The Laffer Curve explains how tax income can go down when tax rates are raised. Image from Wikimedia Commons.
The Laffer Curve is an graphic representation of the theory of Taxable Income Elasticity. First proposed by Jude Wanniski in the 1970s, the Laffer Curve is named after Arther Laffer, a supply-side economist who Wanniski based his work on. Translation for the rest of us: The Laffer Curve tells the government how much money it can charge in tax debt before revenue starts going down.
The math behind the Laffer Curve
For those of us who don’t have degrees in math or theoretical economics, here is how the Laffer Curve works. It is a theory of economics that states taxpayers will change their behavior based on taxes. For example, at 0 percent tax, taxpayers will be motivated to earn as much money as they can, but the government receives no money. At 100 percent tax, the government will also receive no money, because there is no motivation for taxpayers to earn money. Therefore, the ideal tax rate for government is somewhere between 0 percent and 100 percent. Usually, this is a percentage represented on the graphic Laffer Curve as 50 percent, but that is not necessarily the ideal tax rate. Some studies have put the ideal tax rate at anywhere between 30 and 40 percent.
How the Laffer Curve affects U.S. policy
The Laffer Curve was first proposed in the 1970s. However, U.S. taxation policies have often made use of the underlying theory. In 1924, Andrew Mellon made the argument that by lowering the tax rate, the government would bring in more money. The top income tax bracket was reduced from 73 percent to 24 percent between 1921 and 1929. In that same time period, income tax receipts rose from $719 million to $1 billion. Reganomics in the 1980s and the Bush Tax Cuts of the early 2000s also had a very heavy basis in the Laffer Curve theory.
Arguments against the Laffer Curve
Like most economic theories, the Laffer Curve does not exist in an economic bubble. Income tax is supposed to function as a small loan from the taxpayers to the government to make use of the economy of scale. Many historians point out that at near-100 percent tax rates, countries such as Russia were able to maintain a productive economy. Progressive taxation practices also complicate how the Laffer Curve would be calculated.
The Laffer Curve is an excellent description of a concept that underpins and reinforces the conservative viewpoint on taxation. However, it is important to remember that the optimum tax rate resulting in maximum revenue is not the same thing as optimum tax rate for those individuals who earn the money that pays that tax. The true optimum tax rate is one that is high enough to support the required functions of the government, but low enough to make those functions difficult to maintain. The ideal tax rate maintains a lean government.
This is an excellent explanation of what is a pretty complex subject. One query though – not all taxes are on income, and not all taxes are visible.
Sales taxes are widely used to raise revenue (in fact probably more widely than income tax as it is easier to lie about how much you earn than about the price a particular good was sold for). Of course there may come a point where the sales tax is too high and people stop buying, but this is a long way above 100%.
Of more relevance are hidden income taxes. In UK we have a tax called "National Insurance", whose headline rate (at 11% up to an income of £50,000/ $75,000)isn't widely bandied about. Even if you do care about this (and whoever heard of an income tax that taxes the poor more than the rich, especially under a labour government), it is far more difficult to spot the other half of the tax – the tax that employers have to pay (11.8% at the moment, going up to 12.8% regardless of income) which gets a mention on people's pay slips but doesn't appear to come out of the individual's pocket.
At this rate, National Insurance (the hidden tax) is actually taking more out of people's pockets than Income Tax at the average salary.
I have no idea whether hiding the tax makes any difference to government tax take