Sunday, December 19, 2010

The Invisible Elephant: The Payroll Tax Cut

Most discussions of the tax bill that finally passed treat it as a compromise in which Obama, in order to get the bill through the Senate, had to make it more favorable to rich people than his original proposal. In fact, it may well be the opposite. Exact calculations depend on a variety of assumptions about who actually ends up paying what tax, but my guess is that what actually passed made the tax system, on net, more progressive than what was originally proposed, that high income tax payers will end up paying a larger fraction of federal taxes than they would have if the bill had simply extended the Bush tax cuts for lower and middle income taxpayers.

The federal income tax is paid almost entirely by upper income people—in 2007, almost 40% of federal income tax came from the top one percent of the income distribution, while the bottom 60% contributed just over 1% of the total (Figures from the CBO). The payroll tax, on the other hand, is a fixed percentage up to a maximum. The result is that the lowest quintile of the income distribution, which on net pays less than nothing in federal income taxes, pays about 9% of its income in payroll taxes, including (as the CBO does) both employee and employer share.

The bill held the top rate of the income tax at 35% instead of letting it go back to 39.5%. It reduced the employee's share of the payroll tax from 6.2% to 4.2%, reducing the total (employee share plus employer share) from 12.4% to 10.4%. A little arithmetic should convince you that the percentage reduction in the payroll tax is more than the percentage reduction in the top rate of the income tax. The change in the payroll tax in the bill is for only one year; we will have to wait and see whether it, like the Bush tax cuts, ends up lasting for longer than that.

While the actual incidence of the payroll tax—who really pays it—does not depend on whether it is collected from the employer or employee, it does depend on the elasticity of the supply and demand for labor, which determine how much of it ends up as a decrease in wages, how much as an increase in the cost of labor—a point ignored by the CBO in its analysis of tax incidence. Further complications would include other features of the bill—its effect on tax rates on dividends, inheritance, and the like. A full calculation would be complicated and the results would depend on assumptions, in part arbitrary, about who actually ends up paying each tax.

What is clear is that a large and under reported part of what the bill contains is a cut in the one part of the federal tax system a significant part of which is paid, at least directly, by people in the bottom sixty percent of the income distribution.

That is the elephant in the room.


Bill Crain said...

You noted that the actual incidence of the payroll tax "depend(s) on the elasticity of the supply and demand for labor, which determine how much of it ends up as a decrease in wages, how much as an increase in the cost of labor"

Could you expand on that a little? I've never really understood the distinction; maybe just never properly understood the concept of elasticity.

Also, I'm wondering about the reanimated estate tax, ie the possible impact of specific provisions: the survival of the Angel of Death? (stepped-up-basis) & the unlimited marital deduction. The questions here maybe are more practice than policy, but they go still to the progressivity of the code, and the element of class warfare in the legislation.

Richard Allan said...

Bill, the way I would explain it would be this:

An employer is bargaining with an employee. The former has a maximum wage he is willing to pay; the latter, a "reservation wage" that is the lowest he will accept. Between these two figures they will reach an agreement on a wage. The employer gives the wage to the employee.

Payroll taxes drive a "wedge" between the amounts received by the two. The employer pays "wage plus tax"; the "wage" goes to the employee and the "tax" goes to the government.

Now the employer and the employee have a second round of bargaining to do. Let's assume the employer has perfect "bargaining power". He will pay the same wage they agreed before, only some of it now goes to the government, so the employee loses out. Conversely if the employee has perfect bargaining power, he will get the same "after-tax wage" as he was getting before, with the entire tax being eaten by the employer. I'm assuming that the tax isn't so large as to cancel the transaction entirely, which could happen.

I think this example also sheds some light on why "tax incidence" (ie. who pays according to law) makes no difference to the outcome. Either the employer gives the whole amount to the employee who then sends the tax to the gov't, or the employee never sees the tax money and the employer sends it off to the gov't, then paying the employee his after-tax wage only. There's no reason why either case should affect their bargain in any way, assuming of course that neither party is cheating the tax authorites!

I hope the Prof will clear up anything in my post that's lacking.

Anonymous said...

Yes, cutting the payroll tax (for a year) has a progressive effect -- more so than if the payroll tax hadn't been part of the bill, less so than if the $400/person cuts of the previous two years had been continued (as I think was proposed early in the negotiations).

Jeff said...

Bill Crain and Richard Allen: The incidence of the payroll tax (who really pays it) does not depend on whether it's collected from the employer or the employee -- once the system is in equilibrium. Since the new law gives the payroll tax cut to the employee, any adjustment to transfer some of the benefit to the employer would require an explicit cut in the nominal wages of the employee.

But employees resist the idea of taking a cut in wages. I think the economist lingo for this is that wages are said to be "sticky downward." So for the short term at least, I would expect employees to receive all or almost all of the value of the payroll tax cut.

The phenomenon of sticky wages is an argument in favor of monetary inflation, since inflation causes a cut in real wages while the nominal wage remains the same, allowing real wages to quietly adjust downward just by giving less frequent pay raises.

Mark Horning said...

My increased take home pay due to the reduction in the payroll tax was almost perfectly canceled out by my increase in health insurance premiums.

David Friedman said...

Richard Allen puts the argument in terms of "bargaining power," a concept that isn't easily made precise. The usual economic analysis is in terms of elasticity.

The elasticity of labor supply measures how much the amount of labor offered for hire changes with changes in wages received. If the same number of workers work the same number of hours even if their wages change, then labor supply is perfectly inelastic. If a small decrease in wages causes all workers to quit working, labor supply is perfectly elastic. In the real world, one expect something between those limits. Similarly for labor demand--how many worker hours are hired, depending on what they cost.

Wages adjust to the level at which quantity supplied equals quantity demanded. The payroll tax increases the price of labor paid by employers, decreases the price received by workers, decreasing both quantity demanded and quantity supplied--but not necessarily by the same amount. The wage then adjusts until the two quantities are again equal. If demand is very insensitive to price, that means wages go up until workers are getting almost as much as they were before, and employers are paying almost all of the tax--their share as tax, the employee share as higher wages.

If supply is very insensitive to price, on the other hand, but demand sensitive, wages fall until employers are paying only slightly more than before, and the workers are paying their share of the tax as tax, and most of the employer's share as lower wages.

For a more detailed explanation, see my webbed Price Theory.

especially chapter 7.