The “Laffer curve” turns 40 years old

The informal Washington D.C. dinner that took place 40 years ago has become the stuff of legend. That’s when economist Arthur Laffer used a beverage napkin to sketch a chart that became known as the “Laffer Curve.”

The following four decades proved Laffer’s point: People change their behaviors in response to tax policies; raising tax rates can often mean a decrease in tax revenues, while a decrease in rates can mean higher revenues.

Laffer commemorates the anniversary of that dinner in a recent article in Investor’s Business Daily. He explains that the conversation that evening was President Gerald Ford’s proposed 5 percent tax “surcharge,” part of Ford’s plan to “Whip Inflation Now.”

“There was so much wrong with Ford’s plan that we could have railed against the bill for months, but we all focused on one issue: The effect that a 5 percent income tax surcharge would have on overall tax revenues,” Laffer wrote. “At that time, it was simply assumed that raising tax rates by 5 percent would increase tax revenues by 5 percent.”

But that wasn’t true, and Laffer knew it.

“At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base,” he explained. “Likewise, at a 100 percent tax rate, the government would also collect no revenues because no one would be willing to work for an after-tax wage of zero — there would be no tax base. Between these extremes, there are two tax rates that will collect the same amount of revenue: A high tax rate on a small tax base and a low rate on a large tax base.”

People change their behavior in response to tax policies, he wrote.

“In the case of Ford’s 5 percent tax surcharge, it is almost certain that revenues in short order would have fallen because of its undue reliance on raising tax rates the most on the highest income earners,” Laffer wrote. But, he added, “Taxable income can be lowered by earning less income, moving your income from a high-taxed location in the U.S. to a lower-taxed location offshore, changing the forms of your income, say, from earned income to unrealized capital gains, giving more of your income to a 501(c)(3) tax-exempt organization, or deferring more income into an IRA, Keogh or 401(k). When tax rates rise, all of the above avoidance measures come into play, plus outright tax evasion.”

And punitive tax hikes for the “wealthy” (also known as “soaking the rich”) are bad economic policy.

“Raising tax rates on the highest income earners, who are often the largest employers, also almost guarantees an economic downturn,” he explained. “And goodness knows, the tax surcharge was bad politics and the antithesis of a remedy for inflation as proven subsequently by President Carter.”

There’s historical evidence that tax cuts can raise revenue.

“When Kennedy cut the highest income tax rate to 70 percent from 91 percent, income tax receipts from the top 1 percent of income earners rose from 1.3 percent of GDP in 1960 to 1.9 percent in 1968,” Laffer added.