Smart Stimulus

Bryan Caplan

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With flexible prices, many tax cuts are equivalent to each other. If wages instantly adjust, for example, it doesn't matter whether you cut the employers' share of the payroll tax, the employees' share, or the whole thing. The recipient of the tax cut depends solely on supply and demand elasticities, not the law.

Of course, a key problem with recessions is that many prices aren't perfectly flexible. That's why people lose their jobs during downturns, instead of seeing a sudden fall in their wages. The upshot is that during recessions, the legal details of a tax cut temporarily become much more important.

Example: Suppose you cut employees' share of the payroll tax. With rigid wages, this puts money into workers' hands, not employers' hands. But it does nothing to eliminate the labor surplus (a.k.a. "unemployment"). In fact, it makes the labor surplus worse, because more people will want jobs when after-tax wages go up. In contrast, if you cut employers' share of the payroll tax, this puts money in employers' hands, not workers'. But the indirect effect is to reduce the labor surplus; employers want to hire more workers (or lay-off fewer) when labor costs are lower.

Does any country actually take advantage of this insight? Sure - Singapore. Who's next?

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COMMENTS (4 to date)

Latest Comment

dWj writes:

As it happens, the Obama stimulus is just about the same size as suspending the employer's portion of the tax. It's also a lot logistically simpler than gearing up infrastructure investment.

Posted January 7, 2009 12:05 PM

Gary Rogers writes:

One of my favorite quotes is by Thomas Sowell and I will paraphrase it because I cannot immediately find it. He says "Politics is not about truth. Politics is about what politicians can make you believe is the truth." In this case the stimulus is not about what will help the economy, it is about what will look good to all those votors who have never heard of incidence.

Posted January 7, 2009 12:44 PM

Sinclair Davidson writes:

This 'tax cut' is actually a wealth transfer out of employee pension funds to firms. It operates to reduce wages and (might) maintain employment like Bryan suggests, but it is not a tax cut. The Singaporean CDF does not equate to the US payroll tax (although in principle they attempt to perform much the same function). The Singaporean government have effectivily mandated a wage cut across the economy. If the US government did the same thing, I hope, Bryan would be up in arms.

(I should also note that it is very easy to visit Singapore once and be very impressed, but you do need to go there a lot to get a rounded picture. Just a thought ...)

Posted January 7, 2009 4:12 PM

floccina writes:

I think that this “financial crisis” provides a rare opportunity to make a tax cut that will in the long run reduce the government deficit. If taxes are cut by eliminating the SS and Medicare tax (both the employee and employer protions) it will enable us political, to later cut the SS and Medicare payouts to the rich and middleclass. It would end the charade that SS taxes are paying into a retirement/insurance plan where people pay for themselves. This charade leads to people who made more money in their work life demanding that they get paid more from SS and Medicare. Eliminating the SS and Medicare taxes would welfare those program enabling us to target them at the truly need cutting the benefit to the rich and middle class.

Posted January 7, 2009 4:23 PM

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