It seems that raising tax rates would fill the nation's coffers. Taxes are collected by multiplying the money people earn by the tax rate, so if the rate doubles, revenue should double too for the math to work. But can you really keep raising tax rates forever and keep collecting more?
Picture the extremes and the answer becomes clear. At a 0% tax rate, the government collects nothing at all. At a 100% tax rate, on the other hand, everything you earn is taken away, so no one wants to work officially or report income, and there is again nothing to collect. If revenue is zero at both ends, there must be a tax rate somewhere in between where revenue is greatest. Drawing this relationship as a hill-shaped graph gives you the “Laffer Curve.”
In this article, we will look in turn at the story of how the Laffer Curve was born on a napkin, the principle behind how the curve is drawn, what happened in actual policy, and how economists assess it.
The Hill-Shaped Curve Between Tax Rates and Tax Revenue
A Curve Born on a Napkin
The name Laffer Curve comes from the American economist Arthur Laffer, but the idea itself is much older.
(1) A 1974 Dinner in Washington
In 1974, at a hotel restaurant in Washington, Laffer met Dick Cheney and Donald Rumsfeld of the Ford administration. The story goes that Laffer, who opposed the government's plan to raise taxes, explained his point by drawing a curve on a napkin, but Laffer himself says he does not remember the napkin.
(2) The Man Who Named It
The journalist Jude Wanniski, who was also there, gave the curve the name “Laffer Curve.” The name became widely known through an article he wrote in 1978.
(3) Old Roots
Laffer made clear that he was not the first to come up with the idea. The 14th-century scholar Ibn Khaldun wrote in the Muqaddimah that at the beginning of a dynasty, low taxes yield large revenues, while at the end, heavy taxes yield small revenues. In the 18th century, Galiani, Hume, and Adam Smith also left behind similar ideas.
How the Curve Is Drawn
Laffer explained the effect of tax rates on tax revenue by dividing it into two effects.
- Arithmetic Effect: If the size of the income being taxed stays the same, revenue rises as much as the tax rate is raised.
- Economic Effect: When tax rates rise, people work less, look for ways to avoid taxes, or hide income, so the taxable income itself shrinks.
- Revenue-Maximizing Tax Rate: When tax rates are low, the arithmetic effect is larger and revenue grows, but past a certain point the economic effect becomes larger, so raising the rate actually reduces revenue.
- Shape of the Curve: Textbooks often draw it as a symmetrical curve peaking around 50%, but the actual peak could be anywhere between 0% and 100%, and the curve can be lopsided.
Wanniski added that even at a 100% tax rate, economic activity would not stop completely, but would go underground into barter, swapping goods instead of money.
What Happened in Actual Policy
The Laffer Curve was often used as an argument for tax cuts and had a major influence on actual policy.
(1) The Reagan Tax Cuts
In the 1980s, the U.S. Reagan administration, influenced by the Laffer Curve and supply-side economics, cut tax rates sharply. The top income tax rate fell from 70% to 28%, but revenue did not rise on its own, and the budget deficit swelled greatly. George H. W. Bush, a rival in the presidential primaries, even mocked the idea as “Voodoo Economics.”
(2) The Kansas Experiment
In 2012, the U.S. state of Kansas, advised by Laffer, cut state taxes drastically. But when the state budget, which had been in surplus, swung into deficit and budgets for education and infrastructure were cut, the state legislature reversed the tax cuts on a bipartisan basis in 2017.
(3) The Peak of Tobacco Taxes
Conversely, there are cases that appear to have gone past the top of the curve. Australia kept raising tobacco taxes from around 2005, and tobacco tax revenue peaked in 2019 and then began to decline. Excessively expensive cigarettes fueling a black market for smuggled tobacco is cited as the cause.
How Economists Assess It
Most economists accept the principle itself that revenue can fall if tax rates are too high. The debate is about where on the curve we stand now.
(1) Where Is the Peak?
Many studies have estimated the income tax rate that brings in the most revenue, and while the results vary, they generally cluster around 70%. One 2011 study concluded that the United States and most European countries are still on the left side of the curve, that is, the side where raising tax rates increases revenue.
(2) Do Tax Cuts Pay for Themselves?
In 2012, when the University of Chicago in the United States asked economists whether cutting current U.S. income tax rates would raise more revenue within five years, not a single one said yes.
(3) Maximum Revenue Is Not the Same as Best
The tax rate that collects the most revenue is not necessarily a good tax rate. In economics, the optimal tax rate means the rate that raises the money needed while disturbing the economy the least. Laffer himself said in 2007 that taxes should not be raised or lowered on the basis of this curve alone.
The biggest lesson the Laffer Curve leaves is that taxes change people's behavior. Looking only at the numbers on a tax rate table, you cannot know how much will actually be collected.
Asking not whether the curve exists but where on that curve we stand: that is the first step in an economics that truly understands taxes.
