Understanding
the Laffer Curve
In
1974, economist Art Laffer reportedly first sketched his
now-famous curve on a napkin to illustrate his belief that
reducing tax rates could actually increase tax revenues. The
theory is at the heart of supply-side economics, which helped
motivate the Reagan-era tax cuts and President Bush's tax-relief
efforts in 2001 and 2003.
The Laffer Curve is simply a depiction of the law of
diminishing returns. If tax rates are too low, the government
can't raise enough funds to meet the needs and expectations of
the public. If rates are too high, economic activity could be
stifled and cause tax revenues to fall.
A look at the left side of the curve shows that at a tax rate
of 0%, the government collects no revenue regardless of the size
of the tax base. On the far right side of the curve, a tax rate
of 100% also results in no revenue, because there is no
incentive to work, and thus no tax base. Somewhere on the curve
between 0% and 100% lies a tax rate (t) that should maximize tax
revenues.
Policymakers usually disagree on whether tax rates are
resting too far to the left or right on the curve.
Unfortunately, there is no concrete formula that uncovers the
taxation "sweet spot," so they must ultimately rely on trial and
error.
There is considerable debate about the controversial graph.
Supply-siders point to the positive effects that tax cuts can
have on productivity, investment, and employment in a given
economy. They say the curve proves that tax cuts can actually
pay for themselves in the long run by increasing the tax base.
As evidence, they point to the fact that federal tax receipts
and the U.S. economy have grown steadily since federal taxes
were cut significantly in 2003.1
Critics argue that cutting taxes without reducing spending
will cost society more over time, primarily in the form of
interest payments on larger budget deficits. Others object to
the notion of maximizing revenues at all.
Regardless of which side of the debate you take, the Laffer
Curve may help with decisions about your own Financial
situation. For example, if you were to set aside 0% of your
income, it is unlikely that you would be able to reach your
Financial goals.
Conversely, if you were to invest 100% of your income, it is
also unlikely that you would be able to reach your goals because
you would have nothing to live on. Somewhere in between is the
ideal balance. This might seem a bit simplistic, but that's
because the idea is clearest at both extremes.
The point is, any Financial decision you make should be based
on the benefits and drawbacks that apply to your situation,
whether you are considering what to do about risk, taxes, asset
allocation, or retirement plan contributions.
From:
David Waters
Phone: 215.875.8790
1) Haver Analytics, 2006
