The Laffer curve describes how changes in tax rates affect government revenues in two ways. One is instantaneous, which Laffer describes as “arithmetic.” Every dollar in tax cuts directly translates into one dollar of government revenue.
Image courtesy: https://www.investopedia.com/articles/08/laffer-curve.asp
Laffer curve illustrated
At the bottom of the curve, the chart shows how the zero tax does not generate government revenue and thus no government. Of course, increasing taxes from zero will increase government revenue right away. Initially, raising taxes does a good job of increasing total revenue, as shown by the flatness of the curve. As the government continues to raise taxes, payments on additional revenues decrease and the curve becomes steeper.
If only life were as simple as the Laffer curve
What’s not on the chart? Numbers! In other words, real tax rates and the percentage increase in income are the missing factors. If Laffer had the numbers on the map, the government could say, “Hmm, we’ll raise the tax rate from 24% to 25% to get a 2% increase in the tax rate.” If you look at the chart, it seems that the “restricted limit” starts at about a 50% tax rate. If so, today’s chart would be useless. Why? The federal government has not taxed anyone 50% or more since 1986.
Laffer avoids being specific. Whether the tax cuts stimulate the economy, the condition of the curve depends on six factors:
- Type of tax system in place.
- How fast the economy is growing.
- How much is already taxed?
- Tax loopholes.
- Ease of entry into non-taxable, underground activities.
- The productivity level of the economy.
Tax reductions on any of these factors may prevent economic growth.
Tax cuts only work in the restricted range
Tax cuts operate on a “restricted margin” by increasing consumer spending and demand. It promotes business growth and hiring. As a result, government revenue will increase in the long run. The economic effect of the tax cut is greater than the arithmetic effect. Laffer notes another benefit of a fast-growing economy. This helps reduce government spending on unemployment benefits and other social welfare programs.
Cutting taxes outside the “restricted range” does not stimulate the economy enough to offset the reduced revenue. Tax cuts during a recession or slow growth can be detrimental to the economy. During the recessions, government-funded unemployment benefits, social welfare programs, and jobs are raising enough to put the economy in depression. If revenues are further reduced by tax cuts, demand is reduced and businesses suffer from very few customers.
To get the job done, tax cuts must lead to more jobs
The Laffer curve assumes that companies will respond to increased revenues from tax cuts by creating jobs. Several other factors have emerged since the 2008 financial crisis, which revealed that this was not always true. Businesses are not using the money from the Bush tax cuts and the bailout of the complex asset relief program to create jobs. Instead, they saved it and sent it to shareholders as dividends, repurchased their shares, or invested overseas. None of those measures produced enough U.S. jobs to provide the economic boost that Laffer described.
Dr. Laffer agrees, “The Laffer curve itself does not say whether the tax cut will increase or decrease revenue.” Instead, it shows that if the tax is already low, more cuts will reduce revenue without boosting growth. Politicians claiming tax cuts will always raise revenue in the long-running misunderstanding of the Laffer curve.