The "Laffer Curve," developed in 1974, was given its name by a writer for the Wall Street Journal to honor Arthur Laffer, an economist who served on Ronald Reagan's Economic Policy Advisory Board. Originally developed to counter arguments against tax increases being considered by Gerald Ford to reduce the federal deficit. The concept was not at all new. Laffer readily admits that he learned of the concept from reading works of other economists, including Keynes.
The "Laffer Curve,” theoretically, shows the relative relationship between an income tax rate and potential government revenue. As the tax rate increases, along the horizontal axis, government revenue increases and eventually reaches a point of no return.
The curve incorporates these simple principles:
1) A zero tax rate results in zero government revenue.
2) Likewise, a 100% tax rate will also result in zero government revenue,
3) When the tax rate begins to increase, there is a similar increase in government revenue,
4) When the tax rate continues to increase, government revenue increases, but at a decreasing rate,
5) At some point, the curve will peak and turn back toward the horizontal axis and revenue will be reduced.
I have always been enamored with the “Laffer Curve” because it is theoretically correct, but somewhat impossible to quantify the point at which government revenue will go down as various tax rates go up because of the many economic variables. As a result, it is used more as a hypothetical tool rather than a forecasting tool. Change one of the variables and you have an entirely different curve. However, the beginning and end-points of the many possible curves will always be the same. No one could challenge that a zero tax rate would produce zero government revenue, while a 100% tax rate would also produce the same result. Therefore, maximizing government revenue at the highest possible tax rate becomes a matter of trial and error. Unfortunately, the accuracy of the tax rate will only be realized after-the-fact and even then only theoretically. The question that remains is at what tax rate does the government realize the maximum amount of revenue. What makes the curve’s predictability impossible is that the curve’s specific numbers would vary for different income brackets and would not be the same for Personal Income Tax, Corporate Income Tax or for the Capital Gains Tax. The curve would differ for a person making $40,000 per year and a person making $1,000,000 per year, Tax a millionaire at 50% and he might stay in the game. Tax a person earning $40,000 a year at 50% and he’s heading to the welfare office. Although the curve’s beginning and end-points would be exactly the same, the area between the slope and the point of diminishing returns will vary in each case. In addition, the economic conditions, at any point in time, introduces variables such as the basic economic growth rate, banking regulations and practices, loan interest rates, employment rates, consumer confidence, inflation rates and others, which significantly contribute to the shape of the curve regarding the area of the curve on either side of the median. Therefore, no single "Laffer Curve" can be applied at any given time without taking into consideration these conditions. Even then, several curves would probably be appropriate, mimicking our current graduated tax rates, however, the curve could be applied by implementing a simplified graduated flat tax for two or three income brackets and theoretically applying the curve’s principles.
Many politicians have sought to discredit the concept because in determining appropriate tax rates, their ideology elevates the consideration of "economic fairness" above that of an objective cost-benefit analysis. Conversely, other politicians have sought to exploit the curve without concern for the accuracy involved because when it comes to establishing appropriate tax rates, the principle that prevails is that of “limited government,” rather than maximizing government revenue. Peel away the political rhetoric and the principles of the curve prevail. While the curve does not highlight the impact of higher taxes on the economy, we can assume that higher government taxes means less that people will have to spend. Further, it does not matter whether it is an across the board tax or a tax on the rich only, because more taxes means less spending in any class! Although it is not an obvious observation by looking at the curve, it does imply that when taxes go up, discretionary spending goes down. Spending fuels the economy and provides jobs and worker incentives. As taxes increase there is less money being spent by workers and less investment being made by businesses and the wealthy. The challenge, then, is for congress to establish a tax rate that not only stimulates an increase in the Gross Domestic Product, but also stimulates investors to create new productive industries. Easier said than done, but our tax history can play a huge part in determining where on the curve we should be, taking into consideration those variables mentioned earlier. If our goal is to achieve maximum government revenue, it might, at first, appear that the ideal scenario would be to increase taxes to the maximum. However, a more careful examination would indicate otherwise, because in that scenario it is assumed that all workers would continue to be employed and taxable. This would be a critically bad assumption for the private sector because business will do everything possible to maintain profits, which means a reduction in their largest expense: labor costs. On the curve's ascent side, where tax rates are lower than the point at which revenues peak, the downside risk is for inadequate revenue to the government, which will affect many welfare programs. On the curve's descent, where tax rates are higher than the point where revenues peak, the downside risk is not only for inadequate government revenue, but also for reduced private investment, limited entrepreneurial and corporate investment, a decreased workforce and increased corporate outsourcing.
I believe common sense dictates that we stay on the ascent, or left side of the peak. Once we cross over the peak, the problems become much more numerous. We can conclude that the ideal tax rate is one, which generates government revenue relatively high up on the ascent side of the curve, without ever reaching the peak where government revenues would flatten and begin to decline.
