t* represents the rate of taxation at which maximal revenue is generated. Note: This diagram is not to scale; t* could theoretically be anywhere, not necessarily in the vicinity of 50% as shown here.

The Laffer curve is used to illustrate the concept of Taxable income elasticity, the idea that government can maximize tax revenue by setting tax rates at an optimum point. The curve was popularized by Arthur Laffer though it was widely known among economists long before that. Image File history File links Laffer_Curve. ... Image File history File links Laffer_Curve. ... Tax revenue is the income that is gained by governments because of taxation of the people. ... Tax rates around the world Tax revenue as % of GDP Economic policy Monetary policy Central bank   Money supply Fiscal policy Spending   Deficit   Debt Trade policy Tariff   Trade agreement Finance Financial market Financial market participants Corporate   Personal Public   Banking   Regulation        A tax is a financial charge or other levy imposed on... Arthur Betz Laffer, Sr. ...

The curve is most understandable at both extremes of income taxation—zero percent and one-hundred percent—where the government collects no revenue. At one extreme, a 0% tax rate means the government's revenue is, of course, zero. At the other extreme, where there is a 100% tax rate, the government collects zero revenue because (in a "rational" economic model) taxpayers change their behavior in response to the tax rate: either they have no incentive to work or they avoid paying taxes, so the government collects 100% of nothing. Somewhere between 0% and 100%, therefore, lies a tax rate percentage that will maximize revenue. Naively, assuming that the revenue for a given rate of taxation is continuous, it is implied that . In other words, under these assumptions, Laffer's statement is nothing more than a recapitulation of the extreme value theorem and therefore necessarily true. To what extent these assumptions are true are beyond the scope of the underlying mathematics. They nonetheless provide a basis for argument. You can "back into" a continuous curve by assuming the tax rate will be legislated with no more than a given number of decimal points. The resulting discrete function could then be interpolated with line segments, with the same result as the assuption of continuity. Tax rates around the world Tax revenue as % of GDP Economic policy Monetary policy Central bank   Money supply Fiscal policy Spending   Deficit   Debt Trade policy Tariff   Trade agreement Finance Financial market Financial market participants Corporate   Personal Public   Banking   Regulation        An income tax is a tax levied on the financial income... Rational choice theory assumes human behavior is guided by instrumental reason. ... A continuous function in a closed interval has a minimum (blue) and a maximum (red). ... This article is about interpolation in mathematics. ...

The point at which the curve achieves its maximum will vary from one economy to another and depends on elasticities of demand and supply and is subject to much theoretical speculation. Another contentious issue is whether a government should try to maximize its revenue in the first place.

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. In finance, a capital gain is profit that is realized from the sale of an asset that was previously purchased at a lower price. ...

The Laffer-curve concept is central to supply side economics, and the term was reportedly coined by Jude Wanniski (a writer for The Wall Street Journal) after a 1974 afternoon meeting between Laffer, Wanniski, Dick Cheney, and his deputy press secretary Grace-Marie Arnett (Wanninski, 2005; Laffer, 2004). In this meeting, Laffer reportedly sketched the curve on a napkin to illustrate the concept, which immediately caught the imaginations of those present. Laffer himself professes no recollection of this napkin, but writes, "I used the so-called Laffer Curve all the time in my classes and with anyone else who would listen to me" (Laffer, 2004). Laffer also does not claim to have invented the concept, attributing it to 14th century Islamic scholar Ibn Khaldun and, more recently, to John Maynard Keynes. Supply-side economics is a school of macroeconomic thought which emphasizes the importance of tax cuts and business incentives in encouraging economic growth, in the belief that businesses and individuals will use their tax savings to create new businesses and expand old businesses, which in turn will increase productivity, employment... It has been suggested that Two Santa Claus Theory be merged into this article or section. ... The Wall Street Journal (WSJ) is an influential international daily newspaper published by Dow Jones & Company in New York City, New York with Asian and European editions, and a worldwide daily circulation of more than 2 million as of 2006, with 931,000 paying online subscribers [2]. It was the... Richard Bruce Dick Cheney (born January 30, 1941), is the 46th and current Vice President of the United States, serving under President George W. Bush. ... Ibn Khaldūn or Ibn Khaldoun (full name Arabic: , ) (May 27, 1332/732AH – March 19, 1406/808AH), was a famous Arab Muslim historian, historiographer, demographer, economist, philosopher and sociologist born in present-day Tunisia. ... John Maynard Keynes, 1st Baron Keynes, CB (pronounced cains, IPA ) (5 June 1883 – 21 April 1946) was a British economist whose ideas, called Keynesian economics, had a major impact on modern economic and political theory as well as on many governments fiscal policies. ...

