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.
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.