The Laffer curve is the idea that cutting taxes can spur the economic activity over time, so lower taxes take a smaller slice of a much bigger pie increasing revenues overall. The Laffer curve isn’t a law of economics; it’s merely a theoretical framework for understanding why, as President John F. Kennedy said in 1962:
“It’s a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues, in the long run, is to cut the rates now”.
This is an old saw from a school of thought called “supply-side” economics. The supply-side economists, or “supply-siders,” were the group of conservative economists influential with the Reagan administration.
The supply-siders claimed that high marginal tax rates were a big disincentive for people to work, save, and invest. If tax rates were lower, and people got to keep more of their incomes from work or investments, this would create incentives to work more and to save and invest more. As a result, the supply-siders argued, the economy would grow faster. The government, they claimed, could get more tax revenue by taking a smaller slice (lower tax rate) from a larger pie (higher GDP).
The “Laffer curve” describes the idea that lower tax rates could translate into higher total tax revenue. Legend has it that supply-side economist Arthur Laffer sketched the curve on a cocktail napkin at a Washington restaurant in 1974, showing it to then-Ford administration officials Donald Rumsfeld and Dick Cheney. He concluded that tax revenues would not keep rising with increasing tax rates. At some point, increasing tax rates would reduce total tax revenue—and diminishing tax rates would increase it.
According to the supply-siders’ theory, increasing the tax rate does not always reduce tax revenue, nor does decreasing the tax rate always increase tax revenue. It all depends on whether the current tax rate is above or below the tax rate where tax revenue reaches a peak (the “revenue-maximizing” rate).
If the tax rate is already above the revenue-maximizing rate (labeled t* on the graphs), an increase in the tax rate will reduce total revenue. A decrease in the tax rate, meanwhile, will increase total revenue, so long as the new tax rate is still above t*. (If the new tax rate is below t*, then we cannot say for sure whether total tax revenue will increase or decrease.)
On the other hand, if we start out with a tax rate below t*, a decrease in the tax rate will decrease total revenue. An increase in the tax rate, meanwhile, will increase total tax revenue, so long as the new tax rate is still below t*. (If the new tax rate is above t*, then we cannot say for sure whether total tax revenue will increase or decrease.)
To make the supply-side case, one would have to prove that a tax rate was already above the revenue-maximizing rate.
Tax cuts, when used properly, have stimulated the economy. Many credit President George W. Bush’s tax cuts for moving the economy out of recession.
Ireland’s recent tax cuts are believed to have improved living standards significantly. For years, the Irish were faced with high unemployment, budget deficits, and high taxes. In 1986, Ireland faced a fiscal crisis. After reducing government spending, the government lowered taxes on both individuals and corporations. Ireland now enjoys one of the highest standards of living in Europe.
Critics have argued, for example, that Reagan- and Bush-era tax and spending policies cut taxes mostly for corporations and affluent individuals, while mostly cutting programs that benefit lower-income people.
For people who would favor tax cuts anyway, the Laffer curve offers an appealing argument—we can have a tax (rate) cut, but get increased tax revenue, and so not have to sacrifice any of the things we want from the government. (That is, we can have our cake and eat it, too).