Laffer curve

Mr Hafiz Muhammad Qasim
Lecturer Department of Economics, Lahore Leads University

1. The Laffer Curve Public Sector Economics Mr Hafiz Muhmmad Qasim

2. History of Laffer Curve The Laffer curve is named after the economist Arthur Laffer . In 1974, he tried to illustrate this concept to officials Dick Cheney and Donald Rumsfeld from the Ford administration. Legend states that he drew the concept on a napkin (though he doesn’t remember this incident). The term was coined by Jude Wanniski who was also at the meeting. Laffer has since stated he was not the first person to suggest this concept pointing out a 14th-century philosopher -Ibn Khaldun .

3. The Laffer Curve Definition The Laffer Curve states that if tax rates are increased above a certain level, then tax revenues can actually fall because higher tax rates discourage people from working . Equally, the Laffer Curve states that cutting taxes could, in theory, lead to higher tax revenues.

4. Basic Diagram

5. Explanation It starts from the premise that if tax rates are 0% – then the government gets zero revenue. Equally, if tax rates are 100% – then the government would also get zero revenue – because there is no point in working. If tax rates are very high, and then they are cut, it can create an incentive for business to expand and people to work longer. This boost to economic growth will lead to higher tax revenues – higher income tax, corporation tax and VAT. The importance of the theory is that it provides an economic justification for the politically popular policy of cutting tax rates. As Andrew Mellon said in 1924 – 74% of nothing is nothing. Mellon pushed for the top rate of tax to be reduced from 73% to an eventual 24% (He also personally benefitted as he was one of richest men in America). However, economists disagree on the level at which higher tax rates actually cause disincentives to work.

6. What is the optimal level of taxation for maximizing revenue? One study of economists Fullerton(2008) suggests that a marginal income tax rate of 70% is considered a level at which the Laffer curve effect may start to occur. In other words, if income tax rates are 80% and they are cut to 70% – the incentive effect may increase total tax revenue. According to above study 70% is the optimal tax rate, however, it may vary country to country.

7. Optimal Tax Rate

8. Do tax cuts reduce the deficit? This evidence from US CBO suggests tax cuts lead to higher deficit. Tax increases reduce the deficit.

9. Conclusion There is sound reasoning behind the Laffer Curve – at some point, higher tax rates will lead to lower tax revenues. However, the big question is what level will this be? If the peak tax rate is 70%, then the Laffer curve will not affect most western economies – as income tax rates are mostly significantly lower than 70%. For example,  recent US tax cuts  from 35% will have little effect on incentives.

10. Thank You