Sunday, January 31, 2010

Tax credits are useless.

Obama scratches around amongst the selection of strange job creating schemes served up to him by economicaly illiterate conservatives. Tax credits are unfortunately flavour of the month.

These involve rewarding each employer in proportion to the increase in numbers they employ. This idea gets re-invented with monotonous regularity.

The idea was popular in the UK about thirty years ago and was advocated by Richard Layard (former Prof of Economics at the London School of Economics). Anyone wanting to look at the relevant literature will find some of it by Googling “marginal employment subsidy” because the latter was the phrase used to describe the idea in those days.

Two of the current leading advocates of the idea in the U.S. are messers Bartik and Bishop.

Layard & Co produced a variety of ideas as to why the tax credit idea works. Bartik and Bishop simply add to this bright and varied selection of alleged explanations. In other words the advocates of the tax credit idea cannot agree amongst themselves as to why the idea works.

Bartik and Bishop’s explanation seems to be that a 1% cut in wage costs brings a 0.3% rise in employment. Far from being an argument for tax credits, this is a good argument for NOT implementing tax credits because the 0.3% effect is feeble compared to a much simpler alternative: simply spending the money on a straight increase in aggregate demand.

To illustrate say 1% of GDP is devoted to tax credits. Assume wages make up 70% of GDP (this figure actually varies over the years between roughly 60% and 80%, but let’s say 70%).

The expansion in employment that results from the above will be 1/0.7 x 1% x 0.3 = 0.42%.

Now suppose one uses the money to effect a straight rise in aggregate demand (say an increase in government spending on roads, the military, schools, etc). In this case the rise in employment will be 1% x 0.7 = 0.7%. Well that’s a better result (if I’ve got it right). And there is none of the time consuming bureaucratic nonsense involved in trying to ensure that employers are not abusing the system (e.g. “sacking” staff and “hiring” them a few weeks later with the assistance of the subsidy).

In truth, even the above “anti tax credit” argument is nonsensical as the equivalent pro-tax credit argument. This is because both arguments rely on the flawed “value for money” argument or “bang per buck” argument. Bang per buck often makes sense at the micro economic level. At the macro-economic level it frequently becomes a nonsense.

The tax credit idea was implemented in the U.K. about thirty years ago, but was limited to small firms. The scheme was called the “Small Firms Employment Subsidy”. It was abandoned as quickly as it was set up.

Note added 1st Marth 2010: Two papers from about 30 years ago on the subject: and

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