The
Laffer Curve illustrates the basic idea that changes in tax rates
have two effects on tax revenues: the arithmetic effect and the
economic effect. The arithmetic effect is simply that if tax rates
are lowered, tax revenues (per dollar of tax base) will be lowered
by the amount of the decrease in the rate. The reverse is true for
an increase in tax rates. The economic effect, however, recognizes
the positive impact that lower tax rates have on work, output, and
employment--and thereby the tax base--by providing incentives to
increase these activities. Raising tax rates has the opposite
economic effect by penalizing participation in the taxed
activities. The arithmetic effect always works in the opposite
direction from the economic effect. Therefore, when the economic
and the arithmetic effects of tax-rate changes are combined, the
consequences of the change in tax rates on total tax revenues are
no longer quite so obvious.
Figure 1 is a graphic illustration of the
concept of the Laffer Curve--not the exact levels of taxation
corresponding to specific levels of revenues. At a tax rate of 0
percent, the government would collect no tax revenues, no matter
how large the tax base. Likewise, at a tax rate of 100 percent, the
government would also collect no tax revenues because no one would
be willing to work for an after-tax wage of zero (i.e., there would
be no tax base). Between these two extremes there are two tax rates
that will collect the same amount of revenue: a high tax rate on a
small tax base and a low tax rate on a large tax base.
The Laffer Curve itself does not say whether a tax
cut will raise or lower revenues. Revenue responses to a tax rate
change will depend upon the tax system in place, the time period
being considered, the ease of movement into underground activities,
the level of tax rates already in place, the prevalence of legal
and accounting-driven tax loopholes, and the proclivities of the
productive factors. If the existing tax rate is too high--in the
"prohibitive range" shown above--then a tax-rate cut would result
in increased tax revenues. The economic effect of the tax cut would
outweigh the arithmetic effect of the tax cut.
Moving from total tax revenues to budgets,
there is one expenditure effect in addition to the two effects that
tax-rate changes have on revenues. Because tax cuts create an
incentive to increase output, employment, and production, they also
help balance the budget by reducing means-tested government
expenditures. A faster-growing economy means lower unemployment and
higher incomes, resulting in reduced unemployment benefits and
other social welfare programs.
Successful
Examples
Over the past 100 years, there have been three major
periods of tax-rate cuts in the U.S.: the Harding-Coolidge cuts of
the mid-1920s; the Kennedy cuts of the mid-1960s; and the Reagan
cuts of the early 1980s. Each of these periods of tax cuts was
remarkably successful as measured by virtually any public policy
metric. In addition, there may not be a more pure expression of the
Laffer Curve revenue response than what has occurred following past
changes to the capital gains tax rate.
The
interaction between tax rates and tax revenues also applies at the
state level--e.g., California--as well as internationally. In 1994,
Estonia became the first European country to adopt a flat tax and
its 26 percent flat tax dramatically energized what had been a
faltering economy. Before adopting the flat tax, the Estonian
economy was literally shrinking. In the eight years after 1994,
Estonia experienced real economic growth--averaging 5.2 percent per
year. Latvia, Lithuania, and Russia have also adopted flat taxes
with similar success--sustained economic growth and increasing tax
revenues.
Arthur B. Laffer is the founder and chairman of
Laffer Associates, an economic research and consulting firm. This
paper was written and originally published by Laffer Associates.
The author thanks Bruce Bartlett, whose paper "The Impact of
Federal Tax Cuts on Growth" provided inspiration.