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.