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Understanding the Laffer Curve

Posted by mandyf on December 27, 2012

The Laffer Curve is defined as a graphic representation of the theory of Taxable Income Elasticity. To put that into regular people terms what the Laffer Curve expresses is a theory which states that people who pay taxes adjust their behavior based on taxes. Put in even simpler terms a good way to think of the theory behind the Laffer curve is to consider the following example:

 A person that pays taxes at the 0% rate is going to be more motivated to go out and earn as much as they can because they get to keep and spend more of it any way they choose too. The downside of that is that the government is losing income which is used to support national infrastructure like medical care programs, roads, the military, and essentially everything.

On the other hand a person that pays taxes at the 100% rate is going to have no motivation to work because they do not get to keep any of the money they earn. The government on the other hand becomes extraordinarily rich and in theory would support everyone by redistributing the wealth in equal shares.

Considering that example of two extremes the Laffer Curve would base 50% as the ideal rate for taxation – everyone gets something, so in theory everyone is happy and motivated just enough to be productive while government – again in theory has enough to support infrastructure.

The problem with that aspect of the Laffer curve is that mathematical theory does not always translate so cleanly in reality. In actuality, the ideal tax rate is believed to be somewhere between 30%-40%. What value is placed on the Laffer Curve depends on who you ask. Some people point out that when the tax rate is lower than the Laffer Curve states it should be that many industrialized nations go through an economic growth spurt. Others argue that even at taxation rate nearing 100% Russia once had they were able to maintain the economy productively.

Another way to look at the Laffer Curve is to say that when the tax rate passes the threshold which the Laffer Curve says is ideal, it has the opposite impact than what should mathematically occur. This is based on the concept that when people are less motivated to work because they retain less of their income, rather than being disgruntled and working at the same productive rate, they are disgruntled and work at a less productive rate. When that happens their lower production means lower earnings which is less taxable income and in turn offsets or negates a tax increase.

When Arthur Laffer whom the Laffer Curve is named for first postulated this theory he did not consider any outside influences as above mentioned that should be taken into account. He operated in a bubble of sorts solely focused on the mathematical side of the issue. In summation while the Laffer Curve looks great on paper and can in general be used to uphold any economic policy one wishes it to based on the interpretation and presentation of the data, in practicality it isn’t quite so hot.






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