Question

The payroll tax holiday in 2012 reduced workers \(\operatorname{tax}\) by \(\$ 700\) for an income of \(\$ 35,000\) a year and by \(\$ 2,202\) for incomes of \(\$ 110,100\) and over. If the tax holiday ends, the Economic Policy Institute recommends replacing the payroll tax cut with infrastructure spending. Source: The New York Times, September 30,2012 a. Explain how a payroll tax affects the beforetax and after-tax wage rate and employment and unemployment. b. Explain the effects of an increase in infrastructure spending on employment and unemployment. c. Explain which fiscal policy action would have the bigger effect on employment: continuing the payroll tax cut or new infrastructure spending.

Short answer

Payroll tax cuts raise disposable income, affecting consumption and job creation indirectly. Infrastructure spending directly creates jobs and stimulates the economy. Thus, infrastructure spending likely has a bigger effect on employment.

Step-by-step solution

- Understanding the Payroll Tax

A payroll tax is a tax imposed on employers or employees, and is usually calculated as a percentage of the salaries that employers pay their staff. When a payroll tax is in place, it reduces the take-home pay of employees because part of their wage goes towards the tax. Conversely, if there is a reduction in the payroll tax, employees' after-tax wage rate increases, giving them more disposable income.

- Effect of Payroll Tax on Wages and Employment

A payroll tax affects the before-tax and after-tax wage rate and employment as follows. The before-tax wage rate is the wage negotiated between employers and employees before accounting for any taxes. A payroll tax decreases the after-tax wage rate, which is the amount employees actually take home. Lower after-tax wages reduce the mobility of workers seeking employment due to reduced net income, potentially leading to lower employment rates and higher unemployment.

- Infastructure Spending Impact

Increased infrastructure spending directly raises demand for labor, as new projects require workers. This form of fiscal policy can lower unemployment rates through job creation, both directly on the projects and indirectly through increased economic activity spurred by the initial spending.

- Comparing Fiscal Policies

The effectiveness of continuing the payroll tax cut versus new infrastructure spending on employment depends on the immediate and long-term impacts. A payroll tax cut increases the disposable income of workers, potentially boosting consumption and demand for goods and services, which can stimulate job creation. However, infrastructure spending directly creates jobs related to the projects and secondary economic benefits. Therefore, infrastructure spending may have a more substantial and longer-lasting effect on employment compared to just a payroll tax cut.

Key concepts

Payroll Tax

A payroll tax is a tax levied on both employers and employees, based on the wages paid to the employees. It is a percentage of the employee's salary and can affect both parties in the employment relationship. When a payroll tax is in effect, employees see a reduction in their after-tax wage, which means they take home less money. Employers may also feel the impact as their cost of employing workers increases.
The payroll tax impacts the economy by influencing workers' net income, affecting their purchasing power, and potentially altering labor market dynamics.

Before-Tax Wage Rate

The before-tax wage rate is the gross amount paid to employees by employers before any taxes or deductions are applied. It is the negotiated salary or hourly wage that employees agree to receive for their labor.
This wage rate serves as the baseline for calculating payroll taxes and other deductions. Since payroll taxes are subtracted from the before-tax wage, changes in these taxes do not affect the before-tax wage directly, but they do impact the net income employees take home.

After-Tax Wage Rate

The after-tax wage rate, also known as the net wage, is the amount employees actually receive after payroll taxes and other deductions are taken out. It represents the financial resources workers have available for spending and saving.
Reductions in payroll taxes can increase the after-tax wage rate, leading to higher disposable income. Conversely, increases in payroll taxes decrease the after-tax wage rate, reducing disposable income and potentially affecting workers' spending habits.

Employment

Employment refers to the state of having a paid job or being engaged in work activities. Payroll taxes can impact employment levels in several ways:

• Increased payroll costs for employers might reduce hiring or cause layoffs.
• Higher after-tax wages from reduced payroll taxes can boost consumption, potentially driving job creation.
• Changes in disposable income can affect demand for goods and services, influencing the need for labor.

Overall, balancing payroll taxes is crucial for maintaining healthy employment rates.

Unemployment

Unemployment is the state of being without a paid job despite actively seeking work. Payroll taxes can influence unemployment rates:

• High payroll taxes decrease after-tax wages, possibly discouraging workers from seeking employment, raising unemployment levels.
• Reduction in payroll taxes can increase disposable income, encouraging more people to enter the workforce, potentially reducing unemployment.

Fiscal policies must aim to balance these effects to maintain low unemployment.

Infrastructure Spending

Infrastructure spending refers to government investments in public projects such as roads, bridges, schools, and hospitals. It can stimulate the economy and impact employment:

• Direct job creation for construction and related projects.
• Indirect benefits like increased demand for materials and services, leading to more job opportunities.
• Improved infrastructure can lead to long-term economic growth by enhancing productivity and efficiency.

Overall, infrastructure spending is a robust tool for economic stimulation and job creation.

Fiscal Policy

Fiscal policy involves government actions regarding taxation and spending to influence economic conditions. The key fiscal policy tools discussed include:

• Payroll Tax Adjustments: Altering payroll taxes can change disposable income, affecting consumption and employment.
• Infrastructure Spending: Investing in infrastructure can create immediate jobs and induce long-term economic benefits.

Comparing these tools, infrastructure spending tends to have a more profound and lasting impact on employment by directly creating jobs and boosting economic activity, while payroll tax cuts provide immediate but often temporary relief to workers.