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Ronald Reagan, before becoming the 40th president of the United States, was a Hollywood actor involved in a total of 53 films, his last being The Killers in 1964. 16 years later, Reagan - representing the Republicans - won the 1980 presidential election against Jimmy Carter. This began his 8-year presidency which saw the implementation of “Reaganomics” – a neoliberal laissez-faire philosophy orientated around monetarism and supply-side economics. An important part of “Reaganomics” was the drastic reform to taxation in the United States, influenced by Arthur Laffer, a member of his Economic Policy Advisory Board. By popularising the “Laffer Curve”, Arthur Laffer and the Reagan administration challenged the traditional approach to taxation and influenced fiscal policy across the globe – notably Margaret Thatcher’s cabinet during the 1980s. The Laffer Curve, however, has drawn heavy criticism for its abstract approach and lack of empirical support, making it very challenging to implement into contemporary policy.
For an intro on Reaganomics, check out this video below ⬇️
When observing the relationship between the tax rate and tax revenue, it has been long assumed that the two share a positive linear relationship; increasing the tax rate necessarily increases government tax revenue. Such was the philosophy when countries would go to war, necessitating greater spending – and continues to be as Putin is set to increase income tax for the Russian middle class to fund the ongoing war in Ukraine. However, some economists, such as Ibn Khaldun and John Maynard Keynes, have argued that this was not necessarily true. That is, in certain situations, decreasing the tax rate may increase government revenue. This idea was presented graphically by Arthur Laffer in 1974, which gave birth to the famous Laffer Curve represented below.
Credit: Investopedia
As can be seen, the relationship between the tax rate and tax revenue might not be as linear as had been assumed. The curve suggests that there is a certain tax rate that maximises tax revenue, as increasing the tax rate beyond this point disincentivises work and production and by extension reduces revenue. Laffer’s postulate was applied to the context of the US fiscal policy, wherein Laffer argued that the existing tax rate was too high and that – to help solve the growing fiscal deficit – Reagan should cut several taxes. Reagan listened; The Economic Recovery Tax Act of 1981 cut the top income tax rate from 70% to 50%, as well as reduced windfall profit taxes.
This application of “Reaganomics” was immediately controversial, due to the abstract nature of the concept shown by the Laffer Curve. The principle suffers from two seemingly fundamental flaws. The first flaw is that the Laffer Curve fails to indicate what the optimum tax rate is, and where an economy is located along the curve. The absence of this indication means applying the Laffer Curve to a current economy is purely speculative. Furthermore, it is impossible to use empirical data gathered from different economies – such as under Reagan or Thatcher – in order to estimate this optimum tax rate, as each economy has its own set of economic agents, with its own societal norms that influence incentives to work. This seems intuitive; American citizens or businesses will have different responses to taxation than British or Chinese ones. Therefore, each economy has a different Laffer Curve – there is no universal revenue-maximising tax rate.
Another significant flaw that can be discerned is the difficulty in evaluating the independent impact of tax changes. This is due to two factors: the ceteris paribus (all things being equal) assumption of the graph, which is unrealistic, as well as the different lags between the implementation of the policy and the reaction of other economic agents. The ceteris paribus assumption is unrealistic as tax revenue depends on many other factors, such as domestic economic growth or wage inflation. This can be applied to the aforementioned example of the Economic Recovery Tax Act of 1981; the data shows that the fiscal deficit worsened to $221 billion in 1986, before falling to $152 billion by 1989 – but determining whether this was a correlation or caused by the reform is difficult due to other significant factors that acted upon the US economy. The US economy underwent significant economic growth during that period, overturning a recession in 1982 to sustain growth rates around 4% until 1990. Critics of the Laffer Curve argue that the tax cuts worsened the fiscal deficit and that the improvement was due to the larger economic growth driving wage inflation. Supporters, on the contrary, use the Laffer Curve to argue that the improving fiscal deficit was due to the tax cuts increasing incentives to work more.
In this light, we can see that applying the Laffer Curve to an economy today is difficult, as many questions are left unanswered - what does the UK's curve look like? How long will it take for the application of a tax rate reduction to increase tax revenue? Will it increase tax revenue at all? Such questions are not answered by the curve, as it is simply an abstract theory representing a possible relationship between tax rates and tax revenue. Today, many macroeconomists such as Greg Mankiw are extremely sceptical of Arthur Laffer’s ideas, and the curve isn’t particularly popular or used. Thus, whilst being an original idea that challenges traditional thought, the Laffer Curve is an example of economic simplicity, that provides little help in practical decision-making.
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