The Laffer Curve: CNBC Explains

The Laffer Curve is an economic tax theory, that—legend says—was written up on a napkin at a Washington, D.C., restaurant.

What does the Laffer Curve actually say and why is it the darling of tax cutters? Was it really created at a dinner time meeting in the 1970s? CNBC explains.

What is the Laffer Curve?

In simplest form, the curve argues that increasing tax rates beyond a certain point will become counter-productive for raising tax revenue—and that when taxes are too high, tax revenues will actually sink.

In the diagram of the curve, it shows that if a tax rate is zero, there is no revenue—obviously—to the government. But if a tax rate is as high as 100 percent, that won't generate revenue either, as there is no longer any incentive for a taxpayer to earn any income if all the money they make is taxed. Or so the theory goes.

The curve is an important part of what's called "supply side economics," a belief that economic growth is spurred with low tax policies that encourage productivity and investment.

The Laffer Curve is named after U.S. economics professor Arthur Laffer (more on him later).

In explaining the curve,Laffer said somewhere between zero percent and 100 percent is a tax rate that maximizes total revenue.

Laffer said a reduction in tax rates—and lower revenues for the government—does not need to be offset by decreased government spending or increased borrowing.

In 2007, Laffer did say that the curve should not be the sole basis for raising or lowering taxes.

Critics contend that the curve, if followed, would raise taxes on lower-income to middle-income workers, while giving tax breaks to higher-income earners.

Supporters believe that tax cuts would pay for themselves through greater growth of the economy, by the increased spending and investment from the lower tax rates on higher incomes. This is often referred as "trickle down theory" from the supply-side economics belief. In essence, all levels of income would benefit from the lower tax rates on higher incomes, because those high end income people are spending and investing more.

How Did the Laffer Curve Come About?

The term "Laffer Curve" was reportedly coined in 1978 by Jude Wanniski—then an associate editor and writer for The Wall Street Journal—from an article he wrote called "Taxes, Revenues, and the 'Laffer Curve.'"

This was four years after a late-afternoon meeting between Laffer, Wanniski, Dick Cheney, and Donald Rumsfeld. Cheney was a top aide to then-President Gerald Ford, and Rumsfeld was Ford's chief of staff. The group was having dinner at the Two Continents Restaurant at the Washington Hotel in Washington.

In this meeting, Laffer argued against Ford's proposed tax increase designed to help ease a growing deficit and stop inflation, and he reportedly sketched the curve on a napkin to illustrate the concept.

Laffer says he has no recollection of drawing the curve on a napkin, and says that he had used the curve in his classroom lecture.

Whether it was because of Laffer or not, Ford reversed himself and proposed a tax decrease in 1975, which was eventually passed by Congress. The bill did not contain spending cuts and resulted in a federal deficitof around $53 billion for the 1975 fiscal year, and $73.7 billion for 1976.

Did Laffer 'Invent' the Curve?

No. Laffer himself has pointed out that the concept was not original, and has noted similar ideas that go back to the 14th century, and even to British economist John Maynard Keynes, whose theories include using government spending to stimulate economic growth.

Who Is Arthur Laffer?

Born in Youngstown, Ohio, in 1940, Laffer received a bachelor's degree in economics from Yale University in 1962. He graduated from Stanford University with an MBA in 1965 and a PhD degree in economics in 1971.

Laffer played a key role in the late 1970s in the writing of Proposition 13, the California property tax capinitiative that inspired similar initiatives in other states.

He gained prominence as a member of President Ronald Reagan's Economic Policy Advisory Board in the 1980s. In 1986, Laffer lost his bid to be the Republican primary candidate for the U.S. Senate in California.

Laffer is the founder and CEO of Laffer Associates in Nashville, Tenn., an economic research and consulting firm, and is policy co-chairman along with others, including CNBC's Larry Kudlow, of the pro-business Free Enterprise Fund.

Laffer identifies himself as a fiscal conservative and libertarian. He has stated publicly that he voted for President Bill Clinton in 1992 and 1996, and lists John Maynard Keyes as one of his major influences.