laffer curve_Philip curve_kinked curve

Definition: The Laffer Curve is the theory that says lower tax rates boost economic growth. It underpins supply-side economics, Reaganomics, and the Tea Party economic policies. Economist Arthur Laffer developed it in 1979.

The Laffer curve describes how changes in tax rates affect government revenues in two ways. One is immediate, which Laffer describes as arithmetic. Every dollar in tax cuts translates directly to one less dollar in government revenue.

The other effect is longer-term, which Laffer describes as the economic effect. It works in the opposite direction. Lower tax rates put money into the hands of taxpayers, who then spend it. That creates more business activity to meet consumer demand. Then,companies hire more workers, who spend their additional income. This boost to economic growth generates a larger tax base. That eventually replaces any revenue lost from the tax cut.

The chart shows how, at the bottom of the curve, zero taxes results in no government income and, thus, no government. Of course, increasing taxes from zero immediately boosts government revenue. In the beginning, raising taxes still does a good job of increasing total revenue, as shown by the flatness of the curve. As the government keeps raising taxes, the payoff in additional revenue becomes less, and the curve steepens.

At some point, higher taxes create a heavy burden on economic growth.

Demand falls so much that the long-term decline in the tax base more than offsets the immediate increase in tax revenue. Thats where the curve boomerangs backward. Its the shaded section on the chart, which Laffer calls the Prohibitive Range. Beyond this point, additional taxes result in reduced government revenue.

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