Understanding
the Laffer Curve
In 1974, economist Art Laffer reportedly first sketched his now-famous
curve on a napkin to illustrate his belief that reducing tax rates could
actually increase tax revenues. The theory is at the heart of supply-side
economics, which helped motivate the Reagan-era tax cuts and President
Bush's tax-relief efforts in 2001 and 2003.
The Laffer Curve is simply a depiction of the law of diminishing returns.
If tax rates are too low, the government can't raise enough funds to meet
the needs and expectations of the public. If rates are too high, economic
activity could be stifled and cause tax revenues to fall.
A look at the left side of the curve shows that at a tax rate of 0%, the
government collects no revenue regardless of the size of the tax base. On
the far right side of the curve, a tax rate of 100% also results in no
revenue, because there is no incentive to work, and thus no tax base.
Somewhere on the curve between 0% and 100% lies a tax rate (t) that should
maximize tax revenues.
Policymakers usually disagree on whether tax rates are resting too far to
the left or right on the curve. Unfortunately, there is no concrete formula
that uncovers the taxation "sweet spot," so they must ultimately rely on
trial and error.
There is considerable debate about the controversial graph. Supply-siders
point to the positive effects that tax cuts can have on productivity,
investment, and employment in a given economy. They say the curve proves
that tax cuts can actually pay for themselves in the long run by increasing
the tax base. As evidence, they point to the fact that federal tax receipts
and the U.S. economy have grown steadily since federal taxes were cut
significantly in 2003.1
Critics argue that cutting taxes without reducing spending will cost
society more over time, primarily in the form of interest payments on larger
budget deficits. Others object to the notion of maximizing revenues at all.
Regardless of which side of the debate you take, the Laffer Curve may
help with decisions about your own financial situation. For example, if you
were to set aside 0% of your income, it is unlikely that you would be able
to reach your financial goals.
Conversely, if you were to invest 100% of your income, it is also
unlikely that you would be able to reach your goals because you would have
nothing to live on. Somewhere in between is the ideal balance. This might
seem a bit simplistic, but that's because the idea is clearest at both
extremes.
The point is, any financial decision you make should be based on the
benefits and drawbacks that apply to your situation, whether you are
considering what to do about risk, taxes, asset allocation, or retirement
plan contributions.
1) Haver Analytics, 2006
