Tagged: Laffer Curve

The Decline of the Laffer Curve

Part of my review of tax cuts and spending cuts consisted of some conditional criticism of the Laffer Curve. I have pointed out that it should be used with caution and that it is downright irresponsible to assume that there is no correlation between the Curve’s effectiveness and the size of government spending. On the contrary: the bigger government grows, the weaker the Laffer Effect will be. It never goes away, but there comes a point when it is necessary to re-direct the political energy spent on tax cuts, and focus it on spending reform instead.

It is essential for anyone interested in limited government to understand in detail why the Laffer Curve loses its prowess with bigger government. We have already established that the bigger government spending gets, the weaker is economic growth. The next step toward understanding the limitations of the Laffer Curve is to see how weaker growth means weaker tax revenue.

The link is private-sector employment. Since the private sector is our actual tax base, and since the federal government collects more than 80 percent of its revenue from personal income taxes, it is essential for the Laffer Curve that

  1. Tax cuts generate a big boost in GDP growth, and
  2. The growth boost leads to a significant rise in private-sector employment.

The good news for our supply-siders is that there is a tight, clearly visible correlation between real GDP growth and growth in private-sector employment. Figure 1 reports annual rates, quarterly, for the two variables, from 1948 to 2019:

Figure 1

Sources of raw data:
Bureau of Labor Statistics (Employment)
Bureau of Economic Analysis (GDP)

In other words, plain and simple: when the economy is doing well, the private sector hires more people.

Technically, the causality from GDP growth to employment growth is driven by average workforce productivity (Y/L). Figure 2 reports how changes in GDP per employee in the private sector varies with the employment level itself. When average productivity increases, d(Y/L), employment rises with about a two-quarter lag. The arrows in Figure 2 highlights eight such episodes since 1950:

Figure 2

Sources of raw data:
Bureau of Labor Statistics (Employment)
Bureau of Economic Analysis (GDP)

Two noteworthy episodes in Figure 2 (dashed ellipses) mark exceptions to the rule highlighted by the arrows. Toward the end of the 1990s productivity was rising, but the economy still shifted from jobs growth to rising unemployment.

The second episode is the late Obama recovery and the beginning of the Trump economy, where productivity gains were weak. There is a peak associated with the investment boom following the Trump tax cuts, but it is hardly visible compared to previous productivity spikes.

We cannot learn anything definitively from these two exceptional episodes, but they are nevertheless worth noting and something we should return to for future reference. What matters in Figures 1 and 2, and especially in Figure 1, is how GDP growth has weakened over time. For the past decade, the economy has struggled to reached three percent in any four-quarter period.

Since private-sector employment is so closely linked to growth, and since growth in tax revenue tracks very closely with employment numbers, this overall weakness in our economy rapidly translates into weakness in tax revenue.

However, it is actually even worse. Courtesy of my first article on structural spending reform, consider this compelling relationship between employee compensation (Y) and revenue from personal federal income taxes (T):

Figure 3

This image has an empty alt attribute; its file name is spending-reform-3.png
Source of raw data: Bureau of Economic Analysis

Not only does tax revenue weaken with weaker growth, but it is also volatile in comparison. This volatility increases for each new tax reform, as the tax burden is pushed higher up in the income layers, where the tax base fluctuates more violently with the ups and downs in the economy. As GDP growth gets weaker, for reasons we will elaborate on later there is a “drift” of the tax base into these higher, more volatile income layers.

In short: tax cuts in an economy with big government spending

  • are less effective than when government is moderately sized;
  • generate inadequate increases in revenue; and
  • make the tax base more volatile.

The Laffer Curve still works, but it has become much weaker over the years. If we want to save America from perennial economic stagnation, we need to take our eyes off taxes and start working on spending reform instead.

Laffer and Moore Get It Wrong

Art Laffer and Steve Moore are widely considered to be the foremost economists of the libertarian movement. They are praised and raised to the skies, lauded and quoted widely. In Laffer’s case, it is in many ways merited. He did a fantastic job getting the Reagan administration to agree to a sweeping tax reform.

Since then, though, as I have shown in my four-part series on tax and spending reform, his theory has lost its steam.

Tax cuts don’t work anymore. I wish they did, but they don’t. The evidence is irrefutable.

But it gets worse than that. Not only do tax cuts don’t work, but these two fine gentlemen are selling this ineffective medicine as a means to pay for the welfare state. In short: cut taxes, and we can afford socialism.

