Laffer curve

The Laffer curve is an economic model on the relationship between tax rates and revenue proposed by the economist Arthur Betz Laffer in 1974. Laffer had received an undergraduate degree at Yale University and a doctorate in international economics from Stanford University. He had served as chief economist for the Office of Management and Budget (1970-72). He attracted attention for supply-side economic theories that held reductions in federal taxes on business and individuals would lead to increased economic growth and ultimately increase government revenue. This model was highly influential among conservative policymakers and economists and was instrumental in the formation of Ronald W. Reagan’s tax policies in the 1980s.

Laffer developed what became known as the Laffer Curve, which showed that, starting from a zero tax increase, increases in tax rates will raise the government’s tax revenue to the point at which, when rates become high enough, further increases in tax rates will decrease revenue, because such high rates create disincentives against earning more income. In other words, increased tax rates would discourage investment and act as a disincentive to enterprise, therefore leading to a reduction in government revenue. Laffer’s model suggested a level of tax rates at which tax revenue could be maximized, and was illustrated graphically by the curve, whose peak marked an optimum balance between tax rates and government revenue.

Although Laffer was the first economist to emphasize its possible application to the U. S. income tax system, his main points were well known to public finance economists. His theory provoked controversy about where the American economy in 1981 should be located on the Laffer curve. He believed that conditions were right for cuts in tax rates, and this would lead to increased government revenues.

This model was attractive to conservative politicians in the 1970s and 1980s, as it underscored fiscal policies of lowering tax rates to stimulate the economy. The Laffer curve gave a theoretical basis for Reagan’s 1981 economic plan, which called for cuts in marginal tax rates. Laffer served as an economic consultant to the U. S. Treasury and Defense Departments between 1972 and 1977, and as an economic adviser to President Reagan.

The effectiveness of Laffer’s model created considerable criticism. President Reagan reduced tax rates significantly in 1981, and although an economic expansion occurred, there was a substantial increase in the budget deficit. Following the tax cuts, however, actual government revenue was less than had been projected. Supporters of the Laffer curve point to external economic pressures, especially in increased government spending for defense, as well as other areas, while critics argue that the Laffer curve has proven to be discredited.

See also ECONOMY; Reaganomics.

—Stephen Hardman