The Labor Market Post-Budget Deal

Copyright, The New York Times Company

Federal taxes and spending rules were scheduled to expire at the end of 2012, and the American Taxpayer Relief Act, passed last week, established new ones. As a result, it is unlikely that the United States labor market will grow in 2013.

Fiscal policy primarily affects the labor market in the short term by shaping the reward for working and producing. (Government employment also has obvious aggregate employment effects in the short term, as it did with its temporary Census hiring in 2010, but federal hiring or firing on that scale was not discussed in connection with the new legislation.)

It is helpful to summarize the important policy effects on the labor market from workers’ perspectives in terms of marginal tax rates. By that I mean the extra taxes paid (counting subsidies as a negative tax paid) by people when they work compared with when they do not work, expressed as a ratio to total employee compensation when working.

Policies that raise the marginal tax rate reduce the reward to working and vice versa. Many government programs contribute to the marginal tax rate, including, but not limited to, the personal income tax.

The most widely discussed change in 2013 is that the top 1 percent or so of taxpayers face higher rates of federal personal income taxation than they did in 2012. Most taxpayers do not face higher federal personal income tax rates, and the Tax Policy Center estimates that this tax change in the new agreement increased nationwide average marginal tax rates less than 0.5 percentage point. (Note that the center expresses rates in cash income units, while I express the rates as percentages of total employee compensation, which makes my numerical percentages a bit less, similar to measuring distance in meters rather than in yards.) The Medicare tax goes up in 2013 a bit for a small fraction of the labor force. This was a scheduled part of previous legislation.

A table displaying marginal tax rates on different categories of income shows that changes of half a percentage point or so in the marginal tax rate have occurred frequently during the postwar period. The personal income tax increase this year should by itself have a negative short-term effect on employment — but too small to be obvious in the aggregate employment statistics. Because the tax increase is concentrated on people who are more productive and who spend more on a per-capita basis, it will have a somewhat larger short-term negative impact on productivity and spending.

The federal payroll tax is greater this year than it was last year, because its temporary cut was permitted to expire. That increase is 1.8 percentage points when expressed as a share of total employee compensation (some of which escapes payroll tax). The payroll and personal income tax increases together have increased the average marginal tax rate by about 2.2 percentage points.

What surprised me was that the payroll tax cut was allowed to expire, but the purported temporary extensions of unemployment insurance were not. Unemployment insurance extensions add to the marginal tax rate, and subtract from the reward to work, because they provide income to people when they do not work.

Allowing the extensions to expire would have subtracted about 2.2 percentage points from the average marginal tax rate (see Chapter 5 of my recent book) and left 2013 marginal tax rates almost exactly as they were in 2012 despite a payroll tax increase.

Instead, the average marginal tax rate has increased about 2.2 percentage points, putting the rates about halfway back to their stimulus law highs in 2010. For this reason, the labor market could give back about half of its admittedly small recovery from the recession, measured in terms of hours worked per capita.

Population is expected to grow about 1 percent in 2013, and that growth by itself tends to increase aggregate hours worked and employment. But even when the population growth is added to the marginal tax rate increase, it seems more likely than not that aggregate hours worked and employment will fail to grow during the year.