Income Tax Theories – The Laffer Curve

The Laffer Curve, a landmark economic theory fittingly named after seminal economic professor Dr. Arthur Laffer. In addition to Dr. Laffer’s role as trusted economic advisor to President Reagan in the early 1980’s, Dr. Laffer has gained much of his acclaim through his historic work in creating the Laffer Curve. The Laffer Curve states that increases in low level taxes carry a corresponding increase in government tax revenues. As the resulting tax rate increases it inevitably reaches a point upon which people lose their incentive to continue working as hard or as productively. This drop in incentive results in a reduction of income levels and thus, a fall in overall tax revenue. As logic would dictate, this chain of events progresses into a 100% tax rate, whereby individuals have lost all incentive to work and decline to continue to do so. The absence of individual work output would result in government tax revenue of zero.

This is illustrated by the Laffer Curve:

T* represents the optimum tax rate, at which the maximum amount of tax revenue can be collected. Laffer and many other economists used the curve as a tool to illustrate the effects of the excessive rates then in place. They argued that these rates would need to be reduced in order to provide fiscal incentive for hard work. This line of thought became synonymous with supply-side economics and aptly conferred upon Laffer the credit of “Father of Supply-Side Economics.”