Context in U.S. history

The Laffer curve and supply side economics inspired the Kemp-Roth Tax Cut of 1981. Supply-side advocates of tax cuts claimed that lower tax rates would generate more tax revenue because the United States government's marginal income tax rates prior to the legislation were on the right-hand side of the curve. Supply-side economics is a school of macroeconomic thought which emphasizes the importance of tax cuts and business incentives in encouraging economic growth, in the belief that businesses and individuals will use their tax savings to create new businesses and expand old businesses, which in turn will increase productivity, employment... The Kemp-Roth Tax Cut (officially the Economic Recovery Tax Act, or ERTA) of 1981 reduced marginal income tax rates in the United States by approximately 25% over three years (the top rate falling to 50% from 70% while the bottom rate dropped to 11% from 14%) and indexed them... The government of the United States, established by the United States Constitution, is a federal republic of 50 states, a few territories and some protectorates. ... In the tax system and in economics, the marginal tax rate refers to the increase in ones tax obligation as ones taxable income rises: marginal tax rate = Δ(tax obligation)/Δ(taxable income) This can be measured either by looking at the published tax tables (to get the official marginal... In mathematics, the concept of a curve tries to capture the intuitive idea of a geometrical one-dimensional and continuous object. ...

David Stockman, President Ronald Reagan's budget director during his first administration and one of the early proponents of supply-side economics, maintained that the Laffer curve was not to be taken literally — at least not in the economic environment of the 1980s United States. In The Triumph of Politics, he writes: David Alan Stockman (born November 10, 1946) is a former U.S. politician and businessman, serving as U.S. Representative from the state of Michigan 1977-1981 and as the Director of the Office of Management and Budget 1981-1985. ... Ronald Wilson Reagan (February 6, 1911 - June 5, 2004) was the 40th President of the United States (1981–1989) and the 33rd Governor of California (1967–1975). ...

[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve.

Critiques of the Laffer curve

Conventional economic paradigms acknowledge the basic notion of the Laffer curve, but they argue that government was operating on the left-hand side of the curve, so a tax cut would thus lower revenue. The central question is the elasticity of work with respect to tax rates. For example, Pecorino (1995) argued that the peak occurred at tax rates around 65%, and summarized the controversy as: In economics, elasticity is the ratio of the proportional change in one variable with respect to proportional change in another variable. ...

Just about everyone can agree that if an increase in tax rates leads to a decrease in tax revenues, then taxes are too high. It is also generally agreed that at some level of taxation, revenues will turn down. Determining the level of taxation where revenues are maximized is more controversial.

At least one empirical study, looking at actual historical data on tax rates, GDP, and revenue, placed the revenue-maximizing tax rate (the point at which another marginal tax rate increase would decrease tax revenue) as high as 80%. Paul Samuelson argues in his popular economic textbook that Reagan was correct in a very limited sense to view the intuition underlying the Laffer curve as accurate, because as a successful actor, Reagan was subject to marginal tax rates as high as 90% during World War II. The point is that in a progressive tax system, any given person's perspective on the validity of the Laffer curve will be influenced by the marginal tax rate to which that person's income is subject. In the tax system and in economics, the marginal tax rate refers to the increase in ones tax obligation as ones taxable income rises: marginal tax rate = Δ(tax obligation)/Δ(taxable income) This can be measured either by looking at the published tax tables (to get the official marginal... Paul Anthony Samuelson (born May 15, 1915, in Gary, Indiana) is an American neoclassical economist known for his contributions to many fields of economics, beginning with his general statement of the comparative statics method in his 1947 book Foundations of Economic Analysis. ... Combatants Allied powers: China France Great Britain Soviet Union United States and others Axis powers: Germany Italy Japan and others Commanders Chiang Kai-shek Charles de Gaulle Winston Churchill Joseph Stalin Franklin Roosevelt Adolf Hitler Benito Mussolini Hideki Tōjō Casualties Military dead: 17,000,000 Civilian dead: 33,000... A progressive tax is a tax imposed so that the tax rate increases as the amount to which the rate is applied increases. ...

Supporting examples

Laffer himself 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.[1] A flat tax, also called a proportional tax, is a system that taxes all entities in a class (typically either citizens or corporations) at the same rate (as a proportion on income), as opposed to a graduated, or progressive, scheme. ...

He has also referred to the economic success following the Kemp-Roth tax act, the Kennedy tax cuts, the 1920s 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. A capital gains tax (abbreviated: CGT) is a tax charged on capital gains, the profit realized on the sale of an asset that was purchased at a lower price. ...

