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07/17/2009

Payroll Tax Hikes, Keynesianism, and the Recession: A Reply to Drum and Krugman, by Bryan Caplan

I recently pointed out that back in the good old days, Krugman would have graciously granted that a payroll tax hike is an especially bad idea when unemployment is high.  In response, Kevin Drum notes that the tax hike doesn't take effect until 2013.  That's news to me, and I thank him for pointing it out.  It's less bad to impose a payroll tax it in 2013 than it is to impose it today.  Still, it's facile for Kevin to remark, "if the recession isn't over by then we've got way bigger things to worry about than a minor increase in payroll tax receipts."  Recoveries take years, and some employers have been known to look ahead a year or two when they decide whether it's worth hiring someone today.

In contrast, Krugman reiterates Kevin's point about timing, then stops making sense:
Actually, it's even worse: Caplan frames the argument in terms of the nasty effects of raising labor costs. Um, we have a problem with demand, not supply; time to reread Keynes on wages.
Um, low demand does not cause businessmen to stop weighing whether another worker's marginal productivity exceeds his wage.  Yes, when demand is low, workers' marginal productivity is effectively lower.  A waiter in a half-empty restaurant brings in less revenue per hour for his employer.  But if the cost of keeping the waiter around in slack times goes up, employers are still going to want fewer waiters around.

Now if you check out Krugman's "Keynes on wages" link, he's making another argument that I already criticized: That wages cuts won't increase employment because they hurt (or at least don't help) aggregate demand.  As I explained before, this is logically possible, but extremely unlikely:

1. Cutting wages increases the quantity of labor demanded.  If labor demand is elastic, total labor income rises as a result of wage cuts. 

2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income.  So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.
Not convinced by mere theory?  Scott Sumner shows that the experience of the Great Depression strongly contradicts Krugman.  Even when there were tons of idle resources, output sharply fell when labor costs spiked.

In any case, if Krugman were right in theory, than he shouldn't be crowing about the delayed arrival of the payroll tax.  On the contrary, he should want to impose the payroll tax immediately, and make it vastly higher.  I know this sounds like crazy implication to pin on a Keynesian, but it's true. 

How so?  Firms only have to pay the extra tax if they fail to give their employees health insurance.  If the penalty payroll tax were high enough, then, all employers would opt to buy health care for their workers.  And if, like Krugman, you believe that cutting labor costs reduces aggregate demand, you should also believe that increasing labor costs raises aggregate demand.  By this logic, now is a perfect time to make labor more expensive.  Is Krugman ready to bite that bullet?

P.S. In his link, Krugman seems to merely doubt that wage cuts increase aggregate demand.  In a related piece, however, he seems to believe that wage cuts actually decrease aggregate demand: "And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment."


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