increase in total tax revenue. Arthur Laffer claimed that tax cuts have arithmetic and economic effects on the federal budget, however, the curve assumes both a single tax rate and the behavior of businesses and individuals.

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