In 2006, the US Treasury reported that monthly tax receipts in April reached their second-highest point in the history of the nation, totalling $315.1 billion, second only to April 2001's mark of $332 billion prior to the burst of the Internet stock bubble. These results could be interpreted as suggesting that the US was still on the right half of the Laffer Curve, contradicting some predictions in the wake of enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003, . On the other hand the higher tax revenues could simply be the result of a strong economy with low unemployment, unrelated to the tax cuts. The United States Department of the Treasury is a Cabinet department, a treasury, of the United States government established by an Act of U.S. Congress in 1789 to manage the revenue of the United States government. ... Dot-com (also dotcom or redundantly dot. ... The Jobs and Growth Tax Relief Reconciliation Act of 2003 was passed by the United States Congress on May 23, 2003 and signed by President Bush five days later. ...

Difficulties of measurement

The Laffer curve is a static model, in that it models an economy with identical productive capacity under two different sets of tax rules. In a dynamic economic model, economic growth is a relatively general phenomenon, and one would therefore expect tax revenue to increase over time even if the tax regime remains identical. This leads many to suggest that the common comparisons stated to support the Laffer Curve are an unfair test. Look up static in Wiktionary, the free dictionary. ... This article needs additional references or sources for verification. ...

Others respond that, even if the Laffer Curve itself is a static model, a programme of tax cuts nevertheless provides incentives for innovation and investment, which will increase the rate of economic growth, as predicted by endogenous growth theory. Invest redirects here. ... In economics, endogenous growth theory or new growth theory was developed in the 1980s as a response to criticism of the neo-classical growth model. ...

Also, the Laffer Curve is clearly a model assuming uniform tax rates across all income ranges. Since most governments do not have a flat tax rate the Laffer curve would not hold for them, although similar effects may apply, and so it is a useful simplification to think about.

Keynesian critique

Some economists argue that while tax cuts are beneficial to the economy, they are beneficial for different reasons. Keynesian economics suggests that an increased government deficit - for instance, resulting from a tax cut - will stimulate economic output. This leads some to identify instances of the 'Laffer curve' as periods of Keynesian demand stimulation. This article includes a list of works cited or a list of external links, but its sources remain unclear because it lacks in-text citations. ... A budget deficit occurs when an entity (often a government) spends more money than it takes in. ...

The wrong incentives?

Some economists argue that, while it is correct to focus on the problems of incentives in the economy, the problem is not the general level of taxation. The inelasticity of labor supply means that tax rates will have little effect on labor. The focus of analysis should be on the effective use of the labor already available. These economists point to, for instance, principal-agent problems in ensuring staff have appropriate incentives for performance, rather than the level of tax the staff face. In economics, the principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. ...

The Neo-Laffer Curve

At middle, the model collapses into "technosnarl," a region of chaos brought on by real-life complexities

A harsher critique of the Laffer Curve can be seen with Martin Gardner's satirical construct, the so-called neo-Laffer Curve. The neo-Laffer curve matches the original curve near the two extremes of 0% and 100%, but rapidly collapses into an incomprehensible snarl of chaos at the middle. Gardner based his curve on actual US economic data collected in a fifty year period by statistician Persi Diaconis. Image File history File links NeoLaffer. ... Image File history File links NeoLaffer. ... Martin Gardner (b. ...

The satire illustrates the major fallacy commonly committed with the Laffer curve, namely the assumption that the middle is a smooth, concave function merely because the two extreme endpoints are well-defined. A realistic tax curve would most certainly not resemble a smooth parabola or even any other simple function, but rather a very complex curve with many peaks, valleys, and multiple local maxima. Inside the middle, a wide range of various economic factors confound any simplistic attempt at this interpolation. In calculus, a differentiable function f is convex on an interval if its derivative function f ′ is increasing on that interval: a convex function has an increasing slope. ...

As a pedagogical tool, a Laffer curve helps illustrate a specific application of the law of diminishing returns, where the inhibitory cost of taxes may eventually outweigh the increased rate of taxation, and thus led to a counterintuitive lower realization of tax revenue. However the Laffer curve should not be taken as a literal model for a tax revenue curve, especially in debates between relatively moderate amounts of taxation. It is in this context that the Laffer curve is often abused, taken as a serious model for tax revenue when it has little to no predictive value in debates between intermediary rates of taxation In economics, diminishing returns is the short form of diminishing marginal returns, the concept that, as more of an input is applied, each additional unit produces less and less additional output. ...

