LAFFER CURVE THEORY

LAFFER CURVE THEORY. The Laffer Curve Theory states that tax revenues are related to the tax rate in such a manner that no revenue is generated at a tax rate of either zero or one hundred per cent, for at one hundred percent taxable activity would effectively cease; somewhere in between these tax rates lies the revenue-maximizing rate. Higher income taxes reduce the tax base by discouraging saving and labor supply. A reduction in after-tax income will reduce savings. An increase in the income tax rate changes the relative price of consumption and leisure, encouraging leisure. Beyond the maximum, higher rates would reduce income so much that revenues would decrease. Lowering tax rates indirectly encourages investment by increasing savings, potentially increasing income and thus tax revenues. The curve need not be symmetric or have a particular maximum. Professor Arthur Laffer and Representative Jack Kemp argued that a large reduction in U.S. income tax rates would reduce the deficit. This implied that previous policymakers were acting against their own true interests, imposing unpopular high tax rates that reduced the amount of revenue they had to spend. The Reagan Administration's tax cuts during the 1980s led to record large deficits, not to reduced deficits.

BIBLIOGRAPHY

Bosworth, Barry P. Tax Incentives and Economic Growth. Washington, D.C.: Brookings Institution, 1984.

Canto, Victor A., Douglas H. Joines, and Arthur B. Laffer. Foundations of Supply-Side Economics: Theory and Evidence. New York: Academic Press, 1983.

Dunn, Robert M., Jr., and Joseph J. Cordes. "Revisionism in the History of Supply-Side Economics." Challenge 36, no. 4 (July/August 1994): 50–53.