THE LAFFER CURVE AND SUPPLY-SIDE ECONOMICS

One day in 1974 economists 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. Laffer then suggested the United Staes was on the downward-sloping side of this curve. Tax rates were so high he 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 Stockman budget director in the first Reagan administration offers the following story.

When Reagan ran for president 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 become known as supply-side economics.

Economists 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 more favorable to the supply siders.

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