Laffer curve
The Laffer curve, developed by economist Arthur Laffer and often used to justify tax cuts, argues that government can maximize revenue (taxes) by setting an optimal tax rate. At both extremes--zero percent and one-hundred percent--the government collects no revenue: a 0% tax rate means the government's revenue is, of course, zero; moreover, by imposing a 100% tax rate, the government collects zero revenue because taxpayers have no incentive to work or earn. Somewhere between 0% and 100%, therefore, lies a tax percentage rate that will maximumize revenue, an idea central to the supply side economics and tax cuts of the 1980s.The Laffer curve and supply side economics inspired the Kemp-Roth Tax Cut of 1981.
Figure 1: t* represents the rate of taxation at which maximal revenue is generated
Supply-side advocates of the 1980s claimed that lower tax rates would generate more revenue because government was operating on the right side of the curve. Conventional economic paradigms acknowledge this basic notion, but argue that government was operating on the left side of the curve, so a tax cut would thus lower revenue. The central question is the elasticity of work with respect to tax rates.
In the United States, some claimed that both tax cuts and government spending policies of the 1980s caused large budget deficits. Others claim that the data actually shows United States government revenue increased during that period, suggesting that deficits were unrelated to tax cuts, and should be attributed to increased spending alone. The counter-argument is that the income only increased along with growth in GNP at a rate roughly consistent with other 20th century decades. At the same time the federal government commitments to services such as Social Security rose along with population growth. During the Clinton administration government income and GNP increased at an even higher rate despite rises in taxes.
David Stockman, Reagan's budget director during his first administration and one of the early proponents of supply-side economics, maintained that the Laffer curve was not to be taken literally - at least not in the economic environment of the 1980's United States. In "The Triumph of Politics" he writes:
"[T]he whole California gang had taken [the Laffer curve] literally (and primitively). The way they talked, they seemed to expect that once the supply-side tax cut was in effect, additional revenue would start to fall, manna-like, from the heavens. Since January, I had been explaining that there is no literal Laffer curve."
The central idea of the Laffer curve had been written about in antiquity by many scholars including the Islamic Scholar Ibn Khaldun.
Rumor suggests the Laffer Curve was originally sketched on a restaurant napkin in the late 1970s as Art Laffer and Robert Mundell described the concept to Jude Wanniski.