Yes, that’s right. Art Laffer and Steve Moore make this case. In their book Trumponomics they explain that higher growth will pay for our socialist welfare state:[1]

One underappreciated dividend from this higher permanent pedestal of economic growth is that, if Trump succeeds, it will help largely solve the long-term funding crisis of Social Security and Medicare. With 3 percent economic growth, up from the 1.8 percent predicted by the Social Security and Medicare actuaries, the compounding effect over 50 years means more than $50 trillion of revenues into Medicare and Social Security trust funds, largely dissolving the funding shortfalls of these programs – and perhaps leaving them in long-term surplus, not deficit.

That’s it. Cut taxes, get more growth, and we can continue to use two thirds of the federal budget to take from Pete and give to Paul.

This paragraph is also the closest that Laffer and Moore get to even discussing government spending. They have a non-committal passage on pages 99-100 about how nice it would be if people didn’t get more in welfare than they get working a minimum-wage job, but they have absolutely no ideas on how to approach that problem with tangible reform ideas.

I have actually proposed a welfare reform that would do what Laffer and Moore are dreaming about. If Steve Moore had shot me an email, I could have shared my plan with him (again). If the original version is not palatable, I have an updated model from 2012, published on SSRN in 2013, that I originally developed for a presidential campaign.

The problem, of course, is that spending reform is hard work. It is quite a bit harder than to propose and lobby for tax cuts. Spending reform quickly runs into a fire storm of criticism from the left: do you really want to take away Medicare from this grandma and Medicaid from that poor family? Are you cruel and cold-hearted?

My reform circumvents that problem. In other words, the big obstacle to spending reform is not the design of workable solutions – it is the lack of courage among the layers of libertarians. Courage to propose workable reforms. Courage to convince Congressional Republicans to think anew.

Courage to go against the mainstream.

Laffer and Moore lack that courage. The closest they get to discussing actual, actionable spending reform is a quick, positive mention of the Penny Plan. As I recently demonstrated, this plan is entirely unworkable. Why? Because it keeps all the welfare-state promises intact. It rests on the premise that government can provide everything it has said it will provide, only do so more efficiently.

As my numbers show, that is wholeheartedly impossible. The only option is to reform away the promises – to return them to the private sector and get government out of economic redistribution altogether.

Laffer and Moore steer clear of that one. Their solution is a dreamy comment about how higher growth would eliminate the budget deficit and perhaps even let the welfare state run a surplus.

This is the neoconservative approach to the welfare state. It is close to what Irving Kristol, William F Buckley Jr. and others talked about when they discussed the American welfare state. Like Laffer and Moore, the neocons of the 20th century firmly believed that the welfare state should be preserved, but that it should be run a bit more efficiently than it would be under socialist management.

In the 21st century model, this neoconservative dream relies on yet more tax cuts to generate yet more economic growth. I hate to be the Grinch that stole Christmas, but the facts on the ground speak a different language. First, consider Figure 1, which reports 715 pairs of observations of government revenue as share of GDP, and GDP growth. The numbers are from 29 European countries from the period 1996-2019 (with limited availability from some countries). These observations are then organized in deciles based on the tax-to-GDP ratio, with average tax ratios and growth rates for each decile:

Figure 1: Growth and government in Europe

Source of raw data: Eurostat

The bigger government gets, the more sluggish the economy grows. The same economic mechanisms that work in Europe, work here as well.

But wait – didn’t I just say that this is tax revenue as share of GDP? Exactly. But what if we cut taxes? Doesn’t that move us up the blue function?

No, it doesn’t. Laffer and Moore want to keep spending as usual (assuming that they realize what will happen in Congress when the Penny Plan starts pinching away big chunks of our entitlement programs) which means that the welfare state will not get smaller. It will continue to grow. Therefore, government spending will continue in the bracket of 37-40 percent of GDP. If we are going to balance the budget, we need to collect the same share of GDP in taxes, fees and charges.

Since the size of the welfare state remains unchanged, all that the Laffer-Moore growth strategy will accomplish is a redistribution of the tax burden.

But wait: if GDP grows, then the denominator grows. That means the welfare state may not shrink in terms of dollars, but it certainly declines are share of GDP, right?

No, it doesn’t. As I explained in my book The Rise of Big Government, our welfare state has a built-in mechanism that automatically grows its size as GDP grows. It is called the “relative definition of poverty” and states that people are entitled to government benefits, cash and in-kind, when their income is at a certain percentage of median household income. Since GDP growth means that median household income grows, so does the eligibility threshold for welfare-state benefits.

