Laffer Curve
What is Laffer Curve?
The Laffer curve shows that tax revenue rises with the tax rate up to a point, then falls as high rates discourage work and investment.
It implies both a 0% and a 100% rate raise no revenue, so a revenue-maximizing rate lies in between. Supply-siders use it to argue some tax cuts can raise revenue, though where the peak lies is debated.
Laffer Curve: a worked example
Model a country where the taxable base shrinks as the rate rises: base = $800 million × (1 minus the rate). At a 20% rate the base is $640 million and revenue is 0.20 × $640 million = $128 million. At 50% the base is $400 million and revenue is $200 million. At 80% the base has fallen to $160 million, so revenue drops back to 0.80 × $160 million = $128 million. Revenue peaks at 50%. Cutting the rate from 80% to 50% raises revenue by $72 million; cutting it from 50% to 20% loses the same $72 million.
The mistake students make with laffer curve
The error is reading the Laffer curve as "tax cuts pay for themselves." The curve says revenue rises with the rate on the left of the peak and falls on the right, so a cut adds revenue only if the current rate is already past the peak. Below it, cutting the rate loses money in the straightforward way. The shortcut is tempting because the curve is always drawn as a neat hump, which invites the assumption that you are standing on the downhill side. The curve alone cannot tell you which side you are on.
Laffer Curve questions
Do tax cuts increase government revenue?
Tax cuts increase revenue only when the starting rate sits above the revenue-maximizing point of the Laffer curve. Below that point a lower rate does widen the tax base somewhat, since the taxed activity becomes more attractive, but not by enough to offset the smaller share taken from each dollar. Whether a specific cut pays for itself depends entirely on how strongly that base responds to the rate.
Why does a 100% tax rate raise no revenue?
A 100% tax rate raises nothing because it leaves the earner with none of the income being taxed, so the taxed activity stops or moves off the books. That endpoint is what the Laffer curve is built on: zero revenue at a 0% rate, zero revenue at a 100% rate, and positive revenue somewhere in between means the curve has to rise and then fall.
Where is the peak of the Laffer curve?
The peak of the Laffer curve has no fixed location. It sits wherever the base becomes responsive enough that a higher rate shrinks it faster than the rate climbs, which differs from tax to tax. Mobile bases such as corporate profit, or a narrow excise on one good with close substitutes, peak at lower rates than a broad tax on wages, where people have fewer ways to escape.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated