What Is the Laffer Curve?:

The Laffer Curve was developed in 1979 by economist Arthur Laffer. According to Laffer's theory, changes in tax rates affect government revenues in two ways. One is immediate, which Laffer describes as "arithmetic." Every dollar in tax cuts translates directly to one less dollar in government revenue.

The other effect is longer-term, which Laffer describes as the "economic" effect.

This works in the opposite direction. Lower tax rates put more money into the hands of taxpayers, who then spend it. This creates more business activity to meet consumer demand.

Next, companies hire more workers, who spend their additional income. This boost to economic growth generates a larger tax base, which eventually makes up for the initial revenue lost from the tax cut.

Understanding Exactly How the Laffer Curve Works:

The chart above shows how, at the bottom of the curve, zero taxes results in no government revenue and, thus, no government. Of course, increasing taxes from zero immediately boosts government revenue. In the beginning, raising taxes still does a good job of increasing total revenue, as shown by the flatness of the curve. As the government keeps raising taxes, the payoff in additional revenue becomes less, and the curve steepens.

At some point, additional taxes really start to become a burden on economic growth. Demand is inhibited so much that the long-term decline in the tax base more than offsets the immediate increase in tax revenue.

This is where the curve boomerangs backwards. This section is shaded, and Laffer calls it the "Prohibitive Range." Beyond this point, additional taxes actually result in reduced government revenue. At the top of the curve, when tax rates are 100%, then government revenue is zero. If the government takes all personal income and business profit, then no one works or produces goods, so the tax base disappears.

If Only Life Were as Simple the Laffer Curve:

What's missing from the chart? Numbers! In other words, the actual tax rates and the percent increase revenue generated. If Laffer had put numbers on the chart, the government could say, "Hmm, let's increase the tax rate from 24% to 25% to get a 2% increase in the tax base." If you look closely, it seems that the "Prohibitive Range" starts at about a 50% tax rate. However, if that were the case, the chart would be useless for modern times. Why? The U.S. hasn't taxed anyone at 50% (or higher) since 1986. (Source: Tax Foundation, Historical Tax Rates)

Laffer deliberately avoided being more specific because whether tax cuts stimulate the economy (where you are on the curve) depends on six factors:

1. The type of tax system in place.
2. How fast the economy is growing.
3. How high taxes are already.
4. Tax loopholes.
5. The ease of entry into non-taxable, underground activities.
6. The economy's productivity level.

Any one of these factors can prevent tax cuts from stimulating economic growth.
Tax Cuts Only Work in the Prohibitive Range:

Tax cuts work in the "Prohibitive Range" by increasing consumer spending and demand, which stimulates business growth and hiring. This results in increased government revenues in the long-run because the economic effect of the tax cut would outweigh the arithmetic effect of the tax cut. Laffer mentions another benefit of a faster-growing economy. It actually reduces government spending on unemployment benefits and other social welfare programs.

However, lowering taxes outside of the "Prohibitive Range" does not stimulate the economy enough to offset reduced revenues. In fact, tax cuts during a recession or a period of slow growth could harm the economy even worse. During recessions, government-funded unemployment benefits, social welfare programs and jobs boost the economy enough to keep it from going into a tailspin. If revenues are curtailed even further with tax cuts, demand drops, and businesses suffer from not enough customers.

Tax Cuts Must Lead to More Jobs:

The Laffer Curve also assumes that businesses will respond to increased revenue from tax cuts by creating jobs. However, several other factors have emerged since the 2008 financial crisis that show this isn't always true. Businesses haven't used money from the Bush tax cuts and the TARP bailouts to create jobs. Instead, they saved it, sent it out to stockholders as dividends, repurchased their own stocks, or invested overseas. None of those activities created the U.S. jobs needed to give the economic boost Laffer described.

In addition, the economy has become more capital- and technology-intensive, and less labor intensive. Businesses are more likely to use tax cuts to buy computer and other labor-saving equipment than to hire new workers.

Conclusion:

Dr. Laffer admits that "The Laffer Curve itself does not say whether a tax cut will raise or lower revenues." In fact, the Laffer Curve will tell you that if taxes are already low, then further cuts will only lower government revenues without boosting economic growth. For policymakers to assert that tax cuts will always raise revenues in the long-term is a misinterpretation of supply-side economics and its theoretical underpinning, the Laffer Curve.

For example, President Bush cut taxes in 2001 (JGTRRA) and 2003 (EGTRRA). The economy grew, and revenues increased. Supply-siders, including the President, said that was because of the tax cuts. Other economists point to lower interest rates as the real stimulator of the economy. The FOMC lowered the Fed Funds rate from 6% in the beginning of 2001 to a low of 1% by June 2003. (Source: New York Federal Reserve, Historical Fed Funds Rate)