Wednesday, October 07, 2009

A Tax Credit for New Hiring?

The New York Times reports that the some of our leaders in DC are considering a tax credit for companies that create new jobs. This is one of those ideas that pops up regularly when the economy is in recession. The devil is in the details, however, and the more one studies those details, the less attractive the proposal looks.

Some time ago, I suggested a cut in the payroll tax as a fiscal stimulus. Part of the motivation was to cut the cost of labor to firms, thus encouraging them to hire. Some might point out, correctly, that much of this tax cut would be inframarginal--that is, it would apply to workers who already have jobs. Why not get more bang for your buck by targeting marginal jobs?

Sounds good at first. The problem is, how do you define a marginal job? You cannot simply say "new hires." In that case, company A fires Peter and hires Paul. Company B fires Paul and hires Peter. That kind of employment churn is, presumably, not what we are trying to encourage.

Usually, these proposals measure marginal jobs by comparing employment to some base year. Thus, a company gets a tax credit for employment that exceeds, say, 90 percent of employment in 2007. But then, the incentive goes mainly to companies in regions and industries that have been expanding or shrinking only slightly. Those regions and industries that have been deeply contracting do not have an incentive for marginal hires, because their employment levels are now well below the base levels. The playing field is tilted against those regions and industries that have been hit hardest--a result that seems to diminish both equality and efficiency.

Also, how do you handle newly formed companies? Government should not penalize start-ups by subsidizing only employment by their incumbent competitors. But if new companies get the hiring credit, then existing companies are incentivized to create new wholly-owned subsidiaries in order to qualify for the tax break (while contracting employment in the parent company). Similarly, they are incentivized to outsource work to start-ups that get the credit.

The bottom line: The attempt to try to identify marginal jobs in order to give them a better tax treatment than existing jobs creates a range of unintended consequences. In designing tax policy, the KISS principle is a good rule of thumb.