In short: the more the economy grows, the bigger the welfare state gets. Therefore, if Laffer and Moore got what they wanted, their sought-after surge in tax revenue would be chasing welfare-state spending like the rabbit that tried to race the turtle and never caught up with him.

To solve this problem, you need to redefine the ideological nature of the welfare state.

Then, of course, there is the problem with economic planning. Government does not operate under the free-market price mechanism. It uses a different value unit, one that is directly derived from Marxist labor-value theory. Therefore, the allocation of resources under government is neutral, even hostile, to economic growth.

I elaborate on this problem in my forthcoming book Socialism or Democracy: The Fateful Question for 2024. Until it is out this winter, we will simply note that the bigger government gets, the larger a share of the economy is put under growth-hostile administration. There is simply less economic activity out there that can produce the growth that Laffer and Moore depend on.

Simple arithmetic, in other words. I am surprised that two guys as smart as Steve Moore and Art Laffer did not figure this out.

Structural spending reform, folks. Nothing else works.


[1] Moore and Laffer: Trumponomics. All Points Books (2018).

Squeezing the American Taxpayer

I continue to receive criticism and questions over my articles pointing to the futility of pursuing tax cuts. I am happy to answer all those questions, and I will gladly continue to point to why structural spending reform is the only way to go. I will publish my own reform plan soon after the election; for a glimpse of what it will cover, check out my 2012 book on welfare-state reform.

In the meantime, let me reinforce the point about supply-side economics and further tax cuts. I am not the only one to point to the limitations of what this theory can do; last year Cato Institute fellow Ryan Bourne suggested that taxes have become too low for the Laffer Curve to still be effective. In short, he proposes that the tax cuts that have swept across the industrialized world in the last few decades have taken taxes down to where a cut no longer has the stimulative effect on revenue that it had when Art Laffer first introduced his famous curve. When tax rates were in the “ineffective” segment in Figure 1, a cut would increase revenue; once the rates fall into the “effective” segment, a cut reduces revenue:

Figure 1: The Laffer Curve

Bourne has no data to back up his claim, but in order for his argument to work he would need to show that labor supply no longer responds positively to tax cuts. It does, as shown by every tax cut in the United States the past 40 years. The Trump tax reform was particularly effective in increasing workforce participation.

The problem with the supply-side school is not that taxes are too low for the Laffer effect to work. The problem is that we don’t get enough growth out of the workforce participation that comes from lowering taxes. That problem, in turn, is related to the large presence of government in the economy; there is ample evidence – as I have reported in my book Industrial Poverty – of a 40-percent-of-GDP threshold: once government spending is higher, it permanently depresses GDP growth.

Supply side economists have inadvertently helped government grow. As much as a lot of supply-side libertarians want to dislike me for making this point, the evidence is irrefutable: the tax cuts they have helped bring through Congress were all good and necessary in and of themselves, but since they were not accompanied by any spending-reform efforts of even remotely similar magnitude, all that happened when tax revenue surged was that Congress decided to spend even more money.

If the supply-side school had stood equally strongly on both legs – tax cuts and spending cuts – things would have looked very differently in our economy. As it is now, the tax-cut strategy has allowed government to grow to a point where its size depresses the very growth effect that supply-side economists rely on to make their tax cuts work.

Again, that is not to say the tax cuts weren’t good. They were. But since government has continued to grow, the efforts to cut taxes have at least in part become a shuffle game. The tax burden in the U.S. economy has shifted, and not in a way that we should necessarily celebrate. First, consider Figure 2, which reports the aggregate tax burden on corporate profits:

Figure 2: Effective tax rate on corporate profits

Source: Bureau of Economic Analysis

Clearly, U.S. tax policy has moved away from heavily burdening businesses. This is good, of course, even if it for a long time happened through measures that invited advanced – and costly – tax avoidance (which unlike evasion is legal). The federal corporate-tax system we got with the Trump reform was much welcome, but as Figure 3 explains the reduction in taxation of corporate profits has come with a shift toward heavier reliance on other sources:

Figure 3: Composition of U.S. taxes

Source of raw data: Bureau of Economic Analysis

In other words, individuals bear the brunt of the tax burden. That does not mean it is better to have high taxes on corporations – all taxes should be minimal – but Figure 3 is a hint of what happens when we do good tax reforms without equal emphasis on spending reform.

