Explaining the Laffer Curve Theory

The Laffer Curve, although popularized and named for Arthur Laffer, is a very old (and somewhat obvious) concept in economics. It dictates, essentially, that at a tax rate of zero the government will earn no revenue, and at a tax rate of 100% the government will earn no money. At some point in the middle, it argues, there is an optimal tax rate.

The economic basis for the theory is simple: Tax Rate * Total Economic Activity = Revenue for Government. If the tax rate is zero, then the Revenue for Government must be zero. At a 100% tax rate, the incentive to engage in economic activity drops off precipitously, so Total Economic Activity becomes zero, dragging down Revenue for Government with it.

The Curve found its way into popular use when the Reagan Administration used it to argue in favor of Supply-Side Economics – the argument being that the government was not at the optimal point on the curve. The logic goes like this: at high rates of taxation (specifically, those present when Reagan came into office) economic growth was impaired due to a lacking incentive to invest and work. At lower rates of taxation, the government would initially lose money, but economic growth would later accelerate and more than make up for the lost revenue. Also, the Supply-Side Economists argued that greater economic growth would lead to the population being wealthier, and requiring fewer government services, thereby helping to pay for the previous tax cuts.

The dispute with regards to the Curve is not so much over whether it is accurate, but where the optimal rate of taxation is along the curve. A fairly simple calculation (unfortunately, too simple a calculation – it fails do to its excessive simplicity) would go like this:

T1  is the current tax rate, and T2 is the future tax rate (after a tax hike or cut). I1  is the businessman’s percentage return on an investment, and I2 is his future return on investment (after a tax hike or cut). 100-T1=I1 and 100-T2=I2

From this, one can fairly quickly derive the effect of any particular tax rate on the government’s revenue, and the businessman’s incentive to invest:

(T2-T1)/T1= Percentage change in taxes
(I2-I1)/I1= Percentage change in return on investment (i.e. percentage change in a businessman’s incentive to invest).
Because there is a relationship between T2 and I2, we can quickly use calculus to determine the point at which tax revenue is highest: when government taxes account for 50% of GDP.