The Laffer Curve Explained: How the Ideal Tax Rate is Determined

You’ll sometimes hear on the news “the tax rates are at an all-new high,” but what does that really mean in the grand scheme of things? How do governments determine a tax rate and how do they figure out whether to increase or decrease the tax rate? The answer is “The Laffer Curve.”

How the Laffer Curve Works

An idea credited to Arthur Laffer, the Laffer Curve is a parabola that depicts the relationship between tax rates and total tax revenues. Although admitting he didn’t name it the Laffer Curve himself, Laffer states that this idea has been implemented centuries ago–as far back as 1381.

The Laffer Curve

With Tax Revenue on the y-axis and the Tax Rate on the x-axis, notice that it would not be optimal for the government to tax at the two extreme ends of the curve–but why is that?

Obviously, at a 0% tax rate, when you’re making income and keeping all your earnings, there is no tax revenue. The government wouldn’t be able to be funded and their responsibilities of maintaining infrastructure and public officials would not exist. Moreover, employment and production would be abundant considering that the government would not receive a cent in this scenario. At the far right of the curve at 100%, imagine if, for every dollar you make, you have to give all your hard-earned income to the government. You would have no incentive to work and make money right? People would potentially be going out to the black market and not report any of their income. Therefore, the government doesn’t receive any revenue from taxing at 100% either.

Where it gets interesting is the tip of the parabola–this is the optimal tax rate where R* and t* meet on the graph creating prosperity and economic growth. 

The Arithmetic and Economic Effects

Two forces come into play when evaluating the tax rate that makes up the basis of tax theory: the Arithmetic Effect and the Economic Effect.

The Arithmetic Effect is the factor in which an increase or decrease of the tax rate will in turn increase or decrease tax revenues. For example, when tax rates are raised by a certain percent, the government simply collects more tax revenue from the increase. This goes the same with decreasing tax rates which in turn will decrease the amount of tax revenue coming in. Understanding this effect is written right in the name since it is purely mathematical. However, when combined with the Economic Effect, the equation becomes a little more interesting.

The Economic Effect is not as intuitive to understand since it also pertains to incentives and productivity. But essentially it explains that when tax rates are increased, it reduces the attractiveness of going to make money since more of it will be taken away. For instance, businesses faced with a higher tax rate are less productive because they have no incentive to generate a profit at the end of the day since the government is going to swoop in and take a big portion of it. This also applies to decreasing taxes since more are inclined to work since they will be taxed less and thus increases tax revenue from the increased number of people willing to create economic prosperity.

Putting It All Together

Notice on the graph below that if there was a horizontal line on tax revenue (Line R) from the government would be the same, but at two different tax rates seeing as that one is higher and one is lower. Though Laffer explains that having the higher tax rate on Line R closer to 100% makes no sense if you could lower tax rates to receive more productivity and tax revenue. The same goes for the lower tax rate on Line R closer to 0% if there is a chance to increase tax rates for more revenue. The goal is to reach a point at the tip of the parabola where productivity is balanced and tax revenues have reached their maximum.

Here’s where each effect explains how to get to the goal of where R* hits t*. The Arithmetic Effect wins at the tax rate left of t* since with higher tax rates, the higher the revenue for the government. From t* to 100%, the Economic Effect is at an advantage of lowering tax rates to t* so that more people would be incentivized to work again. 

However, there is no exact or right percent the tax rate should be that can be determined through the graph. It simply explains the drivers behind why the tax rate shifts and the notion of finding that sweet spot. This is why governments raise or lower the tax rates with conflicting beliefs from different political parties. From a Republican’s point of view, they believe in the ‘trickle-down’ theory where if there were more benefits to businesses so they can thrive, these wealthy individuals will ‘trickle-down’ and in turn make more job opportunities for the ‘poor’. In terms of a Democratic perspective, they believe that they need to tax the rich and reallocate to the ‘poor’ to create a more balanced playing field. Each has its pros and cons, but it goes to show that there isn’t one distinct method to create economic prosperity.

If you are having trouble with understanding your taxes, why not take the time to consult with a professional accountant? We’re always ready to help!