The Laffer Curve is a pillar of supply side economics popularized by the economist Art Laffer and formed the basis of President Ronald Reagan’s “Reaganomics”. The Laffer Curve argues that at a certain marginal tax rate, an increase in the tax rate will actually result in less government revenue. The argument is based on incentives and that at high tax rates workers have less incentive to work hard thus earn less and lower the tax base. Conversely, low tax rates encourage workers to produce and earn more and increase the tax base. The increase in the tax base, it is argued, should more than account for the reduction in the tax rate. The basis for the curve is simple: at a 0% tax rate the government will have a revenue of zero for obvious reasons, and at a 100% tax rate he government’s revenue will be zero since workers will have no incentive to works because no matter how hard they work and how much they produce the government will take it all. The resulting curve looks like a mountain, with tax rate on the x-axis and government revenue on the y-axis.
The range in which increasing the tax rate lowers government revenue is deemed the prohibitive range because it discourages increased work and output. The debate surrounding the Laffer Curve arises over where the prohibitive range begins. Some economists argue that the prohibitive range begins at 12% while others believe that it is above the 39.5% of the pre-Bush Jr. era tax cuts. For Laffer Curve style tax cuts to be fully effective, they must be accompanied by decreased government spending with the idea that newly incentivized private industry will fill the void left by the government, further increasing the tax base.
Understanding the Laffer Curve, where we are on the curve and where the prohibitive range begins, can be an important tool in helping to reduce the increasingly alarming budget deficits. If we are not yet in the prohibitive range then an increase in tax rates could increase revenue without harming output. However, if our highest tax rates are indeed in the prohibitive range, as many economists suggest, then a lowering of income tax rates could help stimulate the economy and reduce the budget deficit.