The Case Against a Payroll-Tax Holiday for Employers

Although business might like the idea, there's little reason to believe it would increase hiring much right now

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The Obama administration must be getting frustrated. First, it passed a huge stimulus package meant to create jobs. Then, it extended the Bush tax cuts. But in May, just 54,000 just Americans found work, while the jobless rate rose to 9.1%. But it hasn't given up on unemployment yet. Bloomberg reports that the president's advisers are tossing around the idea of a temporary payroll-tax holiday for employers. Is this the right medicine to cure high unemployment?

First, what does a payroll-tax holiday do? Currently, employers face a 6.2% tax on the wages that they pay. This proposal would temporarily suspend some or all of that tax, in the hopes that employers would use that extra cash to pay new hires.

It's Demand, Not Profits

So why aren't firms hiring? As with any problem, to fix anemic job growth you have to first identify its cause. Is it that businesses aren't making enough profit to hire additional workers? This might be the case in some situations, but by in large, business profits have been faring relatively well over since 2010. Instead, the problem is demand: consumers aren't spending enough money to convince employers that it's a good time to hire additional workers.

Unfortunately, a temporary payroll-tax holiday for employers won't solve this problem. For example, let's say that the tax employers pay on wages disappears through 2012. That means that their labor costs would decline by about 6%. To be sure, this will increase their profits, which could be used to hire additional workers. But for most companies, slightly lower labor costs won't result in an epiphany that they must hire more workers, because the reason why they weren't hiring in the first place hasn't changed.

Would It Have Any Effect?

A temporary payroll-tax holiday could have a direct impact on hiring in a situation if a company is selling a product for which demand is totally exploding and wants to hire as many additional workers as possible. In that case, the company can now afford to hire more workers than before, since labor costs are lower. Even in this situation, however, there are a few problems.

First, not all that many firms are experiencing such crazy demand that they are having trouble hiring as many workers as they want. After all, if their revenues were that high, then they could probably afford to continue to hire workers pretty aggressively anyway.

Second, economics teaches us that temporary tax changes tend to have a minimal impact. But the temporary nature of the payroll-tax holiday is especially problematic when applied to employers. This economic theory is more likely to hold for businesses than for consumers. Unlike firms, most people aren't quite so technical about how they spend and save. Businesses, on the other hand, tend to care a lot about budgets and projections. If a firm learns that its costs have declined, then it will analyze how to best use the extra profit. If the windfall is temporary, then the company isn't as likely to make a permanent change -- like hiring more workers.

Finally, even if a firm does intend to utilize the labor cost savings to hire more aggressively and ignores the temporary effect, lower employer payroll taxes won't have that big of an impact on hiring. If a firm's labor costs decline by 6%, this means that it can hire roughly six more employees for every 100 it has on staff, assuming those new employees will make salaries around the firm's average. So the smaller the business, the less effect the payroll-tax holiday will have. A firm would generally need at least 18 employees to save enough money through the tax cut to hire one more worker. And that's assuming that the holiday is for the entire 6.2% payroll tax, not a fraction. If small businesses like start-ups drive growth, then additional hiring would be negligible.

Better Solutions

If Washington wants to help the labor market heal more quickly, there are several ways it can do so. It can work to stop the bleeding of state and local government jobs. It could also act to temporarily eliminate gasoline taxes, so that the price of gas won't weigh so heavy on consumers. It could also fund shovel-ready infrastructure projects. Even cutting the payroll tax further on the worker side could help. Consumers demand remains low in large part because Americans are saving more and paying down debt. More cash in their pocket would allow them to repair their personal balance sheets more quickly.

The idea that business activity will increase if firms pay lower taxes is generally true. But the weak pace of hiring in the U.S. at this time isn't primarily due to firms facing excessive taxes. They aren't hiring because they do not sense that demand exceeds the output their current employees can produce. Until that changes, hiring will remain weak.

Image Credit: REUTERS/Jim Young