How Payroll Tax Cuts Can Create Jobs

Copyright, The New York Times Company

Last week President Obama proposed a collection of policy changes, including payroll tax cuts, unemployment benefit extensions and new infrastructure projects. The latter do not have much job-creation potential, because they reduce private-sector activity in the short run. But they can be desirable for the infrastructure they produce, and because doing some of those projects now would be cheaper than doing them later.

Unemployment compensation may be compassionate, and for that reason alone might be the “right thing to do.” But an unfortunate side effect of unemployment compensation is that it reduces employment by discouraging people from seeking and retaining jobs.

The real job-creating potential in the president’s proposals comes from one of its payroll tax cuts.

The payroll tax is the second most important tax in the United States, normally bringing in almost $900 billion a year through a combination of taxes on employers and employees — about 15 percent of payroll. Although workers may not realize it, most of them pay more payroll tax than they pay in federal income tax.

The president proposes cutting the employer portion of the payroll tax by 3.1 percentage points (bringing the combined total down to about 12 percent) for employers with less than $5 million in payroll. Unfortunately, this last condition is business-distorting. Why encourage a $10 million business to split into two $5 million businesses?

Nevertheless, the 3.1-percentage-point part of the president’s proposal could raise employment by at least a million, albeit the duration of job creation is related to how long the tax cut lasts. I expect that every percentage-point reduction in employers’ costs raises employment by about a percentage point and real gross domestic product by about 0.7 percentage point.

That means employment could be roughly three million greater during the period of the tax cut than it would otherwise.

The tax cut is proposed to last a year, and some of the estimated three million incremental job-years — a job that lasts a year, or 12 jobs that last a month — could be spread over time. So we might see only two million in the first year of the cut, with another one million after the cut expires. But still that’s a lot of jobs.

The other part of Mr. Obama’s payroll tax cut proposal is more complicated — and counterproductive. It would reduce the employer’s proportion of the payroll tax by 6.2 percentage points for increases in its payroll spending. Assuming that this payroll tax change would be in place in 2012, the payroll spending subject to the reduction would be the difference between the 2012 payroll and the 2011 payroll.

Because this part of the cut is based on the payroll difference, it makes expanding the 2012 payroll cheaper — presumably the intention of the law — but it makes it cheaper to contract the 2011 payroll.

That could be part of the reason why employment so far in 2011 has been so low; if you think that tax credits for new hires will catch employers completely by surprise, remember that the Obama administration has been floating ideas like this for three years.

To see this, consider an employer that would have a $1 million payroll in both 2011 and 2012. With the normal rates in place, that employer and its employees would owe a combined $150,000 in payroll taxes in each of the two years (15 percent of payroll; for simplicity I have put to the side payroll tax caps and a employee-side cut that has been in place since Jan. 1), or a total of $300,000.

If this employer decided to increase its 2012 payroll by $100,000, that would add a total of about $15,000 to the tax bills under the normal rates, but only about $9,000 under the proposed cut. In other words, as intended, the proposal makes 2012 payroll expansion about 6 percent cheaper than it would be under the normal rates.

However, if the same employer decided to cut its 2011 payroll by $100,000, that would subtract a total of about $15,000 from the tax bills under the normal rates, but subtract a total of $21,000 from the tax bills under the proposed rates — if the payroll cut was restored in 2012, since that part of the payroll would benefit from the reduced payroll tax rate. Contrary to the policy’s intentions, it makes cheaper certain types of payroll reductions, namely those reductions that occur before the law goes into effect.

While President Obama’s proposals have some real job creation potential, it remains to be seen whether any of them become law and whether the job-creating policies are packaged with too many job-destroying policies.