A Missed Opportunity

It was even worse than I expected.  I expected one good thing (an employer-side payroll tax cut) and lots of ineffective demand stimulus measures.  The actual plan botched the payroll tax cut, and was heavily focused on demand-side measures.

The original stimulus failed because the Fed sabotaged it.  The Fed has only allowed 4% annual NGDP growth during the recovery.  That’s not enough.  But the Fed also seems reluctant to allow an outright collapse in AD—which opens the door to supply-side measures.  Christina Romer recommended an employer-side payroll tax cut, which would help overcome the problem of sticky nominal wages.  It would shift the short run AS curve to the right.  Because the Fed seems reluctant to allow a fall in AD, any increase in SRAS should boost employment.

But Dems don’t seem to understand the principle of incentives, of thinking at the margin.  No matter how hard they try they can’t escape the mindset where only demand matters, or perhaps I should say only demand and “fairness.”  They can’t imagine that business would hire more because their wage costs fall slightly.  “Aren’t they already sitting on a mountain of cash?”  “Isn’t more demand what they really need?”  Yes, but a 2% wage cut is basically equivalent to 2% more AD.  And that’s a lot.  The mistake is to use common sense.  Common sense tells us that if we cut the wage cost for single firm by 2%, that firm wouldn’t be likely to hire many additional workers.  But that thought experiment has no bearing on the impact of an across the board 2% fall in labor costs.  It ignores the indirect effects of the action on other firms.  Ford might hire more workers because their wage costs fall, but also because other firms would respond by hiring more workers and those extra workers would demand more cars.  That’s what common sense misses.

Some will argue that Obama proposes cutting the payroll tax for 98% of firms, and that Fortune 500 firms don’t create many jobs.  But how many firms are there in America?  I’d guess something on the order of 10 million.  The Fortune 500 may no longer be an important part of the US economy, but the biggest 200,000 firms most certainly are.

Even worse, the proposed tax cut is needlessly complicated, especially for small firms that are not computer savvy.  The once simple payroll tax is on the way to becoming as complex as the income tax.  The proposal also includes benefits for firms that pay higher wages, even though (hourly) wage increases will shift SRAS to the left, and thus lower employment.  Now the payroll will have to be divided up in all sorts of complicated ways, with different marginal rates for different categories.  K.I.S.S.

No wonder stocks plunged today.

The GOP should either kill the entire bill, or pass an across the board payroll tax cut.  The problem is that while the GOP does understand incentives and marginal analysis, they’ve also publicly stated that their “number one priority is defeating Obama,” not bring millions of jobs to suffering Americans.

Back in the real world the dollar is soaring as the euro crisis worsens.  And inflation expectations fell again today.  The Fed is now our only hope.

PS.  I checked and there are about 27 million firms, about 6 million of which have payrolls.  If the latter number applies then the biggest 120,000 firms are excluded.  This census link suggests there are about 109,000 firms with more than 100 employees, and they employ about 2/3 of all workers.  That’s a big deal.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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