Designing a Good Jobs and Wage Tax "Cut"

04/05/2010 05:12 am ET | Updated May 25, 2011

The president is proposing a job and wage tax credit to lower unemployment. (Note, while the title is Tax Cut, all the discussions use the word credit, so I will too.) In a statement from the White House last Thursday, the administration tried to explain how it would be effective, be more for small businesses, and not benefit "gaming." As one of the economists who proposed such a credit in the 1970s, I would say this is the good idea for today.

There is a confusion with the statement, however, as in one place it says: "This bonus would be based on Social Security payrolls, ..." and a few paragraphs later, it says "The credit would be administered off an employer's unemployment insurance wage base ..." Which base used can make a difference and I favor using the later as I will explain below.

Before I do that, I would like to suggest why unemployment remains so high in the first place. Some basic economic concepts will help.

To produce output it takes the inputs of labor and capital. In general there is some substitutability between these two inputs. With more capital you need less labor and vice versa. When the price of one of these inputs goes down, in theory, producers will substitute that input for the relatively more expensive one.

The cost of purchasing new capital or what is called gross investment is the cost of borrowing, in other words the interest rate. To fight a recession, monetary policy is used to lower interest rates, so firms will be able to borrow at lower costs to finance their operations. Two years ago the prime rate was 8% now it is 3.25%. It is far cheaper to finance new investment now. The same cannot be said for labor.

This helps explain how an economy can recover and increase output and yet not increase employment. What has happened, at least in the short-run, is that firms have been substituting capital for labor. There are complications to this story. The first is that the "elasticity of substitution" between labor and capital is less over the long run. Thus after a while more labor is needed to maintain and keep the capital working, and as output grows, the economy needs more of both.

The second is that blue-collar workers are more substitutable with capital than white-collar workers. In fact I co-authored research over 30 years ago that found that white-collar workers might actually be complimentary with capital (AER, June 1977). This means as more capital is employed, blue-collar workers are laid off in a higher proportion to the rest of the workforce. The distinction of blue and white-collar workers has been blurred over the years and it may be better to think in terms of high and low paying jobs.

What does all this say about how to design a jobs tax credit? The answer is that the best way to increase employment will be to reduce the cost of low wageworkers relative to both capital and high wageworkers without lowering their wage.

There are two taxes that all employers pay on the payroll of their workers. One is the Federal Unemployment Tax (FUTA), which requires employers (only) to pay 6.2% of the first $7,000 paid to each employee. The other is Social Security that requires both the employer and the employee to pay 6.2% of the first $106,800 wages paid to each employee.

A full time minimum wage worker received $14,500 a year. If the credit is based on the FUTA base, then it would truly be hard to "game" the system. If the base is the Social Security payroll taxes, then there could be a problem.

The White House statement says: "A small business that lays off 10 employees making $50,000 each and hires 20 employees making $25,000 each will receive no credit." This is true if the base is the Social Security payroll and not the FUTA base. The wages subject to Social Security taxes would stay the same at $500,000 while the FUTA tax base would increase by $70,000.

A counter example is that the firm lets go 20 employees making $25,000 and hires 10 employees making $75,000? In this case, the firm's Social Security wage base increases by $250,000 and if I read the proposal correctly, it would receive a nice credit. In this example, the firm's FUTA wage base would decrease by $70,000.

As an aside, I am not sure why the proposal does not want to reward the first case. More people are employed, which is the idea of the plan. Would a firm fire high paid workers and hire low wageworkers just to get a tax credit? This is unlikely as it is doubtful this kind of substitution can be made that easily.

We economists love to say that everything takes place on the margin. Now is the time to lower the relative cost of the lower paying jobs, so that all other things being equal, more hiring is done at this level. I think that most people do not think $106,000 is a low wage. The credit should be based on the payroll subject to FUTA.