So long as the balloon is of the same size, a squeeze on it on one size must result in a bubble on the other side.

With taxes shifting over onto personal income and consumer spending, the pertinent question is what this means for households and their finances. Since consumer spending accounts for about 70 percent of GDP, a concentration of taxes onto households will inevitably depress economic activity. The scope of this problem emerges from Figure 4, which reports the striking decline in work-based earnings and the rise in household dependency on government and equity-based income:

Figure 4: Personal income and taxes

Source of raw data: Bureau of Economic Analysis

We can see a good part of the problem with the Laffer Curve in Figure 4. First and foremost: the three big tax reforms over the past 40 years – Reagan, Bush and Trump – have not lowered the tax burden on personal income. They have helped keep that burden flat, but that is also all they have accomplished.

Furthermore, the composition of private income is such that the intended effects of another tax reform would be limited. Today, wages and salaries account for only half of personal income. This is the share we need to target with tax cuts if we are going to bring about more workforce participation. The Trump tax reform showed, again, that this can be done, but the tax cuts would have to be concentrated to the lowest income segments; the higher a household’s income is, the larger a share of it comes from equity. Cuts in taxes on equity-based income are not as effective in stimulating economic growth.

At the same time, lower-earning households depend to a larger extent on tax-paid entitlements. Their total share of personal income is approximately 17 percent, and will very likely increase further in the future.

The tricky thing with this income source is that households tend to lose entitlements as their work-based income increases. Even if they increase their workforce participation thanks to a tax cut, their total income does not increase accordingly. Thereby, consumer spending is not boosted, depriving the economy of some of the growth the tax reform would otherwise generate.

Again, Figures 3 and 4 tell us with painful clarity that our government has not become cheaper as a result of the practice of supply-side economics. Figure 5 makes this point from a different angle. Suppose we bundled together the cost of federal, state and local government taxes and other revenue sources and created one “all inclusive” personal income tax. What would the rate look like? Figure 5 explores that question with the tax base defined as total personal income (grey), employee compensation (dashed blue) and wages and salaries (solid blue):

Figure 5: The total cost of government as share of personal income

Source of raw data: Bureau of Economic Analysis

Again, our government is not solely funded through taxes on personal income and consumption, but as Figure 3 showed we are moving in that direction. It is also worth noting that even a corporate income tax is ultimately paid by the employees, the investors and the customers of that corporation. Therefore, the experiment in Figure 5 is quite telling of what the cost of our government actually looks like today.

Bluntly: four decades’ worth of tax reforms have not helped reverse the growth in government. Its cost has tapered off, but we have to keep in mind that Figure 5 does not take budget deficits into account. They really aren’t more than a hidden tax on future personal income.

Long story short: all that matters is structural spending reform. Once that is under way, there will be room for further tax cuts. As a bonus, budget deficits will gradually disappear.

Tax Cuts or Spending Cuts: Part 1

There are some very good organizations out there fighting to keep taxes down. Americans for Tax Reform is at the forefront, with others not far behind. They all fight the good fight: it is always preferable to have lower taxes than higher taxes.

Many economists propose tax cuts as a way to reduce the budget deficit. The idea, known as supply-side economics, is based on the premise that lower taxes generate stronger economic growth, which in turn generates more tax revenue.

Supply side economics is a valid theory and the Laffer Curve – almost the hallmark of supply-side theory – has strong empirical support. I recently published an article where I reported data for the European economy, showing a solid Laffer effect on tax revenue. However, I also cautioned:

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

Once the welfare state grows past a certain point, the Laffer effect, while still visible, will be far too weak to close deficit gaps. Plain and simple, the supply-side mechanism ceases to function insofar as the government budget goes. Tax cuts still generate more economic growth and thereby an increase in tax revenue, but without adequately affecting the government budget.

The reason is as simple as it is brutal: too much spending. Having grown increasingly frustrated with the lack of focused attention to the spending side among libertarians and conservatives, in the next few days I will be rolling out a series of articles on the dynamics between tax cuts and spending cuts.

While fiscal conservatives do pay attention to spending, it is almost always in an ad-hoc manner. A common idea for reform is a penny-plan style reform that slows the growth of government spending. This is not a bad idea in and of itself, but as we will see in a coming article it does not solve the underlying structural problems that drive government spending. A penny-plan style spending reform buys us time, slowing the growth of government enough to let Congress piece together a major entitlement reform agenda.

