Fighting Economic Illiteracy One Idea at a Time
[Editor’s Note: Conventional Wisdom has it that as the population in general and Policy Makers in specific have become more educated and more experienced over time, they would have more intellectually consistent and accurate thoughts on economics and economic policy. Alas, this has not proven to be the case. Hence this series of articles]
As a policy for increasing employment, reducing the payroll tax on either the employer or the employee or both sounds like a reasonable and effective program. It is not.
In 2010 the administration and Republicans in Congress agreed on a one year, 2 percentage point reduction in employee payroll taxes. Furthermore, the administration is considering extending the cut and expanding it to the employer portion. The concept is that higher income for employees will stimulate consumption and lower costs of labor will stimulate employment. Why won’t this work?
First of all a 2% of payroll tax cut spread over 52 weeks is not very much for an average family. For an income of $50,000 this amounts to about $20.00 a week, maybe enough to order the pizza with extra toppings instead of just pepperoni, and a glass of wine, but not much more. Policy makers tend to think the working folks are stupid. Well, they are not so stupid that they go out and buy a new car or new furniture or any other major purchases on a $20.00 a week wage increase that will only last for a year.
On the employer side, the demand for labor is what is termed “derived demand” The demand is derived from the demand for final goods and services. Lowering the cost of labor harkens back to pre-1930’s economics, where it was thought that there could not be unemployment if labor was just willing to accept lower wages until they were hired. Keynes and those that followed him showed that this downward wage spiral would not work, that lower wages meant lower consumer income that meant lower consumption that meant lower demand for labor. Unemployment can not be cured by deflating the economy.
Unemployment also cannot be cured by a temporary reduction of 2% in the cost of labor. A payroll tax cut lasts for a year, hiring an employee is a permanent decision. Employers will not hire workers they don’t need just because they can save $1,000 for one year on a $50,000 a year employee.
Thus there are two things going against this policy. On the employee side a trickle of higher income does not stimulate demand for consumer durables, which is what is needed to stimulate today’s economy and the fact that the reduction is temporary renders the policy even more ineffective. On the employer side, a tiny cut in the cost of labor will not cause a business to hire workers it does not need.