How the Ideal Tax Rate Is Determined: The Laffer Curve

Reviewed by Lea D. UraduFact checked by Yarilet Perez

When it comes to the government and taxes, it often feels like too much is never enough. You might be surprised to learn that there is actually a measure that governments use to determine just how much they can squeeze from your wallet.

The Laffer curve, a mound-shaped indicator, was designed to find the ‘ideal’ tax rate that would help the government, as well as the people it serves, prosper. The idea is credited to economist Dr. Arthur Laffer, although Laffer himself notes that Muslim philosopher Ibn Khaldun wrote about it in “The Muqaddimah,” a 14th-century text.

Economist John Maynard Keynes also wrote about it in his economic works. This article will provide an overview of this economic concept and its impact on what part of your check you have to give up each month.

Key Takeaways

• The Laffer Curve is a tax theory suggesting an inverted U-shaped relationship between tax rates and the amount of tax revenue collected by governments.
• The ideal, or optimal, rate of taxation for an economy is the one that falls right at the top of the inverted U.
• The theory argues if tax rates are too high they will discourage taxed activities, like consumption and investment, while rates that are too low fail to generate sufficient revenue.
• The Laffer curve and other theories of taxation are hotly debated topics among policymakers and have a profound impact on the wealth of the working population.

The Logic of the Laffer Curve

The logic of the Laffer curve can be most easily seen at the extreme ends of the taxation spectrum. If the tax rate is 0%, the government will earn no revenue. If the taxation rate is 100%, the government will be the recipient of all revenue generated by the economy, and will thereby maximize its own revenue.

At first glance, this appears to be a rather intuitive state of affairs, but, like most things taxation-related, the Laffer curve is not without its complications.

The rather simplistic idea that 100% taxation would maximize government revenue runs into the economic reality that practically nobody would be willing to work if all of their hard-earned money went directly to the government.

At the other end of the spectrum, a tax rate of 0% would not generate enough revenue to perpetuate the existence of government and to support government projects, such as defense and infrastructure development, as well as the salaries of public officials.

In light of the economic reality that neither a 0% tax rate nor a 100% tax rate would maximize government revenues, Arthur Laffer and his predecessors postulated that the ideal tax rate lies somewhere between the two extremes.

The Basis of Tax Theory

Arithmetic Effect

Underlying this theory is the idea that tax rate changes have two effects on government revenues. The first effect is strictly mathematical: an x% decrease/increase in the tax rate will result in a corresponding x% decrease/increase in tax revenues. Laffer refers to this as the arithmetic effect.

Again, this seems logical enough at face value but is actually more complex when the second effect comes into play.

Economic Effect

This second effect, which Laffer refers to as the economic effect, recognizes that tax revenues increase/decrease in the exact opposite direction of the change in tax rates. In other words, this effect contributes to how raising taxes decreases revenue and lowering taxes increases revenue.

According to this logic, higher taxes discourage business activity and drive down tax revenues. For example, at a certain point, high taxes encourage the creation of tax shelters and encourage business activity that generates paper losses from depreciable assets rather than business activity that creates jobs and generates revenue.

Money spent on plush office suites, the purchase of private jets, and the leasing of luxury cars becomes more advantageous—because of its ability to lower marginal tax rates—than business activity designed to generate a profit. In this case, businesses may tend to choose to be less productive in order to be more profitable.

Conversely, lower taxes encourage business investment, and high after-tax income provides a greater incentive for employees to work more. This increased economic productivity results in an increase in tax revenues, despite the lower rate of taxation. Because the economic effect and the arithmetic effect move in opposite directions, the bottom-line implications of any given tax increase or decrease are not easy to predict with exact certainty.

Limitations and Flaws of the Laffer Curve

Despite its influence, the Laffer curve is not without its flaws. One key critique lies in the assumption of a single peak (as shown in the picture earlier in the article). This suggests a uniform response to tax changes across all economic actors.

In reality, the relationship between tax rates and revenue is nuanced and based on so many factors that may cause multiple “ideal” or peak points based on various combinations.

The Laffer curve is also a fairly static form of analysis, meaning it does not consider how individuals and businesses adapt their behavior. It assumes one set of variables (which may include change), but the model tends to focus more on aggregated revenue without accounting for the uneven or nuanced differences between various industries.

Last, the Laffer curve’s concentration on monetary outcomes disregards non-monetary factors. This can be vitally important, as there are real-world implications to consider. The model tends to neglect broader societal objectives such as concerns related to social equity and environmental sustainability.

