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The Laffer Curve

With all the talk of the deficit and the need to raise taxes today seemed a good day to visit the Laffer Curve. Named after Arthur Laffer, a member of Reagan’s Economic Advisory Board from 1981 – 1989, the curve describes the potential change in tax revenue as the rate itself changes.

This graph, clipped from the image drawn on a napkin (you can click the image to see the full sized one, including Mr. Laffer’s signing it “To Don Rumsfeld.”) illustrates a centuries-old concept. At a zero tax rate, revenue will be zero. This of course stands to reason. But, at a 100% tax rate, why would anyone work? So again, the tax revenue generated is also zero. So what’s left is two concepts, first, that there’s a rate that provides maximum tax revenue raised. Second, that if we are operating at the wrong point on the curve, at a rate higher than the maximum revenue rate, to raise revenue from there, the rate must actually be lowered, not raised.

The concept is intriguing, yet pretty simple. The question, however, is can we ever know where we are on the curve? Of course, as a thought experiment, not every individual may have the same shaped curve, so it’s the aggregate that needs to be optimized. This all goes to the point that as our government tries to get spending under control (they’re doing that, right?) they had best be very careful when tinkering with out tax rates.

  • Doable Finance May 20, 2011, 6:35 pm

    The Laffer Curve has always been interesting.

  • Khaleef @ KNS Financial May 25, 2011, 9:47 pm

    One of the most simple lessons in economics, but one that needs to be repeated often. Everyone thinks you can just keep raising taxes (especially on the rich) and that will solve all of the government’s problems.

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