Payroll Tax Cut, Right Cut, Wrong Side: Obama Botches the Payroll Tax Holiday

Economics and Liberty ^ | 12/08/2010 | Bryan Caplan

[SeekAndFind]

With perfectly flexible wages, it doesn't matter whether tax law says "employees pay" or "employers pay."  Tax incidence depends on supply and demand elasticity, not legislative intent. If wages are nominally rigid, however, the law matters.  If you cut a tax on employers, this reduces labor costs, increases the quantity of labor demanded, and reduces surplus labor.  If you cut a tax on employees, in contrast, this increases worker compensation, increases the quantity of labor supplied, and increases surplus labor.

In both cases, admittedly, a tax cut might directly increase demand and, with nominal wage rigidity, increase employment.  But when you cut taxes on employers, the incentive effect and the fiscal effect work in the same direction.  When you cut taxes on employees, the incentive effect and the fiscal effect work in opposite directions.

That's why Obama's proposed payroll tax holiday botches an idea of truly Singaporean cleverness.  Instead of giving the tax cut to employers, where it would do the maximum good, or splitting it evenly, where it would do intermediate good, he's giving all of it to employees, where it does the minimum good:

The payroll-tax reduction under discussion now would cut the 6.2% Social Security tax levied on a worker's wages to 4.2%. A worker making $40,000 a year would save $800, and some economists say that could help stimulate demand at a time when the economy remains relatively weak.

The employer's half of the tax--also 6.2%--wouldn't be affected under the White House proposal, and thus the cost of hiring new workers wouldn't be directly affected.

Of course, if Obama's goal is simply to salvage his fading popularity, he's right on target.

P.S. If you object that you want to put the money into the hands of people who will actually spend it, remember that cash flow is a good predictor of business spending.

[SeekAndFind]

GREG MANKIW MAKES THE SAME POINT here

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The Tax Deal

I am generally pleased with the compromise over taxes the President and Republicans struck yesterday.  (The President should be too, but he seemed dejected at his news conference.  Buck up, Mr President!  You don't want anyone to start thinking of the word "malaise.")

One aspect of the deal struck me as worth discussing with econ students: The compromise includes a one-year cut in the payroll tax by 2 percentage points.  The tax cut will be entirely in the employees' share.  Why do you think they designed the policy in this way?  Was it the right choice?

One basic lesson of microeconomics is that it doesn't matter which side of a market the government taxes.  As a result, you might think it doesn't really matter which side of the payroll tax is cut.

But this standard analysis assumes that wages are flexible and thus can reach equilibrium of supply and demand.  This assumption might not hold in the short run.  Over the course of a year (the time horizon over which this policy is in effect), it may be better to think of the wage as given.  In that case, it matters which side of the market gets the tax cut.

As the policy was described yesterday, this payroll tax cut goes entirely to the worker.  This increases work incentives, but the main motivation is probably to increase take-home pay, consumer spending, and aggregate demand.  CEA chair Austan Goolsbee recently said, “We’re not saying that our long-term recovery ought to be built on trying to increase consumer spending.”  Maybe not, but the plans for short-run recovery are very definitely consumption-based.

An alternative would have been to reduce the employer's share of the payroll tax, at least to some degree.  Given a sticky wage, this policy would have reduced the cost of hiring and, to the extent labor demand curves slope downward, increased employment.  It would also have increased business cash-flow and, to the extent that firms are cash-constrained, increased business investment.

I should note that, as part of the deal, the President also got his proposal to allow businesses to expense investment spending.  As I have said previously, this is a good idea, but the impact is likely to be modest.

[econjack]

Exactly! Also, making them temporary cuts decreases their effectiveness substantially.

[NonValueAdded]

Brilliant!!! Where is Tolik and his “nailed it” ping list? AWOL since Feb :(

[Shannon]

I believe he’s trying to appeal to the masses and it has nothing to do with helping businesses. Nothing.

[GailA]

Still just a tax freeze, and no additional money in pockets of Seniors who will go a second year with NO COLA raise, but will need food stamps, commodities and heating assistance as a result of inflation.

[Sam Clements]

Obama has done nothing to help small business. I agree with the article completely. I own a small business, 12 employees. The last 3 years have been hell. Cost cutting has been the major strategy just for survival. Many companies in my industry have gone out of business or are just hanging on. A 2% reduction in EMPLOYERS tax would actually save me $10,000 over the next year and would have actually done me some good.

[Sam Clements]

Obama has done nothing to help small business. I agree with the article completely. I own a small business, 12 employees. The last 3 years have been hell. Cost cutting has been the major strategy just for survival. Many companies in my industry have gone out of business or are just hanging on. A 2% reduction in EMPLOYERS tax would actually save me $10,000 over the next year and would have actually done me some good.

[stylin19a]

the FICA cut sux....the cut in FICA gives a tax break to people who wouldn't get one if it was an income tax break.
plus there's nothing paying for it.
I just don't see how this benefits anybody short or long term.
make 20k a year ? keep 400 bucks a year or $7.26 a week.
make 40k a year ? do the math.

bad movc....

[Jess79]

Obama has done nothing to help small business.

I completely agree. The more I hear about this deal the worse it gets. I'm beginning to think Obama is setting up the Republicans to take the fall when it becomes obvious in a few years that "tax cuts" have failed to stimulate the economy. The Democrats have been successful in framing the entire argument around nonexistent "tax cuts". While Republicans may have been successful in staving off a short term economic disaster by preventing an increase in taxes, the fact is this deal does not put any more money in the hands of small business to encourage growth or hiring. The temporary nature of these fixes will continue the same uncertainty that has plagued business since Obama took office. By agreeing to extend unemployment benefits, Republicans are increasing costs on small business as businesses are the ones paying unemployment premiums, and the payroll tax holiday serves only to pander to the middle class, and does nothing to increase cash flow in business or encourage them to hire.