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Laffer Curve

  The Laffer Curve, in economics, relates average taxation rates to total tax revenues. The curve was named after Arthur Laffer, an academic at the University of Southern California, who received acclaim in the 1970s for a theory devoid of empirical content. Legend has it that in November 1974, in a Washington bar, Laffer first drew his curve on the back of a beer mat. Since then his curve has been drawn a thousand times.

The Laffer Curve illustrates a theory about the relationship between tax rates and total tax revenues. As the tax rate rises from zero toward 100%, tax revenues will rise, reach a maximum and decline to zero. To increase tax rates beyond that which produces maximum tax revenues will only cause tax revenues to fall because of the adverse effect upon individual and business incentives. In the hands of advocates of supply-side tax cuts (see supply-side economics), the curve ‘proves’ that most governments could raise more revenue by cutting tax rates. Drawn by those of a different persuasion, it ‘proves’ that raising tax rates will bring more revenues. In the early 1980s, some supply-siders argued that the US had gone beyond the maximum tax revenue on the curve, so that a reduction in taxes would actually increase tax revenues. President Ronald Reagan and a majority in Congress succeeded in reducing tax rates and the economy began to recover from recession. Whether the reduction in tax rates caused an increase in tax revenues is doubtful, because the issue is clouded by the myriad other changes that occurred simultaneously in the economy, including growing federal budget deficits. TF



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