31 Jan 2018

Are Economists Overthinking Tax Cuts and Wages?

Economics 6 Comments

In the wake of companies announcing pay hikes after the tax cut package, lots of economists are weighing in on whether the two can be related. Krugman is quite sure they have nothing to do with each other, and John Cochrane basically agrees with him (even though the tone is miles apart, the underlying analysis is very close). David R. Henderson is more open-minded (and he’s linking to Veronique de Rugy), but even s/he is very cautious.

Believe me, I understand the type of model all four of the above, professional economists have in mind when discussing this stuff. Nobody is denying that a big cut in the corporate income tax rate could affect wages *eventually*, through higher investment that leads to higher productivity that leads to higher wages because of competitive labor markets. And so they they are bouncing around the plausibility of companies raising wages pre-emptively to reduce worker turnover etc.

But are economists overthinking this?

Consider: Suppose they jack up the corporate income tax rate to 100%, and enforce it ruthlessly. I think I can come up with a pretty standard neoclassical model in which corporations don’t want to hire workers (or rent machinery for that matter), if no matter what happens, the corporation has no benefit from the operation. So in that scenario, even though the wages would be deductible, there would be no reason to hire workers and so the wages of workers would fall. Starting from such a standpoint, a cut in the corporate income tax rate from 100% down to 21% would immediately increase the demand for labor and hence the equilibrium wage rate of workers.

If you buy that, is it impossible to tell a story in which cutting the corporate income tax rate from 99.9999% to 21% immediately boosts wages? And not because of expectations of an effect in Year 8, but because of immediate considerations?

If you buy that, why are we so sure it’s impossible that cutting the corporate tax rate from 35% to 21% could have an immediate and direct impact on the demand for labor?

(HINT: I think these economists might be employing models in which there’s no uncertainty. But once you factor that in, I think this apparent mystery could dissolve.)

6 Responses to “Are Economists Overthinking Tax Cuts and Wages?”

  1. Mateusz Benedyk says:

    Isn;t it even more simple than expectations?
    A cut in corporate tax means every unit of finished product brings a higher net revenue for the company. Stated differently – marginal productivity of a single worker in monetary terms does rise when you cut corporate tax, even without additional investement.

  2. Matt M says:

    “If you buy that, why are we so sure it’s impossible that cutting the corporate tax rate from 35% to 21% could have an immediate and direct impact on the demand for labor?”

    There’s also the obvious PR value of giving bonuses and raises sooner rather than later, particularly to incentivize government to continue behaviors you like (tax cuts.)

    The media narrative seemed to go something like this:
    Trump: Tax cuts will be great! It’ll lead to new jobs and more money for the workers!
    Media: Nuh uh, the corporations will selfishly hoard all the money and maybe give it to rich shareholders but workers won’t get anything but reduced government services!

    If you’re a company, once the tax cuts happen, you kind of want Trump to be “proven right” in this situation (even if you dislike his other policies). So even if you hoard/dividend half of the tax-cut boon, it seems like there’s a lot of value in immediately giving raises and bonuses with the other half, even if pure economics don’t dictate that you really need to do so until several years later. You want to react immediately, within the current news cycle, to perpetuate the idea that “tax cuts = raises and workers.” The longer you wait, the more other stuff can happen that people can attribute your eventual later bonuses and raises to.

  3. Tel says:

    Consider: Suppose they jack up the corporate income tax rate to 100%, and enforce it ruthlessly. I think I can come up with a pretty standard neoclassical model in which corporations don’t want to hire workers (or rent machinery for that matter),

    Even in that situation you still have a time delay, in as much as existing contracts exist, both for worker’s employment and also contracts for supply of whatever that corporation is producing. So they would not be able to immediately ditch their workforce, and also the equilibrium wage takes time to be discovered (which would I accept be quite low in this extreme example).

    I could be a tiny bit more cunning and point out the peculiar incentives that might exist with 100% corporate income tax, since this punishes shareholders who own the corporation but the decision maker is the CEO who is just a regular employee drawing a wage (albeit a largish wage). The CEO knows that her wage will not be taxed at 100%, so she would quite prefer to see the corporation continue operation, therefore continue to employ people and sell a product. Since the shareholders are stuffed already, there’s nothing the CEO can do to improve shareholder interests, and by implication no way she can possibly be blamed for failing to serve shareholder interests. I’m aware that traditional economics avoids these kind of issues, but ultimately a corporation does not make decisions in the same way that an individual does (regardless of a legal fiction of corporate personhood).

    • Robert says:

      I’ve never seen a contract for employment (outside of union contracts) that included any kind of time element, unless there was some sort of benefit attached to it, like reimbursement for college tuition, so I doubt that would be a huge factor. I also doubt – though in this area I admit it’s conjecture on my part – that many, if any companies, sign contracts with suppliers that state that they (the company receiving supplies) MUST purchase them. I certainly wouldn’t. There might be a slight delay in order to sell off some assets, in which case I could see some employees being retained to carry out that work.

      • Tel says:

        These are the cases I can think of without going and searching:

        * IT labour contracts (usually 3 month or 6 month fixed price, fixed time).

        * Commercial supply of gas (e.g. to mine sites, turbines, etc).

        * Data network connections (monthly payments but minimum contract length typically 2 years).

        * Mobile phone contracts (usually 2 years).

        * Commercial real estate lease (2 year, 3 year, 5 year).

        * Support contracts on some equipment (also software).

        * Farms contracted to some retailer or supplier (usually 1 crop).

        * Building industry construction projects (disaster if the project stops halfway through, then no one gets paid).

        * Hire purchase agreements on vehicles.

        * Commercial lease agreements on vehicles.

        Probably there would be others, rarely longer than 2 years. These type of contracts will typically penalize either party for leaving early.

  4. Dan K says:

    So far, my most rational explanation is that this tax cut came during an economic crest instead of trough. Many industries have been ramping up efforts to attract key employees over the last several years. They may be making the strategic decision to retain their workforce now with token bonus’s rather than face replacing them in the future (at a much greater cost). Once a few key employees leave, it can be difficult to stop the resulting hemorrhaging. I’ve been through this and it is very distracting to the business.

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