The Home of American Intellectual Conservatism — First Principles

October 18, 2018

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Laffer Curve
Thomas E. Woods, Jr. - 09/17/10

According to the standard story, economist Arthur Laffer, at the time professor of business economics at the University of Southern California, first sketched his famous curve on a cocktail napkin in the late 1970s. He was trying to make a fairly simple point about tax rates, tax revenues, and economic behavior.

A tax rate of zero will of course earn no revenue. But a marginal rate of 100 percent will also earn, if not quite zero, close enough to make any such revenue negligible. If every additional dollar is completely confiscated, people will flee into alternatives: stop working, shelter their income, engage in fraud, revert to barter—anything but pay the 100 percent rate.

Somewhere between these extremes, therefore, must be a point at which further rate increases paradoxically begin to yield lower government revenue. Laffer referred to this as the “prohibitive range.” Since the curve contained no other numbers apart from zero and 100, the determination of where this range lay was a matter of educated speculation.

Although the curve itself was not given explicit formulation until the late 1970s, the idea had precedents in American tax policy. Thus, during the 1920s Treasury Secretary Andrew Mellon was convinced that the wartime tax rates still in force were punitive and economically destructive, and that rate reductions would actually increase net revenue. That is exactly what happened.

The idea of the Laffer curve, popularized by such figures as Jack Kemp and Jude Wanniski, featured prominently in the intellectual apparatus behind the income tax cuts of Ronald Reagan’s presidency. Contrary to popular belief, its proponents did not claim that the behavioral changes lower rates would encourage would in every case completely offset the revenue losses that static analysis attributed to a reduction in tax rates. (Reagan’s budget expected them to make up for only 17 percent of the lost revenue.) What they did claim is that just as high marginal rates affected behavior (by discouraging investment and business expansion, encouraging the use of tax shelters, and so on), considerable reductions would affect behavior in the other direction. As a result, the increased economic output that would result from the rate cuts would offset some of the revenue loss associated with the lower rates.

Some on the political Right expressed concern that the Laffer curve implicitly presumed that revenue maximization was a desirable outcome and that tax rates ought to be set with this goal in mind; small-government conservatives naturally wondered whether the Laffer curve really represented a triumph for conservative values. But this is not what Laffer meant: his purpose was to show that at some point even liberal Democrats, given the logic of his curve, would have to concede that by their own standards rates were too high.

Laffer’s main point, which he considered tautological, has never been refuted, and indeed the 1980s saw modest reductions in top rates even in many European countries.

Further Reading
  • Henderson, David. “Limitations of the Laffer Curve as a Justification for Tax Cuts.” Cato Journal 1, no. 1 (Spring 1981): 45–52.
  • Wanniski, Jude. The Way the World Works: How Economies Fail—and Succeed. New York: Basic Books, 1978.
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