Laffer Curve Economics: The Simple Idea That Revolutionized Tax Policy

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Sometimes, the most revolutionary political ideas come out of nowhere. That certainly was the case with Laffer Curve economics. This theory has reshaped tax policy for decades, and it all came out of a napkin doodle over lunch.

The Famous Lunch Meeting

In 1974, Dr. Arthur Laffer, an economist who specializes in taxation, was working in Washington, D.C. He was close friends with Dick Cheney and Donald Rumsfeld, who were advisers then to President Ford. At the time, Ford was considering a sizable 5 percent income tax, which Cheney and Rumsfeld expected would return an equal 5 percent boost in government revenue.

During a late lunch at the expensive Hotel Washington’s Two Continents restaurant with Cheney and Rumsfeld, Laffer explained the issue with this expectation. He was so passionate about his idea that he whipped out a Sharpie to illustrate his point on a white cloth napkin.

The Laffer Curve Courtesy of The Laffer Center at the Pacific Research InstituteThe Theory

Laffer’s theory posits that increasing the tax rate doesn’t lead to an exact match in the amount of money that comes in. When the tax rate goes up, it lowers the incentive for people to work because they’ll earn less. As a result, some people might leave their jobs, and others might work fewer hours. Some might also hide income to avoid taxes.

This effect starts out slow. At a 0 percent tax rate, the government wouldn’t raise any money. But increasing the rate to 10 percent would lead to a large revenue increase, close to 10 percent, because people would still keep most of their income and have a strong motivation to work.

As the tax rate creeps higher, however, more people would leave the workforce, resulting in the government taking in less money per increase. Eventually, the economy would reach a point where increasing taxes actually lowers the amount of money that comes in, because too many people stop working, causing the economy to shrink. If the tax rate were 100 percent, the government would take in no money at all because people would have no motivation to work; the entire economy would shut down.

The Policy Impact of Laffer Curve Economics

Laffer wanted to warn Cheney and Rumsfeld, because government tax policy was already nearing the danger zone during a time of economic recession. The highest income tax bracket was at 70 percent. If Ford raised taxes, there was a real risk that this would lead the government into a worse financial position by shrinking the tax base.

Cheney and Rumsfeld took this lesson to heart, and lowering the income tax rate became a top priority in Washington. The results were quite impressive. By lowering the tax rate, the government brought in more revenue by encouraging more work from the highest earners. This extra money allowed the government to reduce the tax burden for middle-class workers at the same time.

Influence on State Income Tax Rates

The Laffer Curve is something your state representatives should keep in mind for the state income tax rate. If you live in a state with a high income tax rate, such as California, your reps should know that lowering taxes could both boost revenues and make life better for residents. If you live in a low-tax state, such as North Dakota (3.22 percent income tax), make sure your representatives know that raising taxes could turn out more costly than they expect.

The power of the Laffer Curve theory, a major construct of supply-side economics, comes from its simplicity. Its logic seems obvious, yet without Dr. Laffer’s insight, who knows if the government would have discovered the concept in time? One thing is certain: Before your next big lunch meeting, don’t forget to bring your Sharpie.