Economist.com Fires Back with Respect to its Alleged Backdoor Employment Tax Cut

When I criticized this, I should have placed the following in bold:

So the total taxes paid to the government do not fall – just who ends up directly paying the government.

The rebuttal goes something like this:

The assumption of highly inelastic labour is important, but I would argue that it does not always apply in typical labour markets, especially with respect to a single employer.

Actually, the assumption as to the elasticity of either the supply or the demand schedule is not important for the experiment described as follows:

One participant, who writes about technology, remarked that it is not unusual for tech firms to fire their employees and rehire them the next week as consultants. This is essentially a backdoor payroll tax reduction for the employer. When a worker is considered a contracter they become responsible for their full tax burden to Social Security and Medicare (and the cost of health and pension benefits).

Let’s do a very simple example of an employer-employee relationship where the employer ultimately pays $10 an hour for the services of the worker but the government collects $1.50 an hour in payroll taxes leaving the worker with $8.50 an hour after taxes. If the initial burden of the tax system were split evenly between the employer and the employee, both pay $0.75 an hour to the government with the employer paying the worker $9.25 an hour. Now if the employee becomes an independent contractor, he ends up paying all $1.50 an hour to the government but his check from the employer is $10 an hour. Notice something – I made no assumption about elasticity of demand or supply.

Why does this work out this way? In fact, we had a tax cut for the employer and an equivalent tax increase for the worker. Since the government tax bite has neither increased nor decreased, there is no net effect for either the before-tax wage paid by the employer or the after-tax wage paid by the worker.

To be fair, this demand equals supply model assumes that the labor market clears. I would hate to be accused (again) of “selective quotation” so let me note the following:

In an extremely loose labour market the employee will bear the full tax burden because his labour supply becomes more inelastic. Enough so an employer has the leverage to make that burden explicit and shift it entirely to his employee.

Since we are in a recession, maybe the whole use of demand and supply curve models is a bit misleading. But if one wishes to use such models, maybe one should start off the comparative statics exercise by first noting that the overall tax bit has not changed in the experiment being discussed.

While it is true that the effective wage for workers is likely to fall during periods of weak aggregate demand, this occurrence is not due to some reduction in the tax bite. Maybe the mechanism becomes the shifting of the tax burden without an offsetting increase in the before-tax wage. But the same effect could have been accomplished by simply reducing the wage rate. I guess one could postulate that wages are somehow sticky so employers look for ways around this fact by cutting compensation through some other means – as was once argued by Walter J. Wessels in Minimum Wages, Fringe Benefits, and Working Conditions. But to say that changing the primary incidence of who pays for an unchanged tax bite is the same thing as a tax cut is highly misleading.