Laffer curve

DEFINITION: The Laffer curve is a mathematical function linking economic output to federal tax revenue.

The Laffer curve purports to show that, within certain limits, a decrease in the tax-rate that businesses pay will result in economic growth that will generate enough additional tax revenues to provide positive net income to the federal government.

ETYMOLOGY: There is some dispute involving the actual origin of the Laffer curve. However, the popularization of the concept and its name dates from 1974, when the American economist Arthur Laffer—who was working as a consultant with the US Department of the Treasury at the time—sketched the curve on a napkin in order to help explain the idea to some of his colleagues.

USAGE: The Laffer curve was an important element in the successful selling of the concept of supply-side economics to the administration of President Ronald Reagan.

However, the predictions made by the Laffer curve were not borne out by the real-world consequences of the policies implemented by the Reagan administration, whose eight-year tenure in office resulted in a $100 billion increase to the deficit.

For this and other reasons, the Laffer curve has not been well received by the academic economics establishment, to put it mildly. The Harvard economist Greg Mankiw has summarized the consensus on the Laffer curve in the following terms:

The Laffer curve is undeniable as a matter of economic theory. There is certainly some level of taxation at which cutting tax rates would be win-win. But few economists believe that tax rates in the United States have reached such heights in recent years; to the contrary, they are likely below the revenue-maximizing level.