Why Taxes Don’t Matter

I guess this is part two of my economic policy rant.

This morning I woke up well rested and I was greeted by CNN with yet another Republican talking point: “we should extend the Bush tax cuts because lower taxes for small businesses over $250k will create jobs.” I previously cited the Moody’s report that shows that extending the Bush tax cuts aren’t an effective way to stimulate GDP growth. But the insight into why taxes don’t influence job growth all that well is Economics 101 simple. It really comes down to two factors:

1) The Supply of Labor

The first key insight comes from an abstraction of supply and demand. In this case supply represents the amount of labor utilized by industry while demand is the market demand for the goods produced by that labor. If you learned anything in Economics you should have learned that the golden rule of supply and demand is MR = MC (marginal revenue = marginal cost). In this case, what that means is that employers will continue to hire people up until the amount of revenue generated from one additional employee is equal to the cost (salary, benefits, etc) of that one employee.

2) The Income Tax

It is at this point that it appears that taxes would reduce the value of employees and thus the amount of people who are employed. But the second key insight is that the income tax is not a tax on revenue. Businesses are only taxed on income, that is the revenue in excess of the cost of employment. Sure, there are other factors such as risk and access to cash that make companies hesitant to hire more at higher tax rates, but on the macro level, the employment decision is not significantly changed by the level of taxes.

So What Should We Be Doing Instead?

The real problem has always been, not supply, but demand. There are no jobs because there isn’t enough consumer spending to justify a higher level of employment. There are better stimulus options than tax cuts such as unemployment benefits and food stamps which put more money into the hands of those most likely to spend that money, stimulating demand. A job tax credit would also create jobs by reducing the marginal cost of employment. But none of those options are the focus of the recent plan.

Additionally, as I was later pleased to hear Fareed Zakaria illustrate, the long term health of the US economy requires less individual debt and an investment in the creation of the jobs of the future. This kind of investment was in the original proposal for the first stimulus in the form of a push for green jobs and job retraining. But for some reason we keep chasing tax cuts as a solution to all our woes, which they aren’t.

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