What we need is a master plan for the structural overhaul of our welfare state. We need to reform it away until government is out of the business of economic redistribution.

This is no easy task. It is in fact more daunting than it was back in the 1960s putting the first man on the moon. That, however, is no excuse not to do it. Leaving an unaffordable welfare state for our children to pay for, and asking them to do so while also funding our consumption of the welfare state in the form of a big government debt, is nothing short of collective egoism.

It is also a safe way to ruin the country and the future of generations of Americans.

To see why the master plan is the way to go, and supply-side economics no longer works, we will work our way through a stack of data. We start today with a review of state and local government finances. Specifically, the review will show that the absence of an income tax does not help in terms of containing government spending. Bluntly: states with no income tax have just as big governments as states where income taxes provide a large share of government revenue.

As a first step, Figure 1 reports the combined fiscal balance for general revenue and expenditure for 2018 in all the 50 states. The vertical axis represents the difference between general revenue and general spending as percent of general revenue. This metric varies from year to year, with the majority of states swinging between surplus and deficit. However, the picture is almost always mixed, as reported here:

Figure 1: State and local government fiscal balances

Source of raw data: Census Bureau

Over the long term, states and local governments have had about the same problem with balancing their books as the federal government has. The deficit problem is not as pervasive, but there are years when almost all of them run deficits.

It is important to remember that these numbers include both states and local governments; the local-government share of spending varies significantly across state lines. In other words, to ignore local governments would be to give an unfair, even skewed representation of the role of government in our states’ economies.

Most of our government spending is allocated to the welfare state, i.e., programs that provide government benefits to people for the purposes of economic redistribution.* Two thirds of federal spending is for the welfare state; in 2018 the average for states and local governments was 56 percent. This share has increased over time, slowly increasing the stress on government finances. A spending program for economic redistribution is driven not by what taxpayers can afford, but by the definition of the entitlement embedded in the program. Medicaid, e.g., provides health care to its enrollees, giving them access to a portfolio of medical services the quality of which is defined by medical technology, and the quantity by patient health conditions.

I have discussed the discrepancy between health-care costs and tax revenue in a previous article. The same principle of independent cost hikes applies to education, income-security programs, housing and everything else provided under the welfare state.

This point is almost universally overlooked in the fiscal-conservative movement. Too much focus is no tax reform, specifically to keep taxes as low as possible. While, again, a respectable ambition in itself, it does not help with containing the growth of government. For example, if a state eliminates its income tax, it will most certainly not reduce the size of its government. Again based on 2018 Census Bureau data on state and local government finances,

-In the nine states where the personal income tax contributes 0-1 percent of total revenue, government spending amounted to 21.9 percent of total private-sector economic activity, a.k.a., private-sector GDP;

-In the 12 states where the personal income tax provided more than 15 percent of total revenue, government spending was equal to 21.2 percent of private-sector GDP.

The 29 states in between had roughly similar-sized governments. In other words, it does not help fiscal conservatism to abolish the personal income tax.

But does it harm fiscal conservatism to do so? That question is not primarily a matter of economic analysis, but there is one point that can contribute to the answer. Table 1 reports the revenue share of the personal income tax (Typ) and the revenue share from non-tax sources:

Table 1: Government revenue sources

Source of raw data: Census Bureau

In short: when governments cannot rely on the income tax they seek out other revenue sources instead. To take one of the favorite examples among opponents to the income tax, in 2018 government in Wyoming got 75 percent of its revenue from non-tax sources. This is the highest share in the country. Contrast this to Connecticut, where the personal income tax provided 22.3 percent of total government revenue and non-tax sources added one third of total revenue.

Government spending as share of private-sector GDP was 16.6 percent in Connecticut – and 29.9 percent in Wyoming. In other words, the supposedly low-taxed Cowboy State has the fourth largest government in the country. And this is a reasonably generous measure: if we use private personal income instead – the most proper tax base measure available – Wyoming has consistently ranked in the top two in the country.

However, more important than these factoids is the problem with political effort. It takes a lot of work to advance policy reform – spending of political influence capital – which means that every such effort must be designed to yield the best possible outcome. If we use proper metrics for that outcome (rolling back the welfare state) then it is unquestionably better to focus on spending reform instead of tax reform.

In Part 2 of this series we take a detailed look at why supply-side tax cuts are no longer effective, and why spending reform is the only way forward.


