Laffer Curve: Does it actually work?

By: Aiden Black - Y12

The Laffer curve is a highly debated and notorious concept in economics, being an influential idea for decades since its conceptualization in “1979” (Gayatri Nayak, 2016). In this article, I will discuss the premise of the Laffer curve and the theoretical economics behind it, along with evidence for and against this concept and then I will come to a final judgement on the credibility of the idea.

The Laffer curve attempts to visually show the relationship between tax rates and government tax revenue. This curve suggests that at both 0% and 100% tax rate, government revenue is 0. With T* being the “optimum point” (Adam Hayes, 2023) where tax revenue is maximised. Where if a point is right of T* and tax rates increase, revenue is bound to decrease. This is attributed to a variety of factors: households may work less as incentive to work decreases, or those on higher income may leave to another economy where tax rates are lower and there is a higher incentive to evade tax.

An example of the Laffer curve’s effectiveness can be seen in a proposal by President Kennedy in 1963 to “cut income taxes from a range of 20-91% to 14-65% and to cut the corporate tax rate from 52% to 47%” (JFK Library, 2003). This tax cut was stimulative and as a result led to higher consumption in the economy, and as a result GDP rose by 1.4% in 1964 (World Bank, 2023), which led to a fall in unemployment to facilitate this increased aggregate demand, leading to higher income tax and therefore a tax revenue rise. Showing that a decrease in tax rates can lead to an increase in revenue, aligning with the ideology behind the Laffer curve.

However, the US economy had a GDP growth of 6.1%, 4.4% and 5.8% in 1962, 1963 and 1964 respectively (World Bank, 2023), therefore, it could be said that this increase in tax revenue can only be partly attributed to the decrease in tax rates as the US economy was already experiencing an economic boom at the time and with unemployment decreasing by 0.5% from 1963 to 1964 (ibid) the increase in tax revenue could be attributed to lower unemployment rather than the reduced tax rates.

The Laffer curve has “many serious flaws” (ITEP, 2013), one flaw includes the assumption that higher taxes results in lower revenues due to worker demotivation and firms leaving to other economies with lower tax. This may be false as businesses look to factors other than just tax rates when looking to maintain a market presence and may still benefit from the skilled workforce and high-quality infrastructure in the economy and may maintain their position in the economy even with increased taxes.

An example of the misleading nature of the Laffer curve can be seen in the US states: in 2012, lawmakers argued that the 9 US states without income tax, and therefore with lower overall tax rates, were

“outperforming the rest of the country” (ITEP, 2013), this aligns with the ideology of the Laffer curve as it assumes that decreased tax rates may lead to higher economic performance and higher tax revenue (when the tax rate is right of T*). This argument was false, as residents in the US states with the highest tax rates were experiencing “economic conditions at least as good, if not better” (ibid) than those living in states without an income tax. With real GDP growth at 5.2% in states without income tax, while GDP growth was at 8.2% in ‘high rate’ income tax states (ibid). This presents the Laffer curve as “extremely flawed” (ibid) and misleading due to its oversimplification of business decision-making and tax bands.

On balance, while the Laffer curve brings up some valuable points on tax evasion and motivation to work in the labour force, the oversimplification of the tax rates and lack of consideration for the process of decision making in businesses makes it a partly invalid model. With the continued influence of this concept only being spurred on by politicians, with it originally “exploding into the mainstream” (Elizabeth P. Berman, 2019) in 1978 when there was a large decrease in property taxes. Therefore, the Laffer curve is an outdated and ineffective model that is lackluster in considering all factors affecting tax revenue and tax rates.

Reference List

Gayatri Nayak. (2016) Here is everything you want to know about Laffer Curve and tax Available at: https://economictimes.indiatimes.com/wealth/tax/here-is-everything-you-want-to-know-about-laffer-curveand-tax/tomorrowmakersshow/51098997.cms

Adam Hayes. (2023) Laffer Curve: History and Critique. Available at: https://www.investopedia.com/terms/l/laffercurve.asp#:~:text=The%20Laffer%20Curve%20is%20based,in %20increased%20total%20tax%20revenue

Liam P. Ebrill. (2023) 7 Evidence on the Laffer Curve The Cases of Jamaica and India. Available at: https://www.elibrary.imf.org/display/book/9780939934911/ch007.xml

JFK Library. (2003) John F. Kennedy on the Economy and Taxes. Available at: https://www.jfklibrary.org/learn/about-jfk/jfk-in-history/john-f-kennedy-on-the-economy-and-taxes

World Bank. (2023) GDP growth (annual %) – United States. Available at: https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?locations=US

World Bank. (2023) Unemployment, total (% of total labor force) – United States. Available at: https://data.worldbank.org/indicator/SL.UEM.TOTL.NE.ZS?locations=US

Institute on Taxation and Economic Policy. (2013) Five Critiques of Arthur Laffer’s Supply-Side Model Show Tax Cuts as Junk Economics. Available at: https://itep.org/DebunkingLaffer/

Institute on Taxation and Economic Policy. (2013) States with “High Rate” Income Taxes are Still Outperforming No-Tax States Available at: https://itep.org/states-with-high-rate-income-taxes-are-stilloutperforming-no-tax-states/

Elizabeth P. Berman. (2019) Trump is giving Arthur Laffer the Presidential Medal of Freedom. Economists aren’t smiling. Available at: https://www.washingtonpost.com/politics/2019/06/01/trump-is-giving-arthurlaffer-presidential-medal-freedom-economists-arent-laughing/