Market Related Articles » Laffer Curve - Taxation Theory
Arthur Laffer is the founder and chairman of Laffer Associates, an economic research and consulting firm that provides investment-research services to institutional asset managers. Since its inception in 1979, the firm's research has focused on the interconnecting macroeconomic, political and demographic changes affecting global financial markets.
Dr. Laffer's economic acumen and influence in triggering a world-wide tax-cutting movement in the 1980s have earned him the distinction in many publications as "The Father of Supply-Side Economics." One of his earliest successes in shaping public policy was his involvement in Proposition 13, the groundbreaking California initiative that drastically cut property taxes in the state in 1978.
Dr. Laffer is a founding member of the Congressional Policy Advisory Board, a select group of advisors who assist in shaping legislative policies for the 105th, 106th, and 107th United States Congress.
The Laffer curve is most easily understood by considering the two extremes of income taxation - 0 percent and 100 percent. At the lower extreme, a 0 percent tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100 percent tax rate, the government theoretically collects zero revenue because (in a "rational" economic model) taxpayers would change their behavior in response to the tax rate:
1. They have no incentive to work
2. They find a way to avoid paying taxes, so the government collects 100% of nothing. (However, the government may still collect some revenue if some taxpayers are not "economically rational", or if tax evasion lowers the effective tax rate.)
3. Somewhere between 0% and 100%, therefore, lies a tax rate that will maximize revenue.
The point at which the curve achieves its maximum is subject to much theoretical speculation. It will vary from one economy to another and depends on the elasticity of supply for labor and various other factors. It is therefore expected to vary with time even in the same economy. Complexities arise when taking into account possible differences in incentive to work for different income groups and when introducing progressive taxation.
The structure of the curve may also be changed by other policy decisions, for example, if tax loopholes and off-shore tax shelters are made more readily available by legislation, the point at which revenue begins to decrease with increased
taxation will become lower.
The curve is primarily used by advocates who want government to reduce tax rates (such as those on capital gains) and believe that the optimum tax rate is below the current tax rate. In that case, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing.
Laffer, in an article published at the Heritage Foundation, has pointed to Russia and the Baltic states who have recently instituted a flat tax with rates lower than 35%, and whose economies started growing soon after implementation. He has also referred to the economic success following the Kemp-Roth tax act, the Kennedy tax cuts, the 1920's tax cuts, and the changes in US capital gains tax structure in 1997 as examples of how tax cuts can cause the economy to grow and thus increase tax revenue.
Between 1979 and 2002, more than 40 other countries, including Belgium, Denmark, Finland, France, Germany, Norway, and Sweden, cut their top rates of personal income tax.
It is important to note that cutting taxes - without cutting spending - will only lead to bigger deficits.
Andrew Mellon, Secretary of Treasury in 1924 wrote, "It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the Government, and that more revenue may often be obtained by lower rates."
Exercising his understanding that "73% of nothing is nothing" he pushed for the reduction of the top income tax bracket from 73% to an eventual 24% (as well as tax breaks for lower brackets). Personal income-tax receipts rose from $719 million in 1921 to over $1 billion in 1929, which supporters attribute to the rate cut.