Now it´s up to Bernanke and the FOMC

Especially when unemployment is elevated – and it has been so for a long time – it can make a big difference if the payroll tax cut falls on the employer or the employee. In December 2010 the choice of an employee-side payroll tax cut derived from the “common sense” view that the person is going to spend more if his disposable income (net wage) rises. And when he spends more, this will increase the desire of firms to hire more, thus reducing the unemployment rate.

Unfortunately the “common sense” view does not reflect market realities. Even abstracting from the fact that the beneficiary of the tax cut may not increase his spending, in which case firms will see no incentive to hire more, by increasing the disposable income of potential “voters” the government (and us all) could experience the surprising result that unemployment goes up!

A simple graphical analysis allows us to “visualize” this outcome and at the same time conclude that designating the employer as the beneficiary of the tax cut could have potentially much better results.

The following figure shows what happens when the payroll tax cut benefits the employee. On the vertical axis we have the wage before the tax cut. On the horizontal axis we have the level of employment (with unemployment being given by the difference between the number of people who would like to work at that wage and those that are effectively employed i.e. E2 –E1).

Since with the payroll cut the net wage rises, more people would like to work at the original wage, meaning that some of those that were out of the labor force will now participate. With that the labor supply curve shifts to the right. Since labor demand did not change, the number of unemployed workers rises from E2 – E1 to E3 – E1.

The next figure illustrates the case in which a payroll cut benefits the employer. As the employer will have a reduction in his disbursement for a given wage, he will be encouraged to hire additional workers so that the demand curve for labor shifts to the right and unemployment falls from E2 – E1 to E2 – E3.

If what you want to see is a reduction in unemployment, the cut benefiting employers is the indicated medicine. But there are “secondary” effects.

Suppose the labor force is 100 and there are 90 people employed (unemployment = 10%). If the cut benefits the worker more people (say 2) will enter the LF. The employed will remain the original 90 but now the unemployment rate climbs to 11.7%. Nevertheless the 90 people employed will have an additional 2% of disposable income. Let’s say the original wage is $50. In that case each employed worker will have an additional $1 of disposable income, which sums to $90 of additional income to spend.

If the cut benefits the employer, let´s imagine he hires one additional worker. The rate of unemployment falls to 9% (good psychologically) but disposable income rises by only $1.

But as Scott Sumner says:

The mistake is to use common sense.  Common sense tells us that if we cut the wage cost for single firm by 2%, that firm wouldn’t be likely to hire many additional workers.  But that thought experiment has no bearing on the impact of an across the board 2% fall in labor costs.  It ignores the indirect effects of the action on other firms.  Ford might hire more workers because their wage costs fall, but also because other firms would respond by hiring more workers and those extra workers would demand more cars.  That’s what common sense misses.

And as the tax rebates of 2008 and 2009 showed, people are much more likely to save the (temporary) benefit than to spend it on consumption, while previously unemployed people will most likely increase spending if employed.

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