Recessions and Wages

[Practice Good Theory Blog]

Conventional economic theory says that over-supply typically causes a fall in price, and this cheaper price will cause more demand, till there is no longer any over-supply. Applied to the labor market, when a recession throws people out of jobs, wages should fall, the lower wages should make previous employment levels profitable to businesses, and the unemployment rate should fall back to its norm.

Yet, this does not happen. By and large, managers prefer to fire people rather than reduce wages. Imagine that a recession hits and the unemployed find they must take an average 10% cut in their wages to get similar work. If a firm wants to cut its wage costs by 10%, it seems logical (in a Vulcan way) that the management would force a 10% wage-cut rather than letting 10% of its workforce go. However, managements mostly choose the latter.

Understandably, such managements prefer to cause pain to a few people who are then no longer with the company, rather than cause pain across the board to a whole lot of people who remain. Whatever the cause, wages are "sticky" on the way down.

Against this backdrop, consider the government's decision to cut payroll taxes for 1 year, claiming this would spur job creation and fight against recession. On the surface, it may seem that a tax-break should encourage demand for the thing on which the tax-break is given. However, the context of the payroll tax-break is that it is temporary (even if it is extended by another year), and that businesses are already in a mode where they want to reduce labor costs.

The tax cut is raising nominal salaries in an environment where those salaries are already higher than they would be absent "frictional" cost of change. Therefore, the payroll cut does almost nothing to spur employment, and simply acts as fiscal stimulus, putting a little more money into the hands of consumers.

The government ought to stay out of this area completely, but if they want to meddle, it would be more sensible to raise the employee's portion of the payroll tax, not lower it.

Even with no change in anything else, it would be a good thing to make the hidden payroll tax paid by employers more visible. Someone who earns a salary of $1000 sees $80 being deducted as payroll tax, but the employer pays another $80 which does not show up on the payslip. In reality, the employee is earning $1080, and the tax is $160: that is how it ought to show up, to make the truth of the situation explicit.

If the government is going to meddle, rather than cut the tax, it should say that the entire payroll tax will now come from employee's salaries. It can point out that any employer who wishes to keep things unchanged has simply to adjust nominal salaries upward to bring things back to what they were.

If all employers did re-adjust, there'd be no change. However, it is likely that some will use the political cover to make only partial adjustments, thus cutting the average wages of their employees. If so, that can only help end the recession sooner rather than later.

Notes:

1) At the start of the Great depression, Hoover called on industrialists not to fire workers, and not to reduce wages. Many actually moved to work-share schemes where each employee got less hours of work, so that each person earned less but more could be retained in employment. This was a bad idea, because it did not lower the cost to the firm. It would have been better either to fire workers or to reduce their wage-rates with no reduction in the hours worked.

2) There are a few more important things that ought to be done in the arena of wages:

• unemployment payments should not be extended further, and the maximum duration should be reduced back to pre-recession numbers
• the minimum wage laws should be pulled back
• Bacon-Davis labor laws ought to be revisited and rolled back
• States can do many things: they should issue guidelines on salary levels of city employees, and any higher salaries should be allowed only if passed by a ballot; they can also lay down rules that disallow cities from today's fraudulent pension schemes which place burdens on future taxpayers (if a city wants to offer pensions, they should cost it in a way that makes it rock solid, and does not assume away future costs)

3) Of course, I'd rather see spending cuts, not tax increases.

Blog cross-posted with permission

Edited September 2, 2011 by softwareNerd