The Laffer Curve is a theory by American economist Arthur Laffer which predicts the relationship between the tax rate and the tax revenue of a given government. In general, it predicts that an increase in the tax rate will not necessarily result in an increase in tax revenue because if taxes are too high, workers will simply stop working to their full potential productivity level, and, as their wages fall, they will pay less taxes to the central government. The Laffer Curve is a popular tool used to denounce progressive tax schemes, although in practice it too suffers from a very vague notion of the “peak” point beyond which higher taxes result in reduced income.
The Curve is named after Arthur Laffer, but Laffer himself claims he was simply inspired to present the simple tool based on the work of much earlier economists, and even medieval Muslim philosophers. The name “Laffer Curve” itself comes from Jude Wanniski, who claims to have been present at a meeting in the 1970s when Laffer sketched his curve on the back of a napkin to better explain a point to two then-mid-level Nixon administration officials, Donald Rumsfeld and Richard “Dick” Cheney. Laffer went on to become an influential economic consultant to the Reagan White House, and Rumsfeld and Cheney became important senior officials for both the George H.W. Bush (1989-1992) and the George W. Bush (2001-2008) admininistrations.
Essentially, the Laffer Curve explains the relationship between two competing forces on workers’ decisions to sell their labour to employers. (Economic theory rests on the assumption of buy-sell transactions, and while employees rarely think of themselves as “selling” work-hours to their employers the way independent contractors do, from the perspective of economic theory that is precisely what they are doing.) The first force is a simple mathematical one: as the tax rate increases, a higher percentage of workers’ wages is ceased by the government and therefore a higher revenue is taken in. The second force, however, works in reverse: as taxes increase, workers decide to work less. This reduces their wages, and therefore reduces the revenue the government takes in.
These two forces interact, so that one can chart a curve (an upside-down circle, in this case) on a graph of government revenue versus tax rate. At both 0% and 100% tax rates, government takes in no income: in the first instance because people work but it collects no tax from them, and in the second because taxes are so high that nobody works. As tax rates rise from 0%, revenue increases until a “peak” point at which the rising reaction to high taxes takes control. From there, government revenues fall with rising tax rates, until eventually government revenues drop to zero.
The Laffer Curve is particularly attractive to those who believe tax rates in our society are unacceptably high, because it offers a seeming panacea: cut taxes (pleasing taxpayers in general, and the wealthy and conservatives in particular), yet achieve higher government revenues anyways (pleasing liberals who want to see expanded government programs). This is typically how the Laffer Curve is sold or applied in most countries.
At the same time, there is a serious problem with the Laffer Curve which seriously limits its usefulness for serious policymakers: Laffer was never able to clearly define the peak point at which government revenue starts to fall with rising taxes. For this reason, it is impossible to know until after a tax adjustment has actually occurred whether the country is to the left of the peak, and therefore a tax increase will mean higher taxes (and a tax cut mean lower taxes), or whether the country really is to the right of the peak, and therefore a tax increase will mean lower taxes (and a tax cut mean higher taxes). In the postwar past, the highest tax brackets paid far more than they do today (as high as 90%) and, despite much grumbling and griping, Western countries still achieved major economic progress. Some critics note that people would probably still work (albeit much less efficiently) even in a 100%-tax situation, on the assumption that the taxes collected would be used to provide needed goods and services.