Many students struggle to understand how introductory economics course material is applied in the real world. Part of the problem is that some of it does and some of it really doesn’t. When I taught I would use the term Theoryland for the parts of economic theory that are more difficult to observe in the real world. Theoryland isn’t necessarily a bad thing. The Laffer Curve mostly holds true in Theoryland but there are numerous issues with its use in the real world.
The problem lies in the way the Laffer Curve gets used in what is really propaganda. The Laffer Curve is incredibly over simplistic. It was not developed using data but instead drawn on a napkin in 1979 to refute Gerald Ford’s tax increase. Note: the concept existed before Arthur Laffer’s napkin drawing. The Laffer Curve doesn’t actually state where the peak tax rate occurs although as it is often drawn it would imply somewhere around 50%. This is due to the lack of any empirical data being used in its creation.
A few things that the Laffer Curve fails to take into consideration include the current tax system and rates, whether the economy is expanding and contracting and at what rate, tax loopholes, and underground or black market activities. Needless to say all of these factors impact the tax revenue a government collects.
A 1996 study by Yu Hsing used time-series data from 1959-1991 estimated an revenue-maximizing tax rate of 32.67 – 35.21% (Journal of Socio-Economics, 25 (3), 395-401). The average tax rate in the United States in 2016 was 21%. Therefore, if we were to follow Laffer’s advice, taxes should be raised not reduced.
In order for the Laffer Curve to have any validity, businesses must use any increased revenue from a tax cut to create new jobs. In looking at the most recent tax cut of 2018, it appears that much of it was used for other things such as stock buybacks, dividends, or savings. None of these will result in new jobs nor increased government revenue.
One of the major problems with the Laffer curve is the continued misuse. The point of the Laffer curve was to maximize tax revenue but it is used to justify reductions in taxes, especially on the upper income brackets, in order to “starve the beast”. Again and again, the Laffer curve is used by propagandists to justify tax cuts for the super rich and incredibly profitable corporations. That misuse hurts the average citizen and erodes our society. For all of the reasons stated above one thing is for certain, the continued misuse of the Laffer Curve is absolutely no laughing matter.