Forgetting About Demand, Once Again

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.

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Figure 2 from 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 farily 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).

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Figure 1 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 2 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.


Originally published at Econbrowser and reproduced here with permission.