The Laffer Curve is a theory which describes the relationship between the level of taxation, on the one hand, and the total amount of actual tax revenue, on the other. In particular, the theory states that tax increases will only result in increased government revenue up to a certain (unspecified) point, after which a tax increase will actually reduce overall revenue because overtaxed citizens simply reduce their taxable work, or stop working altogether. Placed on a graph, the theory produces a curve at which no tax is produced at 0% taxation, revenue rises with tax rates until a certain high point, and then declines again, reaching zero revenue again at 100% taxation.
The Laffer Curve is named after American economist Arthur Laffer, who was an influential economic advisor to the Reagan administration. However, Laffer himself never claimed to have invented the curve, instead attributing it to the work of earlier economists like John Maynard Keynes. The term “Laffer Curve” instead comes from a reporter who was present at a meeting in 1974, when Laffer sketched out the curve (supposedly on a napkin) during a discussion with Nixon administration officials Donald Rumsfeld and Dick Cheney (who later occupied influential positions in the Bush administration).
The Laffer Curve emerges from economic theories about the interaction between supply and demand, and the effects taxes have on supply and demand. Taxes have the effect of raising the price from the perspective of the purchaser without raising the price (and thus the potential profit) on behalf of the seller. Typically, we speak of the law of supply and demand with respect to goods and services which are purchased in the market by consumers. However, labour and employment can also be understood as a supply-and-demand relationship, in which employees and workers “sell” their labour to a “purchaser,” the employer.
Income tax affects the employer-employee relationship, then, in a way analogous to the way sales taxes affect the marketplace. From an employee’s perspective, income tax must be subtracted from the gross or total income, so that the real wage or salary is actually noticeably lower than the amount paid by the employer. (For instance, if an employer pays her employee $20 per hour but that employee than pays a 25% income tax, in reality the employee is only earning $15 per hour.) To producers, if taxes are so high that they can only make a profit off their goods by raising prices so high no one will buy them, the only response is to scale back production or stop entirely. Similarly, to employees, if income taxes are so high that there is very little real gain from working a few extra hours, then employees won’t work those hours. In fact, they may even scale back their hours, if more family time or alone time starts to look appealing compared to the modest increase in pay from added time at work.
This reaction to taxation lies at the heart of the Laffer Curve theory. The Laffer Curve theory, in essence, is an expression of the interaction between the obvious force behind taxation (a higher tax rate will mean more taxes collected), and the taxpayers’ reactionary response to taxation (a higher tax rate means less work). If the tax rate is 0%, then taxation will obviously have no impact on the economy – and no taxes will be collected. As the government increases its tax rate upwards from zero, taxation begins to increase.
However, each successive increase results in a slightly lower increase in overall revenue, because of the fact that as taxes rise employees will start to respond by reducing their work and thus their income. Initially, this response will be marginal, so that the Laffer Curve (and overall goverment revenue) keeps rising. The increase in taxation may be so minimal that people do not substantially alter their behaviour, or may even work longer hours to make up for lost income.
Eventually, however, the reactionary response to high taxes begins to win out. The Laffer Curve “peaks” at a certain point (the precise point has never been specified), and then, as reactions to high taxes become progressively more severe, government revenue actually falls. At 100% taxation, the Laffer Curve again reaches zero revenue, on the assumption that if all income is seized as taxes, nobody in society will bother working at all.
The basic logic of the Laffer Curve does seem to make sense, although the curve is not without strong critics. Some note that there would probably still be people working even in cases of 100% taxation, on the assumption that governments would then supply all needed goods and services out of the taxes collected. Others point out that, because the Laffer Curve has never been able to specify the peak point beyond which further tax increases result in decreasing revenue, it has no meaningful value for tax policy-makers. This is because, without knowing where the peak point is, a Laffer Curve analyst will be unable to say for certain whether a given tax adjustment will result in increased revenue (because the tax system has not reached the peak yet), or decreased revenue (because the tax system has already passed the peak).