Laffer Curve Law and Legal Definition

Laffer Curve is a curve illustrating the relationship between tax rates and tax revenues. The curve reflects the fact that tax revenues are low for both very high and very low tax rates.

First, in Laffer Curve hypothesis, the amount of tax revenue raised at the extreme tax rates of 0% and 100% is considered. It is clear that a 0% tax rate raises no revenue, but the Laffer curve hypothesis is that a 100% tax rate will also generate no revenue because at such a rate there is no longer any incentive for a rational taxpayer to earn any income, thus the revenue raised will be 100% of nothing. If both a 0% rate and 100% rate of taxation generate no revenue, it follows that there must exist a rate in between where tax revenue would be a maximum.

Laffer presented the curve as a pedagogical device to show that, in some circumstances, a reduction in tax rates will actually increase government revenue and not need to be offset by decreased government spending or increased borrowing. For a reduction in tax rates to increase revenue, the current tax rate would need to be higher than the revenue maximizing rate. However, in 2007, Laffer said that the curve should not be the sole basis for raising or lowering taxes.