Thursday, December 29, 2011

Temporary & Permanent Tax Cuts

One criticism against the payroll tax cut that has frequently been made from conservative and libertarian economists is that it is temporary, and because people supposedly make decisions on permanent conditions it will have no effect.

This argument has a limited degree of truth in it as it is true that if taxation of investments are reduced by say 5 percentage points for one year, it will have less effect on investments that last more than a year than a "permanent" tax rate reduction of 5 percentage points. Just how great the difference is depends on how long the investment will last (the longer, the greater difference it makes).

However, because total after tax return still rises, it will still promote any investments that generates profits within a year.

Furthermore, the payroll tax reduction isn't about investments, at least not directly, it instead has a positive effect in the form of boosting labor supply, something that increases employment in part through a reduction in frictional unemployment and in part by lowering labor costs. Given the limited degree of wage rigidity that exists cutting the employer's share of the payroll tax cut would have been more effective, but

But don't businesses hire people based on long-term factors? Well, they often do, but there is no rational reason for them not take advantage of temporarily lower labor costs by hiring people temporarily given that America's flexible "hire and fire" laws makes it very easy and costless to fire employees.

Furthermore, it should be noted that no tax rate is really permanent (which is why I've put quotation marks around it except here) since they can, and very frequently have historically been change. While a "permanent" change is in the United States somewhat more difficult to change due to the fact that the two chambers of Congress and the President can usually block them if they want, that is as the historical record illustrates a difference of degree, not kind.

The real problem with temporary instead of "permanent" tax cuts isn't therefore so much that the short term effect is smaller. The real problem is that once the tax cuts expire, the positive effects will expire too, meaning that it will lower future growth, largely cancelling out the short term positive effect.


Blogger Ralph Musgrave said...

All of which illustrates the hopelessly incompetent system in the U.S. for taking major economic decisions. That is, to stipulate that the payroll tax cut (or any other stimulatory measure) should last a specific number of months is plain idiotic: stimulus should last as long as it is needed. If that turns out to be three months, so be it. If it turns out to be five years, so be it.

4:05 PM  

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