Economics and Taxes: The Laffer Curve Explained

In his recent interview on our site, Texas congressional candidate Van Taylor raised an important economic point that I'd like to clarify for anyone who may be unfamiliar: the phenomenon of how lowering tax rates can lead to increased, and not decreased, government revenue.

As Mr. Taylor mentioned, when President Bush's lowered our nation's capital gains tax by 25%, federal government revenue from that tax doubled from $300 million to $600 million. But how can this be, you might be thinking; given that taxes are the primary source of government income, wouldn't higher taxes logically lead to more money in federal coffers?

In reality, the answer is sometimes it does, sometimes it doesn't. And the explanation behind this apparent contradiction is best demonstrated through a graph called the Laffer Curve, which plots government revenue from maximum to minimum along a scale of taxation from zero to 100%.

So how do we make sense of it? Let me explain with an example. Say you have a hypothetical nation that has no taxes. Naturally, this means the government receives no tax revenue. But our government doesn't like having no money, so it decides to raise the tax rate on its citizens' incomes to 1%. Now, all of a sudden, the government has some funds, and it is happy. So it decides to raise the rate again to 10%. And now the government makes even more money and is happier still.

So far so good, but now the government gets greedy. It decides to raise the tax rate all the way to 100%, thinking it will maximize revenue. But all of a sudden, the nation's citizens decide to stop working, because what use is work if they don't get to keep any of their money? Government revenue hence plummets back to zero, and the government is as broke as when it charged no taxes at all.

As we can see, then, taxing people both too little and too much can hurt government revenue. Tax too low and you won't receive enough from each citizen, but tax too high and you'll disincentivize people to work and invest, thereby reducing the number of taxpayers available to fund you.

The optimal tax rate that maximizes government revenue, then, is somewhere between these two high and low extremes. It is this relationship, as expressed on a chart, that we notate as the Laffer Curve.

Being only a representation of data, the curve cannot by itself determine the optimal tax rate (the sample curve above may appear to be maximized at 50%, but this is only a random example); only real-life data can do so. And according to it, the optimal tax rate is very low - perhaps 15% or 17% on income tax.

But whatever the actual optimal rate, if your current tax rate lies above it, lowering taxes will move you towards the optimum and will increase government revenue. If, on the other hand, your current tax rate lies below the optimal rate, raising taxes will move you towards the optimum and therefore increase government revenue. The tax cut to which Mr. Taylor referred raised government revenue precisely because the original tax rate lay above the optimal rate, and cutting it helped bring it closer to maximization.

The question the federal government should ask itself, then, is not whether to raise or lower taxes purely to achieve a rise or cut, but how to adjust taxes accordingly so that they reach the optimal revenue-maximization point on the Laffer Curve. Right now, America's tax rates seem to be above the optimal rate, so cutting taxes toward that rate (but not overshooting it by reducing taxes too much) is quite certain to increase the government's pockets. Given that tax cuts also greatly boost private-sector economic performance, they seem in this situation like a win-win proposal for all involved.