I am working on an essay on Social Security reform, and I ran into what at first seemed a contradiction. I actually don’t think there really IS a contradiction, but since I am having fun thinking through it, I wanted to share with the other geeks reading this blog.
So right now, a salaried employee has 6.2% of his gross pay taken out for OASDI, while the employer pays an extra 6.2%. (It caps out after a threshold of gross pay, which was $118,500 in 2016.)
Suppose the government allows employees to opt out of this particular payroll tax. What happens to the take-home pay of an employee who exercises this option? I have two different answers, both of which seem to flow from textbook analysis:
(1) In the original equilibrium, the market was competitive and so the employee was getting paid his marginal product. The employer took the 6.2% employer “contribution” to Social Security into account when hiring. Now that the government is removing that implicit fee, the employer will still end up paying the total marginal product to the employee, but now it will be in the form of higher gross wages. Thus the employee will pocket the entire 12.4% of the tax reduction.
(2) As with any case of tax incidence analysis, to figure out how a tax is “borne” by the buyer and seller, what matters is NOT the statutory incidence, but the relative elasticities of supply and demand. By removing a tax on labor, both parties will tend to benefit. The only way the gain would accrue entirely to the employee is if the supply of labor were perfectly inelastic and/or the demand for labor were perfectly elastic, which we have no reason to suppose. (In case you think I got those conditions backwards: Note that if lifting the tax is to help only the employee, that means imposing the tax must only hurt the employee.)
So which answer is right? And why did the wrong one, go wrong?
P.S. It’s actually not right to treat the Social Security payroll deduction as a tax, because it is (loosely) tied to a future payment from the government. It’s more correct to view it as a forced investment in a mediocre annuity program, but even this isn’t exactly right because the withholding/benefit rules are so screwy. But for the purposes of this post, don’t worry about this complication; just treat it like a 12.4% tax on wages that is being lifted.