Higher taxes negatively impact the number of people willing to work as illustrated by the Laffer Curve.
The marginal tax rate is measured on the vertical axis, and total tax revenues are measured on the horizontal axis. Note that the Laffer Curve is backward-bending, reflecting the behavioral notion that at some point, people will work less the more they are taxed. This backward bend means that above a certain tax rate, “m” in the figure, an increase in the tax rate will cause overall tax revenues to fall.
For a supply-side tax cut to increase tax revenues, the existing tax rate before the tax cut must be above “m,” perhaps at a rate associated with point “n” on the curve. The tax rate being above “m” is an important point because, in the early 1980s, the Reagan Administration’s economists believed that the economy was on the backward-bending portion of the Laffer curve (above “m”) and that a tax cut would increase total tax revenues. Based on this assumption, it moved forward with one of the largest tax cuts in American history.
In economics, the Laffer curve is a representation of the relationship between rates of taxation and the resulting levels of government revenue. Proponents of the Laffer curve claim that it illustrates the concept of taxable income elasticity—i.e., taxable income will change in response to changes in the rate of taxation.
The Laffer curve postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100% and that there must be at least one rate which maximizes government taxation revenue. The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. The shape of the curve is uncertain and disputed.
One implication of the Laffer curve is that increasing tax rates beyond a certain point will be counter-productive for raising further tax revenue. A hypothetical Laffer curve for any given economy can only be estimated and such estimates are controversial. The New Palgrave Dictionary of Economics reports that estimates of revenue-maximizing tax rates have varied widely, with a mid-range of around 70%. Generally, economists have found little support for the claim that tax cuts from current rates increase tax revenues or that most taxes are on the side of the Laffer curve where additional cuts could increase government revenue.
Although economist Arthur Laffer does not claim to have invented the Laffer curve concept, it was popularized in the United States with policymakers following an afternoon meeting with Ford Administration officials Dick Cheney and Donald Rumsfeld in 1974 in which he reportedly sketched the curve on a napkin to illustrate his argument. The term "Laffer curve" was coined by Jude Wanniski, who was also present at the meeting. The basic concept was not new; Laffer himself notes antecedents in the writings of the 14th-century social philosopher Ibn Khaldun.