What is the Laffer Curve?

The Laffer Curve is an economic model showing the relationship of tax rates to tax revenue as envisioned by economist Arthur Laffer. The model is most commonly displayed in the perfect shape of a bell curve, but the actual reality could be different. The theory was first put forth in 1974, and legend states that Laffer first drew the curve on a cocktail napkin for a couple of Washington power brokers.

The basic premise of the Laffer Curve states that if the tax rate is zero, revenue is zero. If the tax rate is 100 percent, there is also no tax revenue, simply because people have no incentive to work in an otherwise free society. The theory also postulates there is a maximum point at which tax rates will produce the maximum amount of revenue. Anything lower or higher than that rate will reduce revenue.

The point at which revenue is maximized on the Laffer Curve is known as "T." As a practical matter, finding the exact rate for T is difficult for governments. This is not only because the optimum income tax rate is hard to find in itself, but also because there are other taxes to consider, such as sales and property taxes. Further, national moods toward taxation may change from time to time such as during times of war when nationalistic feelings may be higher.

When considering tax policy, a country may have some politicians who argue that the national tax rate as at the T value, and others who argue it is on one side or the other. Whether it is stated that way or not, this is often the crux of the battle. In most cases, the only way to know for sure is simply to implement a value and observe revenue. If the desired results are not produced, adjustments may be needed.

The Laffer Curve is often mischaracterized by those who are against taxation or fight for lower taxes as stating that reducing tax rates will increase revenue. The curve shows that may be true to an extent, but only if tax rates are already so high they stifle revenue growth. If the point on the curve is to the left of the T value, then reducing rates will reduce tax revenue even further.

The accumulation of wealth is the driving mechanism behind the Laffer Curve. In most cases, where people are free to choose whether to work, the Laffer Curve may be a conceivable model. In countries where people are compelled to work by threat or force, the curve cannot work. People in those countries are not motivated to work for personal wealth, even if they have a stipend from government. Rather, they are more motivated to work for personal safety.