Imagine that you were a ruler of a government proposing a tax code. If you wanted to raise the most tax revenue, what would you do? Would you set the tax rate as high as you possibly could? You might already have anticipated some problems with that approach – if, say, you set a tax rate of 100%, there would be no incentive for anyone to work for money (because it would all go to the government), and therefore, no one would work, and your hypothetical government would raise no money in tax revenue. However, if you set a tax rate of 0%, although people would work for money, the government would not raise any tax revenue from it.
So, with the understanding that a tax rate that is too high can economically discourage any activity that would incur taxes (that is, people working for money, or people voluntarily paying taxes)…and a tax rate that is too low can essentially “leave money on the table”, one could theorize that somewhere in between these two extremes is a tax rate by which tax revenue can be maximized. And, at least theoretically, revenue amounts could be plotted against every tax rate between 0% and 100% to find this maximizing value.
This is the concept of a Laffer curve, simply illustrated. The Laffer curve was popularized by Jude Wanninski in the 1970s and named after the work of Arthur Laffer. However, the idea of the curve and of tax revenue maximization is far older than that, as even Laffer admitted, stretching back to 14th century Islamic mathematicians and economists.
The Laffer curve is most commonly used in Supply Side Economics discussions. As that name supposes, supply-side economics is primarily oriented with the economics regarding the supply and production of goods and services within an economy – the economic goal is to lower the barriers on producers to produce. The idea is that, when these barriers are lowered, then producers will be able to provide goods and services at lower cost (and lower price) to consumers, which benefits consumers and the entire economy.
Many supply-side economists believe that taxation has an adverse effect on production – that the producers of goods and services are taxed too highly, and as a result, those high costs of doing businesses trickle down to the consumers in the form of higher prices. So, supply-side economists would likely look to the Laffer Curve with the understanding that governments tend to be on a side of too high taxation that decreases total revenue and discourages economic activity. By lowering tax rates, the lower costs of doing business could trickle down to consumers, increase economic activity, and at the same time increase tax revenue. At least in theory.
The primary issue with the Laffer curve is determining what tax rate increases tax revenue without discouraging economic activity. A study at Southeastern Louisiana University analyzing US tax data from 1959 to 1995 suggested that the ideal tax rate lay between 32% and 35%, but competing surveys have suggested maximizing tax rates being anywhere from 65% to 70%.