Is it possible to reduce taxes by lowering the tax rate? Let’s talk about the Laffer Curve. This theory, posited by Alfred Laffer during the Reagan Era of tax reduction, may hold more water than you’d think. This is a great exercise for webinars where you’re helping clients understand taxes better (and why they should seek to save on that tax bill as much as possible).
What is the Laffer Curve?
The Laffer Curve theory, as Investopedia explains, is the theory that as tax rates increase, people become dis-incentivized to earning more money, and can actually decrease the amount of revenue the government takes in from taxes.
When the rate is 0%, there is obviously no revenue, and then as the rate increases, so does the revenue. Yet, the higher the rate gets, the less desire there is to work for a higher income. After all, if the tax rate was 100%, no one would work, because they wouldn’t have a reason to. The government would get all of their money.
If, however, taxes are decreased after a certain income threshold, people will have an incentive to work and earn more money. This increases tax revenue, because of course the pool of money being taxed is greater.
Using the Cash Flow Calculator to Show the Laffer Curve
Imagine, for a moment, that you could invest $20 one time, and earn 20% every year for 100 years. Without ever adding another dollar, you would earn over 1.5 billion dollars for a single $20 investment, as shown below.
So what happens when you add taxes in there? Let’s add a more extreme tax of 50%. Based on the information you have right now, what would you assume you’ll have after a 50% tax? Many clients often say they would still have about 50% remaining. In this case, that would be about 750 million dollars.
The real result? Only $275,592.
Where Does that Money Go?
We talk about the magic of compounding interest, and opportunity cost, often. This is a great, real-world example.
Because the money is being taxed each year, the growth is also stunted each year. If we could defer those taxes, only paying at the end of the 100 years, your client would be right to say there would be about 750 million leftover.
Yet the money can never reach it’s full earning potential because it is continually being depleted.
And here’s the most shocking part: who got to keep the difference between the $1.5 billion you would have had, and the $275,000 that you ended up with?
At the bottom of the chart, you’ll see that with a 50% tax, the government received just as much as you did (minus a few dollars or so). The rest of the money evaporated, and THAT is the devastating power of opportunity cost.
What Happens When You Reduce Taxes?
If you reduce the taxes on this account to 40%, look what happens. Suddenly, not only has your revenue multiplied, so has the government’s revenue.
At 20%, shown below, the government’s revenue is over $13 million. All from a lower tax rate.
How does this happen? The answer is the time value of money. In the early years, the lower tax rate will translate to lower annual revenue for the government. It’s over 100 years that we see how beneficial it is for people to accumulate and earn more money at a lower rate, because everyone wins.
The unfortunate reality is that the government is not willing to play the long game, primarily because they don’t see the benefits. After all, a lie is easier to understand than the truth is to explain.
From Art Laffer’s theory, we can see that not only do taxes dis-incentivize people to earn more if they’ll be taxed more… higher taxes actually cause money to evaporate. Money that no one gets to enjoy, in the name of short-term gains.