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The Laffer Curve

The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect and the economic effect. The arithmetic effect is simply that if tax rates are lowered, tax revenues per dollar of tax base will be lowered by the amount of the decrease in the rate. And, the reverse is true for an increase in tax rates. The economic effect, however, recognizes the positive impact that lower tax rates have on work, output, and employment and thereby the tax base by providing incentives to increase these activities. Raising tax rates has the opposite economic effect by penalizing participation in the taxed activities. The arithmetic effect always works in the opposite direction from the economic effect. Therefore, when the economic and the arithmetic effects of tax rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer quite so obvious.

The diagram at right is a graphic illustration of the concept of the Laffer Curve—not the exact levels of taxation corresponding to specific levels of revenues. At a tax rate of 0%, however, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100%, the government would also collect no tax revenues because no one would be willing to work for an after-tax wage of zero—there would be no tax base. Between these two extremes there are two tax rates that will collect the same amount of revenue: A high tax rate on a small tax base and a low tax rate on a large tax base.

Laffer CurveThe Laffer Curve itself doesn’t say whether a tax cut will raise or lower revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of moving into underground activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the proclivities of the productive factors. If the existing tax rate is too high—in the “prohibitive range” shown above—then a tax-rate cut would result in increased tax revenues. The economic effect of the tax cut would outweigh the arithmetic effect of the tax cut.

Moving from total tax revenues to budgets, there is one expenditure effect in addition to the two effects tax-rate changes have on revenues. Because tax cuts create an incentive to increase output, employment and production, tax cuts also help balance the budget by reducing means-tested government expenditures. A faster growing economy means lower unemployment and higher incomes, resulting in reduced unemployment benefits and other social welfare programs.
Over the past 100 years, in the U.S. there have been three major periods of tax-rate cuts: the Harding/Coolidge cuts of the mid-1920s, the Kennedy cuts of the mid-1960s, and the Reagan cuts of the early 1980s. Each of these periods of tax cuts was remarkably successful in terms of virtually any public policy metric.