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Labor Pains

An old student asked me a simple question regarding tax incidence and it got me to thinking …

Let’s talk about payroll and income taxes. The economic incidence (who actually bears the burden of a tax) is a function of the elasticity of demand for labor (with respect to wages – actually, total compensation including non-pecuniary factors) and the elasticity of supply of labor (with respect again to total compensation). The economic incidence will fall more greatly on the factor that is less able to adjust to the tax increase, in other words, the more inelastic factor.

Funny thing about labor markets is that many on the left think that by legally requiring firms to pay half of the payroll tax, or by levying a corporate income tax, that the firms will bear the fiscal brunt of it. The irony is NOT that the empirical literature reveals this to be totally untrue (especially if you realize workers are also consumers and stockholders). The real irony is that one of the major reasons those on the left support living wages, workplace regulations, anti-discrimination laws, etc. is that they belief the employee side of the labor market has many, many, many and large frictions. In other words, that many workers do not have the flexibility that seems to be assumed by textbook theory.

So, when it comes to extracting government revenues, folks assume the demand for labor is more inelastic. When we turn our attention to minimum wages and the like, suddenly the supply of labor is more inelastic (the argument is actually much more nuanced, it boils down to the marginal expense of labor faced by firms becoming upaward sloping instead of being perfectly elastic as textbook theory indicates). This is, of course, theoretically and empirically impossible. But when folks litter their preferred arguments with sexy phrases like “monopsony” and “firms legally are required to pay 50% of payroll taxes” it pulls the wool over the eyes of an unsuspecting public … again. The point being, is that these frictions, which form the basis for arguments in defense of mandated wages and regulations, are overlooked when thinking about corporate tax policy.

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