A Critique of The Laffer Curve

Abstract

In December 1974, the economist Art Laffer had dinner at a Washington D.C. restaurant with Jude Wanniski, Donald Rumsfeld, and Dick Cheney. The tax rate was so high in the United States, Laffer argued, that reducing the tax rate would increase government tax revenue. As legend has it, he drew the Laffer Curve on a napkin to illustrate how reducing the tax rate would raise tax revenue. The Laffer Curve has been a mainstay of Supply-Side Economics ever since.
The Laffer Curve relates government tax revenue to the tax rate. Figure 1 is the Laffer Curve (Laffer, 2004). The x-axis shows tax revenue and the y-axis shows the tax rate. The Laffer Curve plots the relationship between the tax rate and tax revenue. As figure 1 shows, tax revenue is maximized, or optimal at RO, when the tax rate is TO.

[Fig 1: LAFFER CURVE]

Further, the Laffer Curve illustrates that tax revenue decreases as the tax rate rises above the optimal tax rate. For example, imagine the tax rate is suboptimal at TS. At this tax rate, government revenue is suboptimal at RS. Even though the tax rate TS is higher than TO, tax revenue RS is actually lower than RO. In this case, government can increase tax revenue by reducing the tax rate. Generally, government can increase tax revenue by lowering the tax rate whenever the economy is located on the downward sloping part of the Laffer Curve. In short, the Laffer Curve suggests that extremely high taxes are counterproductive even from the government’s own perspective.
Murray N. Rothbard stressed that Laffer’s analysis contains a hidden value judgement: maximizing government tax revenue is desirable. Rothbard writes,
“Laffer assumes that what all of us want is to maximize tax revenue to the government. If—a big if—we are really at the upper half of the Laffer curve, we should then all want to set tax rates at that “optimum” point. But why? Why should it be the objective of every one of us to maximize government revenue? To push to the maximum, in short, the share of private product that gets siphoned off to the activities of government? I should think we would be more interested in minimizing government revenue by pushing tax rates far, far below whatever the Laffer Optimum might happen to be” (Rothbard, 1984: 17-18; Block, 2010).
Economists who use the Laffer Curve conduct their analysis with a fixed curve. However, in a progressing economy, the Laffer Curve is constantly expanding. Put differently, the Laffer Curve is always shifting to the right in a progressing economy. Advocates of the Laffer Curve fail to realize that the position of the curve is far more important than the economy’s place on a given curve.
The position of the Laffer Curve depends on the stock of accumulated capital. As economists underscore again and again, capital accumulation is the only way to raise overall living standards. Ludwig von Mises writes,
“there is but one method available to improve the conditions of the whole population, viz., to accelerate the accumulation of capital as against the increase in population. The only method of rendering all people more prosperous is to raise the productivity of human labor, i.e., productivity per man hour, and this can be done only by placing into the hands of the worker more and better tools and machines.” (1951: 282)
Significantly, capital accumulation and hence overall living standards depend on the tax rate. As economists have known for centuries, high taxes impair capital accumulation:
“If the funds which the successful businessmen would have ploughed back into productive employments are [taxed and] used by the state for current expenditure or given to people who con-sume them, the further accumulation of capital is slowed down or entirely stopped. Then there is no longer any question of economic improvement, technological progress, and a trend toward higher average standards of living” (Mises, 1955: 51).