In economics, the Laffer curve is used to illustrate the idea that increases in the rate of taxation may sometimes decrease tax revenue. Since a 100 percent income tax will generate no revenue (as citizens will have no incentive to work), the optimal tax rate that maximizes government revenue must lie below 100 percent. Increasing taxes beyond that point would decrease tax revenue. The Laffer curve was popularized by Arthur Laffer (b. 1940) in the 1980's. However, the underlying principle has been well known since at least the time of Ibn Khaldun's Muqaddimah (1377). In his General Theory of Employment, Interest, and Money, John Maynard Keynes described how past a certain point, increasing taxation would lower revenue and vice versa.
The Laffer-curve is central to supply side economics, as it provides an argument for why lowering taxation may actually increase tax revenues. Many economists have questioned the utility of the Laffer Curve in public discourse. According to Nobel prize laureate James Tobin, "[t]he 'Laffer Curve' idea that tax cuts would actually increase revenues turned out to deserve the ridicule with which sober economists had greeted it in 1981."
The point at which the curve achieves its maximum is subject to much theoretical speculation. It will vary from one economy to another and depends on the elasticity of supply for labor and various other factors. It is therefore expected to vary with time even in the same economy. Complexities arise when taking into account possible differences in incentive to work for different income groups and when introducing progressive taxation. The structure of the curve may also be changed by other policy decisions, for example, if tax loopholes and off-shore tax shelters are made more readily available by legislation, the point at which revenue begins to decrease with increased taxation will become lower.
The curve is primarily used by advocates who want government to reduce tax rates (such as those on capital gains) and believe that the optimum tax rate is below the current tax rate. In that case, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing.
Note that Laffer himself does not claim credit for the idea, although he does seem to be responsible for popularizing the concept and its implications to policy makers.
The Laffer curve and supply side economics inspired the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more tax revenue because the United States government's marginal income tax rates prior to the legislation were on the right-hand side of the curve.
In 2003, the United States Department of the Treasury released a non-partisan economic study showing that the 1981 tax act produced a major loss in government revenues of almost 3% of GDP. Of course, unless GDP was unaffected by the tax act, this analysis would be misleading, as the predicted increase in revenue might come in the form of increased GDP. Thus revenues could be increased, fixed, or decreased, as a percent of GDP, and the Laffer curve predictions of absolute increased tax revenue, above what otherwise would have occurred, could still be correct.
David Stockman, President Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, maintained that the Laffer curve was not to be taken literally — at least not in the economic environment of the 1980s United States. In The Triumph of Politics, he writes:
At least one empirical study, looking at actual historical data on tax rates, GDP, and revenue, placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) as high as 80%. Paul Samuelson argues in his popular economic textbook that Reagan was correct in a very limited sense to view the intuition underlying the Laffer curve as accurate, because as a successful actor, Reagan was subject to marginal tax rates as high as 90% during World War II. The point is that in a progressive tax system, any given person's perspective on the validity of the Laffer curve will be influenced by the marginal tax rate to which that person's income is subject.
Critics at the libertarian Cato Institute have charged that to support these calculations, the paper assumes that the 10% reduction in individual tax rates would only result in a 1% increase in gross national product, a figure they consider too low for current marginal tax rates in the United States.
However, in practical Communist societies such as the now-defunct Soviet Union, all workers were paid some meager wage, usually tied to the level of demand for their services much like in capitalist societies. They also were given government subsidized food, public transportation, and housing associated with the level of their occupation and its importance to the central government. Combined, these "benefits" could be considered income.
The result of these low-paying and highly subsidized systems is a very high effective rate of taxation with little left to the worker in terms of disposable income. Since much of the worker's true productivity is returned to him in a manner not of his choosing and all similar workers receive the same benefits regardless of the degree of their efforts, there is little incentive to produce in terms or quality or quantity. This is the classic case of an economic system operating on the right half of the Laffer curve, where oppressive government taxation severely dampens economic activity. These societies do much more to substantiate the validity of the Laffer curve theory than to disprove it.
The very low productivity and wage levels of the old Soviet system were the basis of what has been called the "Soviet National Joke": "We pretend to work; they pretend to pay us!".
A harsher critique of the Laffer Curve can be seen with Martin Gardner's satirical construct, the so-called neo-Laffer Curve. The neo-Laffer curve matches the original curve near the two extremes of 0% and 100%, but rapidly collapses into an incomprehensible snarl of chaos at the middle. Gardner based his curve on actual US economic data collected in a fifty year period by statistician Persi Diaconis.
The satire illustrates the major fallacy commonly committed with the Laffer curve, namely the assumption that the middle is a smooth, concave function merely because the two extreme endpoints are well-defined. A realistic tax curve would most certainly not resemble a smooth parabola or even any other simple function, but rather a very complex curve with many peaks, valleys, and multiple local maxima. Inside the middle, a wide range of various economic factors confound any simplistic attempt at this interpolation.
As a pedagogical tool, a Laffer curve helps illustrate a specific application of the law of diminishing returns, where the inhibitory cost of taxes may eventually outweigh the increased rate of taxation, and thus led to a counterintuitive lower realization of tax revenue. However the Laffer curve should not be taken as a literal model for a tax revenue curve, especially in debates between relatively moderate amounts of taxation. It is in this context that the Laffer curve is often abused, taken as a serious model for tax revenue when it has little to no predictive value in debates between intermediary rates of taxation.
The Neo-Laffer curve is most commonly used to selectively criticize the right half of the Laffer curve. However, it also implies that the left half of the curve should be just as unpredictable (i.e. that raising taxes has an unpredictable effect on revenue).