Laffer curve
/ LAFF-er /
Here is a riddle about taxes. If the government sets the income tax rate at 0 percent, it collects nothing. If it sets the rate at 100 percent — taking every penny you earn — it also collects nothing, because no one would bother working when they keep none of it. So at both extremes, revenue is zero. Somewhere in between, revenue must rise and then fall. The Laffer curve is the simple, almost obvious picture of this: a hump-shaped relationship between the tax rate and the total revenue collected.
The logic is that higher rates have two opposing effects on revenue. The arithmetic effect: a higher rate collects more per dollar of the tax base. The economic effect: a higher rate discourages the very activity being taxed — people work less, invest less, or hide income — so the tax base shrinks. At low rates, the arithmetic effect dominates and raising rates raises revenue. Past some peak rate, the economic effect dominates and raising rates further actually reduces revenue, because the shrinking base outweighs the higher rate. In principle, if you are on the 'wrong side' of the peak, cutting tax rates could raise revenue.
The Laffer curve is genuinely true as a concept — the two extreme points really are both zero, so a peak exists. The fierce, often political controversy is about where the peak sits, and most economies are nowhere near it. Estimates of the revenue-maximizing income-tax rate are typically quite high (often well above 50 percent for top earners), which means cutting rates that are already moderate almost always loses revenue rather than raising it. The honest caveat: the curve is real but the claim 'tax cuts pay for themselves' is, for most taxes at most rates, simply false — it only holds in the rare case where rates are above the peak. Be very wary of anyone who draws the curve with the peak conveniently near current rates.
At a 0 percent rate, revenue is zero; at a 100 percent rate, no one works, so revenue is zero again. Between them lies a peak. If a country's top rate is already on the low side of that peak, cutting it further will lose revenue, not 'pay for itself' — the curve's logic does not justify every tax cut.
Both 0 percent and 100 percent yield zero — but the revenue-maximizing peak is usually far higher than today's rates.
The curve is real, but 'tax cuts pay for themselves' only holds if rates are above the peak — which most are not. Empirical revenue-maximizing rates are typically high.