It was the most famous dinner in the history of economics. Back in 1974, Arthur Laffer, Jude Wanniski, Dick Cheney, and Donald Rumsfeld met at the Washington Hotel, in the nation's capital. As legend has it, when the conversation turned to tax policy, Laffer drew a graph on a napkin to illustrate that higher tax rates do not always lead to higher tax revenue. At some point, higher rates kill economic activity, driving down revenue.
Resident Scholar Kevin A. Hassett
It's odd that the curve caused so much controversy, given that Laffer's point is perhaps the most ancient in economics. Indeed, as Laffer himself has noted, Ibn Khaldun, the great Muslim writer, alluded to the same dynamic in his epic 14th-century work The Muqaddimah. And in the 1800s, French scholar Jules Dupuit made the point with such precision that many economists today refer to the "Dupuit-Laffer curve."
Perhaps the curve provokes controversy because, although its hypothetical existence is not disputed, whether it characterizes our economy at any given moment is another question. The problem appears to be that the benefits of tax cuts are gradual. Reductions in capital-gains taxes are the only cuts that indisputably have increased revenue immediately, and they may be a special case in which reductions release an avalanche of pent-up gains.
Source: OECD, OECD Tax Database, Table II.1; OECD, Revenue Statistics, 2005
Of the countries represented on the chart, the U.S. has the highest rate but collects the second-lowest amount of revenue. This suggests, as economist Kimberly Clausing recently wrote in a study for the Brookings Institution, that "the United States is likely to the right of the revenue-maximizing point on the corporate income tax Laffer curve." Countries with low rates can collect more taxes because they stimulate domestic corporate activity, and because they attract multinational corporations willing to operate wherever the tax climate is best. That's a lesson the U.S. could afford to learn.
It is positively exasperating that a Republican-controlled government has taken no steps to reduce corporate taxes. Perhaps Vice President Cheney should invite Majority Leader Frist, Speaker Hastert, and President Bush to the Washington Hotel for dinner--and supply them each with an illustrated napkin.
Kevin A. Hassett is a resident scholar and director of economic policy studies at AEI.