Laffer Curve Explanation
Why Tax Cuts No Longer Work
The Laffer Curve is a theory that states lower tax rates boost economic growth. It underpins supply-side economics, Reaganomics and the Tea Party’s economic policies. Economist Arthur Laffer developed it in 1979.
The Laffer Curve describes how changes in tax rates affect government revenues in two ways. One is immediate, which Laffer describes as "arithmetic." Every dollar in tax cuts translates directly to one less dollar in government revenue.
The other effect is longer-term, which Laffer describes as the "economic" effect. It works in the opposite direction. Lower tax rates put money into the hands of taxpayers, who then spend it. It creates more business activity to meet consumer demand. For this, companies hire more workers, who then spend their additional income. This boost to economic growth generates a larger tax base. It eventually replaces any revenue lost from the tax cut.
Laffer Curve Explained
The chart shows how, at the bottom of the curve, zero taxes results in no government income and, thus, no government. Of course, increasing taxes from zero boosts government revenue right away. In the beginning, raising taxes still does a good job of increasing total revenue, as shown by the flatness of the curve. As the government keeps raising taxes, the payoff in additional revenue becomes less, causing the curve to steepen.
At some point, higher taxes place a heavy burden on economic growth. Demand falls so much that the long-term decline in the tax base more than offsets the immediate increase in tax revenue. That's where the curve boomerangs backward. This is the shaded section on the chart, which Laffer calls the "Prohibitive Range." Beyond this point, additional taxes result in reduced government revenue.
At the top of the curve, when tax rates are 100 percent, government revenue is zero. If the government takes all personal income and business profit, then no one works or produces goods. This results in the disappearance of the tax base.
If Only Life Were as Simple the Laffer Curve
What's missing from the chart? Numbers! In other words, the actual tax rates and the percent increase in revenue generated. If Laffer had put numbers on the diagram, the government could say, "Hmm, let's increase the tax rate from 24 percent to 25 percent to get a 2 percent increase in the tax base." If you look at the chart, it appears that the "Prohibitive Range" starts at about a 50 percent tax rate. If that were the case, then the chart would be useless today. Why? The federal government hasn't taxed anyone at 50 percent (or higher) since 1986. (Source: "Historical Tax Rates," Tax Foundation.)
Laffer avoided being specific. Whether tax cuts stimulate the economy (where you are on the curve) depends on six factors:
1. The type of tax system in place.
2. How fast the economy is growing.
3. How high taxes are already.
4. Tax loopholes.
5. The ease of entry into non-taxable, underground activities.
6. The economy's productivity level.
Any one of these factors can prevent tax cuts from stimulating economic growth.
Tax Cuts Only Work in the Prohibitive Range
Tax cuts work in the "Prohibitive Range" by increasing consumer spending and demand. It encourages business growth and hiring. This results in increased government revenues in the long-run. That's because the economic effect of the tax cut outweighs the arithmetic effect. Laffer mentions another benefit of a faster-growing economy. It helps reduce government spending on unemployment benefits and other social welfare programs.
Lowering taxes outside of the "Prohibitive Range" though does not stimulate the economy enough to offset reduced revenues. In fact, tax cuts during a recession or a period of slow growth harm the economy. During recessions, government-funded unemployment benefits, social welfare programs and jobs boost the economy enough to keep it from going into a depression.
If revenues are curtailed even further with tax cuts, demand drops and businesses suffer from too few customers.
To Work, Tax Cuts Must Lead to More Jobs
The Laffer Curve assumes that companies will respond to increased revenue from tax cuts by creating jobs. Several other factors have emerged since the 2008 financial crisis, which revealed this isn't always true. Businesses didn’t use money from the Bush tax cuts and the TARP bailouts to create jobs. Instead, they saved it, sent it out to stockholders as dividends, repurchased their stocks or invested overseas. None of those activities created the U.S. jobs needed to give the economic boost Laffer described.
Also, the economy has become more capital- and technology-intensive and less labor intensive. So, businesses are more disposed to use tax cuts to buy computers and other labor-saving equipment than to hire new workers.
Dr. Laffer admits that "The Laffer Curve itself does not say whether a tax cut will raise or lower revenues." Instead, it shows that if taxes are already low, then further cuts reduce revenues without boosting growth. Politicians who claim tax cuts always raise revenues in the long-term misinterpret the Laffer Curve.
For example, President Bush cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). The economy grew, and revenues increased. Supply-siders, including the president, said that it was because of the tax cuts. Other economists point to lower interest rates as the real stimulator of the economy. The FOMC lowered the Fed Funds rate from 6 percent at the beginning of 2001 to a low of 1 percent by June 2003. (Source: "Historical Fed Funds Rate," New York Federal Reserve.)