Why employees got the payroll tax cut

By Felix Salmon
December 7, 2010
Greg Mankiw discusses the economics of the payroll tax cut, and raises the question of whether it might have been better used to cut employers' share of payroll taxes, rather than employees' share:

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Greg Mankiw discusses the economics of the payroll tax cut, and raises the question of whether it might have been better used to cut employers’ share of payroll taxes, rather than employees’ share:

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…

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.

After raising the question, Mankiw stops short of answering it, leaving the possibility open that maybe Congress and the White House came to the wrong decision for political reasons. But of course they didn’t: this is a no-brainer.

Michael Cooper had a great article in the NYT in October about the last payroll tax cut, a/k/a “the Tax Cut Nobody Heard Of.” The idea is that the less noticeable a tax cut is, the more effective it is:

The tax cut was, by design, hard to notice. Faced with evidence that people were more likely to save than spend the tax rebate checks they received during the Bush administration, the Obama administration decided to take a different tack: it arranged for less tax money to be withheld from people’s paychecks.

They reasoned that people would be more likely to spend a small, recurring extra bit of money that they might not even notice, and that the quicker the money was spent, the faster it would cycle through the economy.

Economists are still measuring how stimulative the tax cut was. But the hard-to-notice part has succeeded wildly. In a recent interview, President Obama said that structuring the tax cuts so that a little more money showed up regularly in people’s paychecks “was the right thing to do economically, but politically it meant that nobody knew that they were getting a tax cut.”

So we know that people spend payroll tax cuts rather than saving them, which is exactly what we want any fiscal stimulus to do. Businesses, by contrast, are another thing entirely: they’re sitting on large and growing piles of cash, and showing little if any propensity to spend any excess cash which falls into their laps.

I certainly can’t imagine that a 1-year cut in payroll taxes would incentivize any employer to hire more people. A 2% cut in payroll taxes on a worker earning $30,000 a year amounts to a one-off payment of $600: very nice for the worker, but not remotely enough to get the employer to hire someone else. After all, payroll taxes will go back up to their normal levels in 2012.

And while business investment might increase “to the extent that firms are cash-constrained,” as we’ve already seen, they’re not really cash-constrained at all. Certainly large companies aren’t.

So really there’s no conceivable reason to give this tax cut to employers rather than employees. And if Mankiw weren’t being disingenuous*, he might make that a bit more obvious.

*Update: Apologies to Mankiw, I’ve now changed my mind, and no longer think he was being disingenuous. (But I’m still a fan of employee-side tax cuts.)

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