The Great Debate©: Stimulus – Supply Side or Demand Side?

Prof. Casey Mulligan, University of Chicago and Prof. Menzie Chinn, University of Wisconsin, debate the relative merits and effects of provisions in the new tax law.

Sticky Wages, Sticky Prices and the Keynesians

This is a column from the New York Times, December 18, 2010 by Casey B. Mulligan, economics professor at the University of Chicago.

The effects of the payroll tax holiday — part of the new federal tax bill being considered in Washington — depend on the flavor, if any, of Keynesian economics that best describes our economy.

Since 1983, employers and employees have each “contributed” 6.2 percent of payroll to the United States Treasury, earmarked for the Social Security program (those contributions apply only to the first $100,000 or so that each employee earns for the year). President Obama and members of Congress have proposed to reduce the employee contribution rate to 4.2 percent for the duration of 2011 while keeping the employer contribution rate at 6.2 percent.

They argue, and I agree, that the proposed tax cut will increase what employees take home after taxes.

Essentially all economists believe that it usually doesn’t matter whether employers or employees, or some combination, are obligated to pay Social Security tax, because the employer portion of the tax just results in lower wages for employees (and lower wages induce employers to hire more.)

Thus, if the current tax-cut proposal were instead aimed at employers, employees would still see more take home pay because employers could afford to pay higher wages.

From that perspective, it’s fine that politicians are proposing a cut for employees; maybe they score some extra political points for a cut that would be more obvious to employees than an employer cut would be.

However, one version of Keynesian economics stresses that our economic recovery from the recession is hampered by “sticky wages.” That is, employment would rebound more vigorously if only wages would fall, making it more economical for employers to hire. But imperfect competition in our labor market prevents wages from falling as much as would be efficient.

If the sticky-wage flavor of Keynesian economics were correct, then cutting taxes for employees has less impact on employment than cutting taxes for employers would, because the employer tax cut is the only way employers will see lower hiring costs. (It may be true that the employee cut would “put money in the hands” of different people than an employer cut would, and perhaps it is also true that money in the hands of employees would do more to increase national spending. But that effect on employment, if any, is less direct than lowering employer hiring costs).  Continue…..

Forgetting about Demand, Once Again

Guest Author: Menzie Chinn is Professor of Public Affairs and Economics, Robert M. La Follette School of Public Affairs, University of Wisconsin, Madison, WI – Vita.    This was originally posted December 15 at Econbrowser.

Professor Mulligan asserts that the payroll tax cut will have little effect on output, even in sticky price Keynesian, and New Keynesian, models. He writes:

Sticky-price Keynesians agree that an employer tax cut would have the same effect as an employee tax cut. But both cuts have a minimal employment effect, if any, because it’s not employer costs that hold back hiring — it’s the lack of demand for consumer goods that would be there if only prices would fall.

Indeed, some sticky-price Keynesians have argued that payroll tax cuts would actually reduce national employment, because more people would compete for jobs that aren’t there.

In summary, the proposed payroll tax cut does not increase national employment in the sticky-price Keynesian model, regardless of whether the cut is aimed at employers or employees. The sticky-wage Keynesian model says that, because the cut is aimed at employees, it will not increase hiring in those sectors where wages are sticky — such as the market for low-skilled workers.

It is interesting that Professor Mulligan observes that sticky-price Keynesians believe in demand effects arising from payroll tax reductions, then quickly segues to Krugman’s model, and finally completely fails to deal with the demand argument, and focuses on the supply side. In this sense, Professor Mulligan remains completely predictable and consistent (see here, here and here).

Professor Mulligan argues that the reduction in taxes will not affect the labor supply response in the sectors with sticky wages, exactly where least adjustment is necessary. But even if employment does not increase, the total after-tax wage payments going to workers will go up, raising disposable income, and hence increasing consumption via the standard Keynesian consumption function.

The CBO has assessed the per-dollar effect of payroll tax reductions on employment. Focusing on this demand side, rather than supply side, it compares well with other measures.

Figure 1. This is Figure 2 in CBO Director D. Elmendorf, Policies for Increasing Economic Growth and Employment in the Short Term February 23, 2010.

The payroll tax reduction is therefore a fairly effective means of stimulating the economy, assessed from the demand side, relative to tax cut extensions (note higher yielding measures, such as payroll tax reductions for firms that increase employment [1], were killed off by Republican opposition).

By the way, the CBO has tabulated the components of the tax deal. The two year cost is $797 billion, while the ten year cost (2011-2020) is $857.8 billion. Macroeconomic Advisers has provided an interesting breakdown of the components. I’ve shaded the components primarily favored by the Republicans pink, and those primarily favored by Democrats blue (keeping the AMT fix uncolored).

Figure 2 from Table 1 of The Tax Compromise: It’s Complicated, Macroeconomic Advisers, Dec. 8, 2010. High income tax cuts relates to extension of EGTRRA/JGTRRA provisions to households with income in excess of $250K (aka Todd Henderson households).

In other words, most of the package is not in line with Republican wishes; on the other hand, the “high income tax cuts” as well as estate tax reductions do provide extremely high benefits to a very small portion of the overall economy, with (as stressed in Figure 1 from CBO) very little stimulative impact on the economy. In this sense, these provisions constitute almost pure rent transfers.

More on the advisability of continuing tax cuts for high income households here, on the revision of the macro outlook here and here.

Posted by Menzie Chinn at December 15, 2010 09:05 PM

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