Laffer Curve

Should five percent appear to small
Be thankful I don't take it all
--The Beatles

Although economist Art Laffer is associated with advancing the relationship pictured in what today is known as the 'Laffer curve,' the concept far precedes him. In fact, any reasoning mind can derive the theory.

The theoretical issue involves the relationship between revenue raised by government and tax rates employed to raise that revenue. At the extremes we know that government gets no revenue. If it does not tax at all, then government gets nothing. If the tax rate is 100%, then the government gets nothing on this end as well because no one will voluntarily produce if they cannot keep a fraction of their spoils.

Somewhere in between there is a tax rate where government can maximize its revenue. However, the point of maximum revenue does not correspond to the best social welfare. Because government is an inefficient resource allocator, economic growth will be impaired when government takes control of economic resources.

As such, the tax rate associated with the point of maximum economic growth will be less than the tax rate associated with point of maximum government revenue.

The only real questions involve at what tax rates do these two points reside. Or, stated differently, how much less is the growth maximizing tax rate than the revenue maximizing tax rate?

Although these seem like empirical questions, their answers are well approximated by good theory.