Faced with the slowest labor market recovery in modern US history and the potential for a relapse into recession, the President unveiled his proposal for an American Jobs Act (AJA) before a joint session of Congress on Thursday night. The centerpiece of the proposal calls for halving employers’ tax obligations on their first $5 million in payroll. No payroll taxes would be levied for new employees and for wage increases. Amongst its other provisions, the proposal also extends full expensing of investments through 2012, allocates funds for teacher salaries and for other policy priorities, and outlines a strategy for infrastructure investment.

Consistent with the prevailing political climate, initial assessments of AJA reflect a significant degree of partisanship. But the question of whether payroll tax cuts will stimulate hiring can be evaluated on its merits, as well.

The findings of the Congressional Budget Office (CBO) over the last several years match a consensus amongst many of the nation’s leading labor economists: the employer tax cut will stimulate increases in hiring amongst firms that can boast improving demand for their goods and services; it will not result in new hiring by firms that face weak or declining demand. The policy’s ultimate effectiveness is limited by these demand-side considerations in business hiring decisions since, all else being equal, they will remain features of the market even after the proposal’s adoption. Improvements in demand resulting from the hiring incentive are important but secondary effects, more rangebound than extensions of unemployment benefits.

Overall, the positive impact of the plan on employment trends is overstated by its proponents and by several nationally recognized economists. The suggestion of an incremental gain of 2 million jobs is difficult to substantiate. In the near term, the proposal could have a negative effect on hiring trends. Some firms will postpone plans for payroll expansion until the timeframe and exact provisions of new measures become clear, and to maximize the likelihood of qualifying for benefits given uncertainties stemming from Congressional gridlock.

An Employer Tax Cut

While the reduction of firms’ total payroll costs is beneficial in principle, it may not result in significant new hiring if other factors are binding on labor input decisions. This was stated succinctly in a 2009 analysis by the Center on Budget Policy and Priorities (CBPP) which contrasts payroll tax holidays for employees and employers:

Suspending employers’ payroll taxes, by contrast, would put cash into companies’ coffers, where it is likely to sit as long as sales are weak and factories are operating below full capacity.[1]

The CBPP position is generally consistent with the views articulated more formally by the CBO. In a 2008 analysis endorsed by then-Director Dr Peter Orszag (Dr Orszag was subsequently chosen by President Obama to head the Office of Management and Budget), the CBO stated its view as follows:

Increasing the after-tax income of businesses typically does not create an incentive for them to spend more on labor or to produce more goods and services, because production depends on the ability to sell output.[2]

In a 2010 report, released under the leadership of Dr Douglas Elmendorf, the CBO again posits ambiguous benefits from an employer payroll tax cut:

CBO estimates that reducing employers’ payroll taxes would raise output cumulatively between 2010 and 2015 by $0.40 to $1.20 per dollar of total budgetary cost.

Except at the upper end of the range, the tax holiday policy has greater costs than benefits in the estimation of the CBO.

An Employer Tax Cuts for New Employees

The CBO clarifies that business tax cuts can stimulate investment indirectly, and that adjustments in taxes that target new investments and hiring are likely to be more effective than adjustments that are applied across the board. The rationale is as follows:

… the best way to use payroll tax incentives to increase employment is to use them to directly reduce the cost of labor. This can be accomplished ….  by targeting specific categories of workers (the unemployed) for an employees’ payroll tax cut that would be tethered to an employers’ tax incentive to significantly reduce the cost of labor.[3]

Analysis of the New Jobs Tax Credit in 1977 and 1978, which was similarly introduced to stimulate new hiring but which suffered from a degree of complexity, is largely inconclusive. In their preliminary analysis, Jeffrey Perloff and Michael Wachter find “the potential for a large employment effect,” but also concede that their “results may overstate the program’s employment effect.”[4]

The CBO concedes that “the [1977 and 1978] program directly subsidized about 2.1 million new workers, but the net number of jobs induced is unclear.” The overstatement of the program’s effect could result from firms delaying hiring until the program’s implementation, such that the policy itself induces a sharp change in net new employment upon its enactment. The problem arises again that the program does not address the demand-side of the equation:

… linking the availability of the credit to payroll growth would provide no incentive to maintain employment at firms that have been contracting and thus less incentive to maintain employment overall in industries and regions where the economy remains the weakest.[5]

Cutting Employee’s Payroll Taxes

As for whether a reduction in employees’ payroll taxes will result in substantially greater household consumption, the assessments are mixed as to the magnitude of the positive impact. Changes in consumption depend on a variety of factors; there is not a one-to-one correspondence between disposable income and spending. Rather, the consumption function shows a relationship between disposable income and spending that is influenced by confidence, amongst other factors. The extension of unemployment benefits to very income-constrained households should translate into consumption more efficiently than other programs.

In one of the most recent cases of a discrete economy-wide income shock, which followed from the passage of the Economic Stimulus Act under President Bush, households largely hoarded their stimulus monies, driving savings rates up temporarily. Uncertainty about job security and weakening consumer sentiment were factors in tempering the stimulative impact of that small but positive income shock. Notably, these are factors in the market today, as well.

[1] Chye-Ching Huang, Payroll Tax Holiday a Poor Stimulus Idea, Center on Budget and Policy Priorities, January 15, 2009.

[2] Options for Responding to Short-Term Economic Weakness, Congressional Budget Office, January 2008.

[3] Richard Thompson Ainswort, Will Cutting the Payroll Tax Increase Jobs? (Empirical Evidence from the EU VAT), Boston University Working Paper 11-01, January 7, 2011.

[4] Jeffrey Perloff and Michael Wachter, The New Jobs Tax Credit: An Evaluation of the 1977–78 Wage Subsidy Program, American Economic Review Papers and Proceedings, vol. 69, no. 2, 1979.

[5] Policies for Increasing Economic Growth and Employment in 2010 and 2011, Congressional Budget Office, January 2010.