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Thinking through the White House’s Plan to (Further Cut) Payroll Taxes

e21 | September 28, 2011

A major part of President Obama’s announced jobs plan came in the form of cuts to payroll taxes. The employee share of payroll taxes is cut in half, while the employers’ share is also cut in half until they reach a total payroll of $5 million.

Lowering the employer’s rate lowers the marginal cost of hiring additional workers, which some argue might induce more hiring. Lowering the worker’s share results in an unexpected windfall for employees, but may not fundamentally alter hiring and firing decisions. The CBO has suggested that employer-side tax cuts may be more effective than employee-side ones.

The tax cut on the employer side is fairly complicated. Firms will receive tax credits if they raise wages – a bizarre strategy that may lead to some firms opting to pay existing workers more for additional hours rather than hire more workers. Also, the cuts are narrowly targeted towards small businesses. The White House argues that the $5 million payroll cap applies to 98% of companies. However, this ignores the fact that the remaining companies hire a disproportionate share of workers. Fast growing companies would be notable losers, as the benefits to hiring phase out as they grow. This is like imposing a high effective marginal tax rate on growth, similar to the high effective marginal tax rates created by phase-outs for tax preference items like the earned income tax credit,

Scott Sumner links to Census data that suggests that firms that hire between 100-499 workers had an average payroll of $7.75 million in 2008. Fewer than 2% of firms hire at least 100 workers; yet these firms account for two thirds of overall employment. In fact, just the top thousand firms in the economy are responsible for as much as a fourth of all employment in the country.

payroll tax cuts

It may make fine rhetoric to announce how the payroll tax cut will help the overwhelming majority of businesses (just as formerly proposed income tax hikes were pitched as affecting only the rich). However, this sort of micro-slicing of the tax pool for perceived fairness reasons can be very problematic. The firms that the Administration’s plan is excluding are precisely the ones most responsible for hiring in the economy. Meanwhile, the added tax problems of figuring out precisely which payroll tax credits a firm qualifies for (on top of the current burdens of handling a tangled income tax code) will likely frustrate businesses.

The overall effect, as Scott Sumner suggests, is to push the payroll tax into being as complicated and burdensome as the income tax.