One day in 1974, economist Arthur Laffer sat in a Washington restaurant with some prominent journalists and politicians. He took out a napkin and drew a figure on it to show how tax rates affect tax revenue It looked much like panel (e) of our Figure 6. Laffer then suggested that the United States was on the d~ward-sloping side of this curve. Tax rates were so high, hf argued, that reducing them would actually raise tax revenue.

Most economists were skeptical of Laffer’s suggestion. The idea that a cut in tax rates could raise tax revenue was correct as a matter of economic theory, but there was more doubt about whether it would do so in practice. There was little evidence for Laffer’s view that U.S. tax rates had in fact reached such extreme levels. Nonetheless, the Laffer curve (as it became known) captured the imagination of Ronald Reagan. David Stock man, budget director in the first Reagan administration, offers the following story [Reagan) had once been on the Laffer curve himself. “1 came into the Big Money making pictures during World War II,” he would always say. At that time the wartime income surtax hit 90 percent. “You could only make four pictures and then you were in the top bracket:’ he would continue. “So we all quit working after four pictures and went off to the country.’; High tax rates caused less work. Low tax rates caused more. His experience proved it. When Reagan ran for in 1980, he made cutting taxes part of his platform. Reagan argued that taxes were so high that they were discouraging hard work. He argued that lower taxes would give people the proper incentive to work, which would raise economic well-being and perhaps even tax revenue because the cut in tax rates was intended to encourage people to increase the quantity of labor they supplied, the views of Laffer and Reagan became known as supply-side economics conomists continue to debate Laffer’s argument. Many believe that subsequent history refuted Laffer’s conjecture that lower tax rates would raise tax revenue. Yet because history is open to alternative interpretations, other economists view the events of the 1980s as !Dore favorable to the supply siders Some economists take an intermediate position. They believe that while an overall cut in tax rates normally reduces revenue, some taxpayers at some times may find themselves on the wrong side of the Laffer curve. Other things equal, a tax cut is more likely to raise tax revenue if the cut applies to those taxpayers facing the highest tax rates. In addition, Laffer’s argument may be more compelling when considering countries with much higher tax rates than the United States. In Sweden in the early 1980s, for . instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would indeed have raised more tax revenue if it had lowered its tax rates Economists disagree about these issues in part because there is no consensus about the size of the relevant elasticities. The more elastic that supply and demand are in any market, the more taxes in that market distort behavior, and the more likely it is that a tax cut will raise tax revenue. There is no debate, however, about the general lesson: How much revenue the government gains or loses from a tax change cannot be computed just by looking at tax rates. It also depends on how the tax change affects people’s behavior.


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