*) This category of spending includes social programs, income maintenance, health care, unemployment benefits, housing and community development and education. The last item is often overlooked, but regardless of whether or not one defines education as an essential government service, it does belong in the redistribution category. Government provides the service based on criteria defined by government, not decisions made by individuals; funding is also independent of the use of the service.

Laffer Curve: Use with Caution

There is a tradition among Republicans to try to fix budget deficits with tax cuts. Three times in the past 40 years they have deployed this strategy, each time with largely the same results: a solid rise in tax revenue but no budget balance.

Now there are rumblings about an even bolder plan. Steve Moore, an economist with President Trump’s economic recovery task force, has suggested that Congress suspend federal personal and corporate income taxes for 2021. By 2022 taxes would revert back to their normal levels.

As with the Reagan, Bush and Trump tax cuts, the idea is to exploit the Laffer effect, according to which the initial loss of tax revenue from a tax cut is made up for with growth in the tax base. As a result, government collects more tax revenue down the road than it would have done at the initial, higher rates.

There is a fair amount of evidence to support the Laffer effect. However, it does not apply in Steve Moore’s case, and the reason is simple: temporary tax cuts have no lasting effect on economic growth. The only effect of Moore’s proposal would be an even bigger deficit hole in the federal budget.

With the experience that Moore has, you would have expected him to have kept this in mind while designing his proposal. As it is now, his tax holiday would only result in a massive increase in our already oversized money supply. No sane investor is going to lend even remotely enough money to the Treasury if it expands an already-gargantuan budget deficit by temporarily giving up 55 percent of its tax revenue.

More than anything, Moore’s proposal would accelerate us into an acute fiscal crisis. At that point, anything can happen – even Republican tax hikes.

In other words, the Laffer Curve is not to be taken lightly. You cannot throw it around like candy and hope for the best. That said, there is no doubt that the curve exists. Figure 1 reports data from 30 European countries from 1996-2019.* Two time series are compared:

  1. T/GDP, i.e., the ratio of total tax-revenue collections from all levels of government to GDP. Both variables are in current prices.
  2. T Growth, i.e., annual growth in current-price tax revenue.

The variables are paired by year, by country, then organized as two time series based on the second variable. The red-gray columns represent growth rates in tax revenue, while the green curve is a polynomial trend line for the tax-to-GDP ratio (representing 719 observations for T/GDP). Behold the Laffer Curve:

Figure 1: Euro-Laffer

Source of raw data: Eurostat

It is worth noting the up-sloping segment of the curve, giving the impression that it is good to raise taxes. That is not the case, however: the upslope is associated with declining tax revenue or revenue growth rates that are tepid at best. This indicates that we are looking at economies in recession; tax revenue only plummets during recessions or in the first year of a Laffer-driven reduction in taxes. Europe has seen practically nothing of the latter, so the cause of this decline is to be found in the former.

But why, then, is there an upslope in the Laffer curve? Simple: during recessions the total tax collection from the economy declines faster than GDP. In almost every mature welfare state – of which there is plenty in Europe – the tax burden is disproportionately placed on higher incomes. Those are the first to take a beating when the economy tanks. Therefore, at constant tax rates the tax-to-GDP ratio falls in a recession and rises as the economy revs up again.

Once the economy is out of a recession, however, high taxes stifle economic growth. This is visible in the peak of the Laffer Curve; the only way to increase the annual growth rate in tax revenue is to actually cut taxes.

To see how the Laffer Curve works in practice, let us take a look at one of the worst examples of bad tax policy in modern times, namely Greece in the aftermath of the Great Recession. Figure 2 reports the same variables as in Figure 1, though the T/GDP ratio is reported as actual data, not a trend line.

During the austerity episode after the 2008-2010 Great Recession, the Greek government raised taxes significantly. As a result, the average growth rate in tax revenue almost ground to a halt:

Figure 2: The Laffer Effect in Greece

Source of raw data: Eurostat

To summarize the two periods in the Greek economy:

If the Greeks did the opposite now, returning taxes to pre-austerity rates, they would spark a significant rise in GDP growth. Tax revenue would surge in the backwater of that growth. However, it would have to be permanent tax cuts, not some silly one-year holiday.

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

On the other hand, when used properly, the Laffer Curve works just fine.


*) All raw data numbers are sourced from the Eurostat databases on national accounts and government finances. The countries are: Belgium, Bulgaria, the Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Croatia, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, the Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, the U.K., Norway and Switzerland. For Switzerland, data is only available for 1996-2018.