The Laffer Curve: Still influencing the tax debate
The Laffer Curve: Still influencing the tax debate
The name Arthur Laffer might not be immediately recognisable but a sketch he did in the 1970s of a graph showing a bell-shaped curve on a napkin still features in political debates today. It is known as the Laffer Curve.
The idea he was putting forward was that raising taxes too high, at a certain point, actually reduces the government's tax revenues and is therefore, ineffective.
This thinking has since influenced several Western Governments and their approach to fiscal (tax) policy.
Laffer Curve
Illustrative version of the Laffer Curve (based on Laffer, 1974)
Where is the sweet spot?
The Laffer Curve is a relatively simple concept: tax too little, and the government fails to raise tax revenue to support spending; tax too much, and people stop working, investing, or declaring income, and again tax revenue is reduced.
It becomes clearer when considering the extremes of the tax rates. At a 0% tax rate, the government collects no tax revenue at all and at a 100% rate, the theory suggests that no one would work or invest since all income would go to the government, so also generating no tax revenue. Therefore, there is a point somewhere in between 0% - 100% – the ‘sweet spot’ that is the optimal tax rate for generating the highest level of tax revenue. This is the point just before the tax rate becomes counterproductive i.e. the rate becomes a disincentive to work or invest more, or in extremis the ‘black-market economy’ expands which is hidden from government taxation.
Applications through history
The Laffer Curve really gained political traction in the 1980s, most notably due to the approaches on taxation of U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher. Both leaders implemented significant tax cuts based on the idea that lower rates could stimulate economic growth and, paradoxically, boost government revenue.
Reaganomics: Reagan’s 1981 Economic Recovery Tax Act reduced the top marginal income tax rate from 70% to 50%, and later to 28% by 1988. Reagan’s supporters point to the economic boom of the mid-1980s, stating that rising tax receipts were evidence of the Laffer Curve theory in action. Conversely, his critics argue that the tax cuts just led to larger budget deficits.
Thatcher’s Reforms: In the UK, Thatcher reduced the top income tax rate from 83% to 60%, and eventually to 40%. These changes coincided with broader economic liberalisation.
Trump tax cuts
Even in recent years, the American fiscal debates continue to reference the Laffer Curve, mainly among Republican policymakers advocating for tax cuts. The 2017 Tax Cuts and Jobs Act under President Donald Trump is arguably an example of Laffer-inspired thinking, slashing corporate tax rates from 35% to 21%. While the business environment was robust and share prices rose, the promised increase in tax revenue did not materialise at the expected scale, and federal deficits widened.
Downsides of Laffer
The Laffer Curve presents an attractive solution to what is often a political dilemma - what is the best way to raise tax revenues? The politician wants to show they can provide the appropriate funding and investment to deliver the public services they promise. Laffer’s theory is enticing because the message of cutting taxes is always more palatable than raising them. However, there are some issues to consider:
Oversimplification: Tax systems are complex. The Laffer Curve oversimplifies the relationship between taxes in the use of a single tax rate.
Where is the peak? The optimal tax rate is not easily known and will likely vary between countries.
Elasticity of behaviour: The model assumes significant behavioural change in response to tax rates, which may not always be the case, especially in short time frames.
Distributional effects: Critics argue that the Laffer Curve, when used politically, often justifies regressive tax policies that benefit the wealthy at the expense of public services.
Balance is crucial: Governments must consider not just revenue, but incentives, efficiency, and long-term economic behaviour.
There is no free lunch: Tax cuts don't always pay for themselves; a cost/benefit analysis must be weighed against fiscal sustainability. If insufficient tax is raised post a cut then it creates additional pressure on government finances.
Rising debt and deficits
Financial markets seem to have come to terms with the uncertainty caused by the ongoing US tariff situation. Whilst talks continue, there is no resolution at the time of writing (President Trump’s position can change on a daily basis).
Tariffs are a part of fiscal policy as they raise tax revenues, and they are also part of foreign policy agenda. This in itself highlights why tax policy is not the only consideration in the bigger picture for any government. In the US, the longer-term aim of the Trump Administration with what appears to be an isolationist approach, is unclear. We note that the Administration is presenting how much tax the tariffs would raise in a positive light, especially as it is not paid by consumers directly. In practice though, it is an indirect tax resulting in the likelihood of higher product prices.
Another significant factor that will influence US fiscal policy in the short term is the proposed One Big Beautiful Bill Act referred to as “OBBB”, which has been voted through by the House of Representatives and is now being debated in the Senate.
From a tax perspective, notable proposals include extending or making permanent the tax provisions that were implemented by the 2017 Tax Cuts and Jobs Act which are due to expire. The OBBB does not impact or look to change current capital gains tax rates or corporate tax rates.
Government Debt as a % Gross Domestic Product (GDP)
Source: Artorius, Bloomberg
We live in a time of more indebted governments in the developed Western world, and they continue to operate with budget deficits. Indeed, looking at the US, the OBBB, whilst containing tax cuts, is still expected (in its current form), to increase the US Government deficit to over $2 trillion by 2034 according to the Tax Foundation, a US based leading tax policy nonprofit organisation that is not related to any political party.
Government budget surplus/(deficit) as a % of GDP
Source: Artorius, Bloomberg
Closer to home, UK Chancellor Rachel Reeves, set out her Spending Review on Wednesday 11th June in the House of Commons. This is a more strategic plan for the allocation of Government spending rather than changes to existing tax rates. The point of note though is that hard decisions have to be made. The key department beneficiaries look to be the NHS and Defence and this looks to be at the expense of the Home Office which includes the police force.
Rising prosperity, generally a positive for equities
The Laffer Curve can be considered a powerful conceptual tool in highlighting and understanding the trade-offs inherent in tax policy. Therefore, we believe it is relevant but not definitive. The right tax balance is a key factor in creating a robust economy where consumers and companies can prosper. This provides a buoyant backdrop where companies can grow profits and be a positive driver for share prices (through earnings growth). In the US, the situation at present with tariff negotiations largely unresolved and the OBBB under Senate review means the economic outlook remains uncertain. We retain a tilt towards European equities at present due to US uncertainty, lower valuations and the prospect for lower interest rates.
Phil Carroll
Head of Alternatives
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