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A couple of weeks ago, during a Q&A after a presentation, I was asked about the Laffer Curve and realized how poorly the media typically portrays it. Let's set the record straight. First, a bit about the history: Dr. Art Laffer, an economist, was explaining to President Ford's Chief of Staff, Donald Rumsfeld, why a tax increase of five percent would not result in a five percent increase in revenue from taxes. This concept was not an astonishingly new idea. It has been well-known among economists for centuries. He sketched a graph on a napkin to clarify his point to Rumsfeld. The media began calling it the Laffer Curve. The principle is simple: if the tax rate is zero, the government will collect no tax revenue. Equally obvious is that if the tax rate is one hundred percent, no one will be willing to work if the government takes all of your earnings. Therefore, the tax revenue will again be zero. The graph below shows the Laffer Curve as the media usually portrays it.

This portrayal creates two significant misperceptions: that the ideal tax rate is in the middle at fifty percent and that the ideal tax policy is to maximize revenue. Neither of these things are true. Laffer's point to Rumsfeld: a five percent change in the tax rate would not result in a five percent change in revenue. Why not? Because the graph is a curve, not a straight line, the rate of change between the two is variable, not constant. Additionally, the area beyond the peak is not usable since tax rates in this area decrease revenue. This elimination of the area beyond the peak compresses the usable area, further altering the relationship between rates and revenue. The second graph shows a more accurate picture. The dashed line shows the same as the first graph, but the solid lines show other possibilities. The peak, the maximum revenue point, is not in the center but may occur anywhere. Shifted to the right implies that the people are willing to work for less than half of their actual earnings. A shift to the left suggests that people are only willing to work if they can keep more than half their earnings.

Considering this, the following graph shows the more likely curve.

Now that we've cleared up the curve, we must address another issue: the assumption that government should maximize its revenue. Knowing how to maximize revenue from tax rates does not imply that doing so is a good idea. There is a heaping bowlful of reasons not to do so. The government should base its budget on the least expensive ways to provide the citizens with what will benefit them rather than taking as much money as possible from them and then finding ways to spend it. Furthermore, if the budget is always running close to the maximum, there is no room for necessary expansion due to emergencies. Another factor is that when close to the maximum, there is always the temptation to go a little over and increase the national debt. Government spending sets the tax rates, and excessive spending creates deficits and inflation. Most Americans limit their debt to amounts they can comfortably service. Why is the government never as wise as the people?

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