Problems With A Hiring Tax Credit

Today, a letter signed by a number of prominent economists was sent to Congress suggesting a tax credit for companies that hire additional workers. The proposal isn't a completely awful idea. It could encourage some firms to hire more quickly than they otherwise would have. My colleague Derek Thompson has written about the idea before, listing pros and cons. I have several additional concerns. No matter what scenario you can imagine, the credit may be pointless at best or harmful at worst.

Before getting into scenarios, under what condition will a firm hire due to a tax credit? The size of the credit would have to be equal to (or greater than) the total cost (salary, benefits, overhead, etc.) a firm incurs on those employees that are hired for the time that would have elapsed until they the firm would have brought them on without the credit. Let's consider three scenarios: if the credit is too large, too small or just right.

Too Small: A Waste Of Money

If the credit is made too small, then it won't encourage any companies to ramp up hiring. Instead, the only companies who will end up collecting it are those that would have hired anyway. Those companies would be rewarded for what they were already planning on doing.

This is a major criticism of other government tax credits like the first-time home buyers credit. There's no way to separate those who were motivated by the credit to act and those who would have done so anyway. This would result in purely wasteful government spending. Unfortunately, given the challenge of passing any new spending measures in Congress these days, the credit ending up too small to actually create any new labor demand is a real danger.

Too Large: A Double-Dip?

If the credit is larger than it should be, then this could create a labor demand mismatch: companies who actually shouldn't be hiring based on their future demand may do so just to get the credit. Unfortunately, such a credit probably can't be targeted at specific industries and firms -- so it can't just be given to those that should be or would soon be hiring. Not all firms and industries will rebound in the same way.

If firms are encouraged to hire more than real demand will warrant their doing so, that will cause inventories to rise again: consumers and businesses won't buy as much as they're producing. This could result in big inventory surpluses. Firms will only allow those inventories to grow so much before they begin laying people off again, so to liquidate their excess supply. Firms laying workers off again once the recovery appears to be well underway could spook the markets and damage the strengthening consumer sentiment. If these firms had instead wait to hire until actual market demand for goods and services dictates, then you'd have a smooth recovery with less risk of a double-dip.

Just Right: What's The Point?

But let's say that Washington somehow gets the credit just right (see definition above). In that case, the government and individuals should be indifferent to the tax credit and extending unemployment. In both scenarios, those individuals would have had approximately the same income, and the government would have faced approximately the same expenditures. The only difference is that the companies would have created excess inventory during the time period when they wouldn't have otherwise begun hiring, which I already explained is probably undesirable.

For these and additional reasons others have mentioned, I'm pretty skeptical that a hiring tax credit would be a great idea. It's based on the theory that companies aren't hiring when they should be. I'm not sure how that could be a real problem: unless firms are turning away business, they'll have to hire before long if they see demand increasing. As a result, it would be better to allow employment to follow its natural growth path or rely on other stimulus measures, rather than risk the negative consequences explained above.