Estimates of the effectiveness of the Laffer curve

In 2005, the Congressional Budget Office released a paper called "Analyzing the Economic and Budgetary Effects of a 10 Percent Cut in Income Tax Rates" [2] that casts doubt on the idea that tax cuts ultimately improve the government's fiscal situation. Unlike earlier research, the CBO paper estimates the budgetary impact of possible macroeconomic effects of tax policies, i.e., it attempts to account for how reductions in individual income tax rates might affect the overall future growth of the economy, and therefore influence future government tax revenues; and ultimately, impact deficits or surpluses. The paper's author forecasts the effects using various assumptions (e.g., people's foresight, the mobility of capital, and the ways in which the federal government might make up for a lower percentage revenue). Even in the paper's most generous estimated growth scenario, only 28% of the projected lower tax revenue would be recouped over a 10-year period after a 10% across-the-board reduction in all individual income tax rates. The paper points out that these projected shortfalls in revenue would have to be made up by federal borrowing: the paper estimates that the federal government would pay an extra $200 billion in interest over the decade covered by his analysis. To support these calculations, the paper assumes that the 10% reduction in individual tax rates would only result in a 1% increase in gross national product, a figure some economists consider too low for current marginal tax rates in the United States. [3][4] The paper appears to focus on Federal government revenue only and does not look at the total public sector revenue (i.e., it does not include increases in local and state government revenue). The Congressional Budget Office is a federal agency within the legislative branch of the United States government. ... Measures of national income and output are used in economics to estimate the value of goods and services produced in an economy. ... In the tax system and in economics, the marginal tax rate refers to the increase in ones tax obligation as ones taxable income rises: marginal tax rate = Δ(tax obligation)/Δ(taxable income) This can be measured either by looking at the published tax tables (to get the official marginal...

Precedents to the Laffer curve

The idea inherent in the Laffer curve has been described many times prior to Laffer, including:

• The 14th century Islamic scholar Ibn Khaldun
• The 18th century politician Alexander Hamilton
• The 19th century French economist Frédéric Bastiat
• The 19th century constitution of the Confederate States of America
• The 20th century economist John Maynard Keynes

Note that Laffer himself does not claim credit for the idea,^[1] although he does seem to be responsible for popularizing the concept and its implications to policy makers. Ibn Khaldūn or Ibn Khaldoun (full name Arabic: , ) (May 27, 1332/732AH – March 19, 1406/808AH), was a famous Arab Muslim historian, historiographer, demographer, economist, philosopher and sociologist born in present-day Tunisia. ... Alexander Hamilton (January 11, 1755 or 1757–July 12, 1804) was an Army officer, lawyer, Founding Father, American politician, leading statesman, financier and political theorist. ... Frédéric Bastiat Claude Frédéric Bastiat (June 30, 1801–December 24, 1850) was a French classical liberal theorist, political economist, and member of the French assembly. ... Motto Deo Vindice (Latin: Under God, Our Vindicator) Anthem (none official) God Save the South (unofficial) The Bonnie Blue Flag (unofficial) Dixie (unofficial) Capital Montgomery, Alabama (until May 29, 1861) Richmond, Virginia (May 29, 1861–April 2, 1865) Danville, Virginia (from April 3, 1865) Language(s) English (de facto) Religion... John Maynard Keynes, 1st Baron Keynes, CB (pronounced cains, IPA ) (5 June 1883 – 21 April 1946) was a British economist whose ideas, called Keynesian economics, had a major impact on modern economic and political theory as well as on many governments fiscal policies. ...

See also

Wikimedia Commons has media related to:

Laffer curve

• Trickle-down economics
• Supply-side economics
• Inflation-driven revenue
• Reaganomics
• Macroeconomics
• List of economics topics
• Lawrence Kudlow

Image File history File links Commons-logo. ... The Wikimedia Commons (also called Wikicommons) is a repository of free content images, sound and other multimedia files. ... Trickle-down economics and trickle-down theory, in political rhetoric, are characterizations by opponents of the policy of lowering taxes on high incomes and business activity. ... Supply-side economics is a school of macroeconomic thought that argues that economic growth can be most effectively managed using incentives for people to produce (supply) goods and services, such as adjusting income tax and capital gains tax rates. ... Reaganomics (a portmanteau of Reagan and economics, coined by radio broadcaster Paul Harvey) is a term that has been used to both describe and decry free market advocacy economic policies of U.S. President Ronald Reagan, who served from 1981 to 1989 and economic policies perceived as similar. ... Circulation in macroeconomics Macroeconomics is a branch of Economics that deals with the performance, structure, and behavior of the economy as a whole. ... This aims to be a complete list of the articles on economics. ... Lawrence (Larry) Kudlow (born August 19, 1947 (age 59)), is an American conservative, supply-side economic commentator. ...

External links

• Arthur Laffer describing the Laffer Curve

Footnotes

1. ^ The Laffer Curve: Past, Present, and Future