Laffer Curve Works Again

Ronald Reagan once said an economist is someone who sees something that works in practice and wonders if it would work in theory. So why is it that when confronted with a concept that works in both practice and theory, so many people refuse to believe it?

The Laffer Curve, popularized by economist Arthur Laffer, says the government can maximize tax revenue by setting the tax rate at the peak of the revenue curve, and that raising taxes beyond that peak can actually decrease tax revenues. Similarly (and seemingly paradoxically), tax revenues can rise even when taxes are cut.

The logic is obvious on the ends of the spectrum: if the tax rate is 0%, the government collects no money. If it is 100%, people have no reason to earn, and the government still collects no money. The peak of the curve lies somewhere in-between. Where? It varies over time, but monitoring tax receipts and how they respond to changes in the tax rate can help tell us which side of the curve we’re on. And President Bush’s 2003 tax cuts do just that.

Federal tax receipts for October and November (the first two months of fiscal 2006) were $288 billion. This is up from the first two months of fiscal 2005 ($271 billion), 2004 ($254 billion), and 2003 ($244 billion). Despite cutting tax rates in May 2003, tax receipts for this two-month period have risen for three consecutive years. We were on the wrong side of the curve (and may still be): Tax rates were too high.