How Obama's Hiring Tax Credit Could Work -- And Why It Might Not

In the State of the Union, President Obama promised to get started on a jobs bill -- and fast. Well here we go: The White House has proposed taking the $30 billion of TARP money banks have repaid and give it to companies who hire in 2010. Here's how the tax credit would work:

• Tax credits for new hires. A small business that hires ten new employees in 2010 will receive a $50,000 tax credit to help offset the costs of those new hires. However, if the same small business lays off ten employees in 2010 and hires five new employees, it would receive no credit. 
• Tax credits for pay raises. A small business with 50 employees that, through increased hours or higher pay, provides all of its employees a $1,000 real wage increase in 2010 will receive a $3,100 tax credit, enough to cover the Social Security payroll taxes on those increases. 

Tax credits aren't so different from the other job creating strategies out there like job sharing (where the government pays employers to cut workers' hours to free up more work for new hires) and a payroll tax cut, which is the most straightforward way to give employers money to hire. One problem with job sharing and payroll tax cuts is that they pay employers upfront without the guarantee that they'll actually use the cash to hire. That's one reason some economists prefer tax credits to reward hires that have actually happened.

But there's a downside: Companies could game this system a couple ways: (1) Fire Peter, hire Paul, and say "Look we hired! Tax cut please." (2) Replace one full-time worker with two part-timers (3) Divide one company into multiple companies on paper, then shuffle workers around to increase the payroll at those companies. The Obama administration anticipates all three cheats:

• No benefits for gaming. A small business that fires 10 workers and hires 10 workers to
replace them would see no net increase in employment and thus would not receive a credit. A
small business that lays off 10 employees making $50,000 each and hires 20 employees
making $25,000 each will receive no credit. Likewise, a small investment firm that raises
salaries for its top employees from $300,000 to $350,000 will not receive a credit ... In addition, rules would prevent businesses from renaming themselves or merging in order to claim the credit.

The White House does not go into detail about how they will monitor hirings and firings and name changes.

To compare tax credits to other job creation theories, check out my pro-con rundown of the nine best way to reduce unemployment.