In economics, the Laffer Curve is a graphical representation of the theoretical relationship between the level of taxation and the level of revenue from that taxation. In short, it predicts that as tax levels are increased, tax revenue will increase only to a certain point, after which it will decline because high taxes persuade workers to work fewer hours.
The curve is named after Arthur Laffer, an American economist who was influential within the Reagan administration of the 1980s. According to the journalist who was allegedly present and coined the term, Jude Wanniski, Laffer first sketched the graph on a napkin as part of a casual explanation of economic principles for others present at a White House meeting, including Donald Rumsfeld and Dick Cheney (who went on to hold influential positions in the second Bush administration). Laffer himself claims that he derived the curve from the work of earlier economists, including John Maynard Keynes.
– Economic Theory and Wages –
The Laffer Curve is an extrapolation from one of the most basic principles of economics, the law of supply and demand. Economic theory states that as the price of a good or service falls, fewer people will be willing to produce or provide it. Economists also apply this principle to human labour or employment. In other words, when the price of labour (i.e. wages or salary) is high, more people will be willing to do the job – and, when it is particularly high, to work longer houses doing it. However, at very low prices, fewer people will be willing do the work, and they will be more likely to reduce their hours so that they have time left over for something more fulfilling or rewarding.
Taxation, economists go further, has the effect of altering the effective “price” of a worker’s labour. When taxes are very low, workers will generally behave just as they would with no taxes – barring, of course, some griping about the government’s continual cut of each pay check. However, as taxes increase, then real wages decrease as well. As an example, if an employee earns $20 per hour from his or her company but loses $5 in taxes, then at the end of the day he is effectively only earning $15. If the tax rate is doubled, then the same employee is actually only earning $10. At a low enough tax rate, many people will simply choose not to work at all, or at least to work much less than normal, reasoning that the extra effort on their part simply is not justified by the small amount of take-home pay left over after taxes.
– The Laffer Curve and Economic Theory –
This is where the Laffer Curve comes in. From the government’s perspective, a tax increase equals greater tax revenue, which can then be spent on more government programs. Generally, in democratic countries, the only check on tax increases is that the government must attempt to gain more support from the new government programs than it loses from the tax increase itself.
However, the Laffer Curve warns us that the relationship – more taxes equals more government revenue – is actually not so simple. To a certain point, this is true. However, once taxes grow high enough, people will begin to decide that the reduced take-home pay is less valuable to them than spending more time with family, or simply doing nothing. Once they have made this decision, they will cut back on their work-hours. This will mean reduced income for them, but it will also mean reduced income for the government (which cannot tax the non-existent lost income). In short, beyond a certain point, raising taxes will actually result in a drop in the government budget, because fewer people are producing taxable income.
The Laffer Curve can be placed on a graph measuring government revenue (on the Y-axis) versus tax level (on the X-axis). The general shape of the curve is known: an upside-down parabola, or half-circle. If the government does not levy any taxes (0%), then it will have no revenue ($0). However, the same is said to be true when it has a 100% tax rate, because people simply refuse to work if they will get no money from it (so at 100%, revenue is also $0). Moving forwards from 0% or backwards from 100%, the tax rate rises until it meets somewhere in the middle, at the highest or optimum tax level.
Today economists are not actually certain where this middle “high point” is on the Laffer Curve. It may be somewhere in the 30-40% range, although Scandinavian studies suggest it could be as much as twice as high. This limits its usefulness in driving actual government policy, beyond the realm of extreme ideologues, because it is difficult to tell which side of the high point a given country is on. In short, until after the tax levels are actually adjusted, it will still be difficult to tell whether a raise in the tax rates will result in an increase in revenues, or a decrease in revenues. Logically, however, the high point must exist, even if it is difficult to find.
As with much work in economics, the Laffer Curve was originally based on theoretical logic rather than on empirical data. This is why it is difficult to determine for certain where the high point lies. Moreover, some critics point out that the curve does little to explain the ramifications of contemporary tax systems, which are rarely so simple as a single percentage tax applied to all taxpayers equally, and also that the extremes of the curve may be misleading. (For example, in a society where tax rates were 100%, people would probably still work, with the expectation that the tax revenues would be used to supply all necessary goods and services.) However, despite the difficulty of pinning down any specific point on the Laffer Curve, the general principle is still an important one: very low taxes can be increased without damaging the government’s revenue, while cripplingly high taxes can be lowered without actually harming goernment revenue either.