As the clock wound down on 2010, President Obama signed into law the tax deal he struck with Republicans. One provision is a one-year, 2-percentage-point reduction in the employee portion of the Social Security payroll tax. This measure is supposed to reduce unemployment by boosting spending, but a more effective approach would have cut the employer portion of the tax.
The rationale for cutting the payroll tax on employers relies on basic economics: If the government makes it less expensive for businesses to hire workers, businesses will tend to hire more workers.
This is a straightforward statement, analogous to saying that if the government lowers the sales tax, consumers in the aggregate tend to shop more.
Some analysts argue that lowering labor costs — by reducing the payroll tax on employers — won’t translate into more hiring, because businesses are already operating below capacity.
Yet this view simplistically lumps all businesses together. Even in the depths of the recession, some companies were hiring, while others were laying off workers.
After a severe recession, there is eventually a turning point when the economy begins adding jobs, on net, every month. When this happens, it’s not because all of a sudden every company in the country stops shrinking and starts expanding. Rather, the turning point occurs when the growing group of expanding companies finally begins adding more jobs than are cut by the shrinking group of downsizing companies.
Giving all employers a 2% cut in labor costs would simply stack the deck in favor of the expanding companies. Even in a tough economy, expanding companies could try to win market share by slashing their own prices to consumers.
This strategy is all the more affordable when the government lowers its tax bite on wages paid to employees.
In contrast, the tax deal gives the 2% payroll tax cut to the employees, based on the Keynesian notion that what the economy needs right now is more spending. By letting workers keep a larger portion of their pretax income, the hope is they will go buy more things, which in turn will give employers reason to hire more workers.
Even on its own terms, it’s not clear that giving the workers the tax cut will boost “spending” more than giving the cut to the employers. To the extent that employers would hire more workers if they had received the tax cut, those new hires would have entire paychecks in new income to spend, as opposed to the 2% increase in the take-home pay of existing workers under the actual legislation.
So if the goal is to get workers as a group to spend money, then giving the payroll tax cut to the employers might be the better approach.
Another problem is that the tax deal, by giving the payroll tax reduction to employees, might perversely increase the official unemployment rate. By increasing after-tax wages and salaries, the payroll tax cut makes jobs more enticing to those currently not in the work force.
For example, a stay-at-home mom and her husband may have been discussing for months whether she should try to get a job to help make ends meet. Figuring in the cost of child care, they may have agreed that it didn’t make sense. But if the couple reruns the numbers now that her take-home pay would be 2% higher, it may make sense for her to begin applying for jobs.
To the extent that the payroll tax cut pushes some people over the edge to look for a job, the official unemployment rate will be higher than otherwise. The unemployment rate is calculated as the number of people actively seeking employment, divided by the total work force (defined as job seekers plus job holders).
As a matter of principle and fairness, it is always welcome when the government lets workers keep more of their money. Yet if the goal is to reduce the unemployment rate, cutting the payroll tax on employers would have yielded better results.
• Murphy earned a Ph.D. in economics from New York University and is a senior fellow in business and economic studies at the California-based Pacific Research Institute. He is co-author with Jason Clemens of “Taxifornia,” available on PRI’s website.