Labor Supply Response to Tax Cut

The wage that matters for labor supply decisions is the after-tax real wage. If income taxes are cut, and the real wage is unchanged, then households will supply more labor. The Laffer Curve Supply-side economics was controversial and generated a great deal of debate back in the 1980s and since. Yet the argument that we have just presented is not really controversial at all. Almost all economists agreed that as a matter of theory, cuts in taxes could lead to increases in the quantity of labor supplied. The disagreements concerned the magnitude of the effect. Some proponents of supply-side economics made a much stronger claim. They said that the positive effects on labor supply could be so large that total tax revenues would increase, not decrease. They argued that even though the government would get less tax revenue on each dollar earned, people would work so much harder and generate so much more taxable income that the government would end up with more revenue than before. This argument was encapsulated in the so-called Laffer curve. Economist Arthur Laffer asked what would happen if you graphed tax revenues as a function of the tax rate. Obviously (he observed) if the tax rate is zero, then tax revenues must be zero. And, Laffer argued, if the tax rate were 100 percent, so the government took every penny you earned, then no one would have an incentive to work at all, and the quantity of labor supplied would drop down to zero. Once again, income tax revenues would be zero. In between, tax revenues are positive. Figure 12.12 “Laffer Curve” shows an example of a Laffer curve. There is some tax rate that will lead to the maximum possible revenue for the government. This itself is not that interesting: the goal of the government is not to raise as much tax revenue as possible. But if the tax rate lies to the right of that point, then—as the picture shows—a cut in taxes will increase tax revenues.