Q: Tax Playa, what is the Laffer Curve, and what does it tell us about the real world?
Michael, Philadelphia PA
A: The Laffer Curve is a mathematical theory created by Art Laffer. The basic idea is that as high marginal tax rates come down, revenues go up. At some point, a revenue-maximizing level is attained, and further marginal rate cuts reduce revenue.
Conversely, as very low marginal tax rates rise, tax revenue also rises until a revenue-maximizing point is hit. After that, the high marginal tax rates discourage revenue growth.
What this tells us about the real world is that incentives and disincentives matter for economic growth.
Let's say Bill is an hourly worker. His fortieth hour of work in a given week has a marginal tax rate of 30%. But suppose that Bill is on the cusp of the next tax bracket. If he works a forty-first hour, it will be taxed at 50%--he'll lose half that hour's salary.
Bill is far less likely to work that forty-first hour. Why should he, when he would lose half of it?
However, if his marginal tax rate on the forty-first hour was the same as the fortieth (30%), he is much more likely to work that hour. That's a good thing, since Bill has just gotten that much more productive. We all benefit because Bill decided to work that extra hour (him most of all).
Why should ordinary people care about lower marginal tax rates on labor and capital?
1. In their own work and investment, they have a higher incentive to do productive activities instead of consume or take leisure time.
2. The economy benefits when more and more people work more and more hours and save more and more money. Wealth increases.
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