In the year 1978, a simple theory sketched out by the economist Arthur Laffer suddenly gained popularity. This was the Laffer Curve, which shows the relationship between tax rates and the total amount of tax revenue generated by a government.
This is the full version of the video. I uploaded a Short last week on the same topic.
0:00 Intro
0:38 Laffer Curve theory
1:35 Story goes viral
2:52 Reaganomics
3:45 Problems with the curve
5:45 Outro
However, it was a journalist that made this theory popular. The story goes that four men went to a restaurant in Washington to discuss President Ford’s decision to raise taxes. One of these men was Arthur Laffer, who proceeded to draw a diagram on his napkin. What he drew was something like this.
At one extreme, if there are no taxes in an economy, the government will clearly raise no tax revenue as people get to keep all their income.
At the other extreme, if taxes are 100%, there will also be no tax revenue. This is because no one will go to work if all their income is taxed away.
The implication is thus that we have an inverted U-shaped curve. At the extremes, the government gains no tax revenue. With tax rates somewhere in between, the government obviously does receive money through taxation.
The purpose of this was to illustrate the following point. Suppose that we’re on the right-hand side of the curve. We could reduce tax rates and still increase our tax revenue.
The obvious policy would be to reduce taxes because we can generate more revenue and everyone has higher incomes because they’re taxed less. It’s a win-win situation.
Strangely enough, this story of the Laffer curve quickly went viral. It’s not surprising that the idea was popular, as people do like the idea of lower taxes. But it’s likely that this theory spread so quickly because of its simplicity. It’s quite easy to explain the curve, so much so that you can do it on a napkin. A popular idea that is simple to share with others can be a very contagious story.
This changed the way a lot of people viewed tax policy, and did, at least to some extent, increase support for cutting taxes. This may have contributed to the election of Ronald Reagan as US President in 1980 and his commitment to cutting taxes. Tax cuts were a key part of Reaganomics, where Reagan also decreased social spending, deregulated domestic markets, and reduced growth in the money supply.
Now, as with many other narratives, we can’t really say how much of a role the story of the Laffer curve played here. A number of other factors were also at play. For example, when Reagan was first elected, the US economy was going through a period of stagflation.
The problem that a lot of economists had with the Laffer curve is that no evidence was given to say that the US economy was on the right-hand side of it. The reason the story spread so quickly was that it was simple. But this simplicity also means the theory doesn’t address a lot of problems.
For one, the curve may not be shaped like this. Our assumptions only tell us that there should be no tax revenue at zero and 100% taxation. The curve in between could be any shape. It might have flat sections or multiple peaks, so decreasing taxes could massively reduce tax revenue.
The curve may also change over time, as labour markets, tax structures, and people’s preferences change. It is thus very difficult to determine whether decreasing taxes would increase tax revenue.
People may like the idea of reducing taxes, but this theory primarily advocates reducing taxes for the rich, and not the poor. High earners are the ones paying the highest rates of income tax and are thus more likely to be on the right-hand side of the curve. Reagan did cut the top income tax rate from 70% to 50%, and later down to 28%. It has since been shown that, as expected, this cut did not increase tax revenue. In fact, the government deficit heavily increased during Reagan’s presidency.
However, these arguments aren’t as catchy or as popular as the original story. You need to know a lot more about economic theory to understand the problems with the Laffer curve than to understand the supposed benefits of it. Only when we know both sides of the argument can we make an informed decision. This is one of the key points that mean narratives can have a major impact on an economy. It’s not about what is true, it’s about what people believe.
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