Though the model is meant to analyze the financial implications, there are often many non-financial considerations to be made (each of which may or may not come with future costs of their own).

Note

The Congressional Budget Office is especially interested in tax revenue, and the agency often puts forth forecasts or scenario analyses to discuss alternatives.

The Ideal Tax Rate and the Politics of the Debate

Determining the tax rate at which productivity and revenues are both maximized is the subject of great political debate, as the Laffer curve does not provide a clear numerical answer to the taxation question; it merely suggests that such a hypothetical rate does exist.

In the world of politics, it all comes down to theories of how to manage the economy. The Laffer curve is an idea closely aligned with supply-side economics and the tax-cutting policies of former President Ronald Reagan—often referred to as Reaganomics.

The Argument

Sound bites from the competing sides of the debate have characterized their opponents as either ‘trickle-down‘ Republicans or ‘tax-and-spend’ Democrats. The Republicans’ stance is that since rich capitalists create jobs for others, they should be given free rein to manage their businesses with a minimum of government interference.

The benefits of increased productivity, goes the thinking, will then flow down the income ladder. The gains from tax breaks will allow the rich capitalists to provide more jobs for the rest of the population. According to this view, additional tax revenue is generated because the government can tax the now-higher incomes of those individuals.

The Democrats’ counterarguments state that governmental redistribution of society’s wealth via taxation is a vehicle for taking from the rich and giving to the rest. They view the Republican idea as giving the majority of the benefits to the rich and letting the remnants trickle down to others.

The Evidence

Both sides of the debate cite an extensive array of statistics, often referring to the very same events and studies. Neither side agrees with the statistics provided by the other, but both groups generally agree that the Laffer curve is legitimate. Supporters of supply-side economics argue that the economy is always positioned on the Laffer curve in a manner such that tax cuts increase revenue, whereas their counterparts argue the reverse.

For example, to support their argument that tax cuts jump-start the economy, supply-siders, including Laffer himself, cite statistics from the three major tax-cut proposals implemented in the United States over the past 10 decades. Laffer notes that the Harding-Coolidge cuts in the 1920s, the Kennedy cuts in the 1960s, and the Reagan cuts in the 1980s were “remarkably successful, as measured by virtually any public policy metric.”

On the demand side, democrats cite the differences between the economy under Bill Clinton versus the economy under Ronald Reagan and George Bush. They describe Clinton as having raised taxes on the wealthy, but also as having created jobs, implemented budget surpluses, and presided over years of prosperity.

What Is Tax Elasticity in the Context of the Laffer Curve?

Tax elasticity refers to how sensitive tax revenue is to changes in tax rates. If a tax is inelastic, this means that changes in rates have a minimal impact on behavior. This also means the Laffer curve may be steeper because revenue isn’t as responsive to changes in tax rates. Conversely, if a tax is elastic, the opposite is true. Small changes in rates can have significant effects on economic activity, and the Laffer curve will be less steep.

How Does Economic Growth Factor into the Laffer Curve Analysis?

Economic growth is central to Laffer curve analysis. A growing economy can withstand higher taxes without triggering negative effects, potentially shifting the curve to the right. On the other hand, in a stagnant economy, tax increases might have a more immediate impact on reducing economic activity.

How Do Behavioral Responses Like Tax Evasion Fit into the Laffer Curve Framework?

High tax rates may incentivize individuals and businesses to engage in tax avoidance strategies, potentially reducing actual revenue collected. This underscores the importance of considering broader economic behaviors and responses when analyzing tax policies, as it’s common that there are external implications that respond to the changes made beyond tax rates and revenue.

The Bottom Line

When the dust settles, supply-side economists still favor tax cuts of all types, using the Laffer curve to support their arguments. Demand-side economists rarely favor across-the-board tax cuts, instead choosing tax plans that favor lower-income workers over those classified as wealthy. Both sides of the debate continue to look at the exact same scenarios and arrive at wildly different conclusions.

So, where does this leave the American economy? What comes immediately to mind is a remark often attributed to Benjamin Disraeli, a British Conservative statesman and literary figure: “There are three kinds of lies: lies, damned lies, and statistics.”

With each side of the debate arguing the correctness of its views, the country’s economic direction is largely a matter of which political party is in control at any given moment. Neither side has found the ‘ideal’ tax rate, but both sides are still looking, acknowledging that the Laffer curve may be the closest we can get to it.

Read the original article on Investopedia.