As discussion of the Bush tax cuts of 2001 and 2003 creeps back into public discourse, we are met again with a little-understood and hotly-debated concept in economics – the Laffer Curve.

The other day I was watching TV when a news host told her guest, “If we raise taxes, we should get more revenue!”  On the surface, this makes sense.  But her statement is not always true.  The idea that changes in the tax rate do not affect behavior depends on a very static view of the economy.  Nothing can change, no one can act differently according to varying incentives, and no one part of the economy can affect another.

This is not realistic. 

Tax policy can be ridiculously complicated.  But this concept doesn’t have to be.  Basically, income tax revenues include two main variables (and these two variables are multiplied together).  The basic formula is this: tax revenues equal the tax base (the taxable money) times the tax rate (the percentage of the money that will go to the government).

Mathematically, the higher the two variables are, the greater we would expect their product to be.  But in reality, tax rates can have an incentivizing effect on the tax base.  If I know that I have an opportunity to make more money, chances are I will take advantage of that opportunity!  That is, unless I also know that the rate of taxation I will face with my new, higher income will actually cancel out any additional money I might see.  That would make working harder (or maybe hiring a new worker) less rewarding.  The tax rate actually affects behavior.

Opponents of the Bush tax cuts want older, higher rates to come back into play to help solve the deficit problem.  But this is a bad idea.  Higher rates of taxation – especially on income – discourage hard work and hiring, and keep the tax base stagnant. 

But on the other hand, extending the Bush tax cuts might allow the federal government to see more money in revenues.  How is this so?  Lower rates of taxation mean more money is in the hands of taxpayers.  These taxpayers see the rewards of their work, and this affects their behavior.  They work harder, hire more workers, and grow their businesses.  When their incomes increase, and more people are employed, the tax base grows (remember that’s one of the variables for revenues!).  This is a much more appealing way to fix the deficit, because it fixes the economy simultaneously.  While not all tax cuts pay for themselves, tax cuts usually have an economically stimulating result.  Allowing the Bush tax cuts to sunset would be far more costly in economic terms than the additional revenue that higher rates might create.

The Laffer Curve teaches us that tax rates affect behavior.  We should keep this in mind as we discuss the future of the Bush tax cuts.