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The more you tax something, the less you have of it. That happens because a tax raises the cost of a commodity or service above the market price. It creates an artificial gap between what buyers want to pay and what sellers want to receive. Taxes raise prices. As prices increase, buyers of a good or service want to buy less. Taxes also reduce sales receipts. As sales receipts decrease, sellers of a good or service want to supply less. The result is less buying and selling than would occur without the tax.

These principles apply to the labor market. If you tax employment, and add other kinds of costs to labor contracts, you’ll have fewer jobs. A labor contract is a type of business transaction. We tax some business transactions – the sale of cigarettes, for example – in order to reduce the number sold. Yet for labor contracts, we don’t seem to recognize that heavy taxes on employment make labor contracts hard to form.

Let’s take an example with round numbers to illustrate why labor contracts don’t form when employment taxes create a price gap that prevents buyers and sellers from coming together. Suppose Acme Manufacturing has strong demand for its product. It has a big plant, and would like to spread its fixed costs over as many units as it can sell. It calculates that it can increase its sales revenue $55,000 a year for every worker it hires at $50,000 a year. Even more promising, Acme’s plant is located where qualified workers are available.

Bill is one of those workers. He has a wife and three children, rent to pay on his house, and the usual bills for electricity, water, groceries, car insurance, and so on. He needs to take home $50,000 a year to cover his family’s needs, and he has the skills he needs to work at Acme’s plant.

Sounds like a good match, right? Acme can increase its profits and Bill can support his family. Beyond that, consumers can buy and enjoy Acme’s high-quality products. We know with these numbers, though, that the match won’t be made. Look at the large gap between what Acme has to pay to make the hire, and what Bill takes home. After Bill pays the state income tax, federal income tax, Social Security tax and Medicare tax, plus his share of health insurance, he takes home $35,000 a year. After Acme pays Social Security tax, Medicare tax, assessments for workmen’s compensation and unemployment insurance, plus its share of health insurance for Bill and his family, its cost for the hire is $65,000 a year.

The difference between what Acme pays out and what Bill takes home is huge, given that this labor contract started out as a deal worth $50,000 per year. Acme’s cost is $15,000 above the contract’s nominal salary, and $10,000 greater than the revenue it can earn from the hire. Bill would work full time and still not be able to cover his family’s needs. He would have to find $15,000 somewhere to pay his bills. Neither party to this contract has any incentive to make it happen.

The $30,000 price gap for this contract is due entirely to taxes and other requirements outside the parties’ control. They would like to conclude a deal – Bill would like to sell his services for $50,000 a year, and Acme would like to buy them – but they’ll never get together in a labor market where employment is taxed so heavily. The externally imposed difference between what the seller earns and what the buyer pays is just too great.

We do know how to increase the number of jobs. Everyone knows: we have to remove government’s financial impediments from the labor market. Yes, we’ll always have taxes, but we can fashion tax policy so as to minimize the impact taxes have on labor contracts. If we reduce taxes on labor contracts, we increase the number of contracts and therefore the number of people engaged in paid work. If we reduce government interference with labor contracts, the number of contracts goes up, which is to say, the number of jobs goes up.

Here are five things we can do to reduce taxes on labor contracts, and reduce government interference in the labor market:

~ Health care has evolved into a required benefit for employees. As such, the cost of health insurance functions as a tax for a company that wants to hire workers: the payments are mandatory, and they are unrelated to the company’s central mission. Therefore, decouple health care costs from employment contracts.

~ Employers should not have to act as government agents for collection of any tax. It adds hugely to their administrative costs, and makes launching a new company with just a few employees much more difficult. Under the current arrangement, companies are liable for something that reduces profits and curtails their growth. Therefore, decouple tax collection from employment contracts.

~ The Social Security tax is so stifling, unfair and burdensome, it does not even bear discussion. It drags down the number of people employed for pay, and has done so since its inception. End the Social Security tax.

~ The taxes for Medicare and Medicaid fall in the same depressing dustbin as the tax for social security. They are regressive, heavy to the point of being punitive, and an obvious deterrent to hiring. End the taxes for Medicare and Medicaid.

~ Skilled workers are more productive than unskilled workers. Consequently companies pay skilled workers more than they pay unskilled workers. Because we’re committed to a belief that a progressive income tax is more fair than a flat tax, we tax skilled workers more heavily than unskilled workers. It has become so expensive to hire a well-trained engineer or similar worker, many companies prefer not to do it. As a result, many of our most productive people do not work. To reduce the cost of employing skilled workers, tax all employment at the same low rate.

I should add payments for workmen’s compensation and unemployment insurance – assessments a firm has to pay for each worker on the payroll. These payments reduce the return on hiring. Unemployment insurance in particular deters companies from hiring. A predictable proportion of new hires aren’t going to work out. The new employees prove unproductive, and the company lets them go. Then the company’s payments for unemployment insurance go up. These payments are especially hard to bear for small businesses. What is the rational choice in a situation like this? Don’t hire in the first place – you get along with your current employees, because hiring new ones carries too much risk.

By now you’re ready to ask, how will we pay for all our entitlement programs if we end these employment taxes? I have two responses. First, if we tax all employment at the same low rate, we can expect employment to increase – a lot. Taxing a big pie at a low rate yields more revenue than taxing a small pie at a high rate. We’ve all seen the diagrams and the curves: forty percent of one dollar is ten cents less than ten percent of five dollars. Multiply that dime by trillions of dollars over the entire economy, and you have a substantial increase in tax revenue.

The second response is less analytical. Ask an unemployed man who has lost his job and is about to lose his home – would you rather have a job or your entitlements? Ask the little girl who has lost her daddy to suicide because he couldn’t support his family anymore, and succumbed to depression and despair – what would you give to have him back?

You say that question’s unfair? How so? How do we manage to pretend that the pain families are undergoing now isn’t related to a sclerotic system of employment taxes, rules and entitlements that just won’t change? How have we convinced ourselves that allocating billions in stimulus funds can possibly overcome the smothering effect of heavy taxes on companies’ willingness to hire, and on entrepreneurs’ willingness to start new companies? We know how to solve these problems of slow growth and too little work. Yet we wring our hands and pretend we don’t. It’s a self-induced blindness that indicates how bound we are to established ways, no matter how destructive and miserable those ways have proven to be.

No, we won’t touch Social Security or any of the other employment taxes. They’re fixed stars in our employment universe, and only people without jobs are interested in change that drastic. Instead of changes that actually work, we’ll cogitate endlessly about what government programs might augment the ones we already have – programs that reduce our ability to sustain job growth over the long term. We’ll continue our impotent discussions about how to create jobs, about unemployment’s impact on the president’s reelection prospects. Our sense of pessimism about high unemployment and what to do about it is palpable. Yet we know what to do about it. The path to labor market freedom and growth lies directly in front of us.


Related posts:

Laffer’s Laudable Logic

Tax Illogic

Tax Conundrum

See also The Jeffersonian’s Books page and Revolution on the Ground for more writing on politics.