Can Tax Credits Create Jobs? Don't Bet On It: Echoes

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By Joseph J. Thorndike

In her post this week, Amity Shlaes reminds us that when it comes to labor costs, “margins matter.” By raising the cost of labor, minimum-wage laws curb hiring. If that’s true, then government policies to reduce the cost of labor should boost employment, right?

If only.

In recent weeks, President Barack Obama and congressional Democrats have floated the idea of extending last year’s payroll-tax cut. This time, however, they want to give the break to employers, not workers. Their logic is simple, familiar and very nearly compelling: Lower the cost of labor, and companies will hire more workers.

Great idea, in theory. But hiring decisions are not theoretical. In the real world, tax incentives for job creation have a less-than-stellar record. Most have been expensive and inefficient, delivering windfalls to employers without doing much to alleviate unemployment.

Tax incentives for job creation come in both shotgun and rifleshot varieties. Shotgun credits try to encourage hiring throughout the economy, often by lowering broad-based taxes on employment like the Social Security payroll tax. Rifleshot credits, by contrast, offer targeted benefits to particular groups, industries or regions. In addition, some job credits try to target new hires, rather than employees already on a company’s payroll.

Both shotgun and rifleshot incentives have their defenders. Since at least 1936, when Cambridge University economists Arthur Pigou and Nicholas Kaldor debated the use of wage subsidies to alleviate unemployment, academics and policy analysts have been arguing over the idea.

In 1977, Congress tried out these ivory-tower notions in the real world. In response to the recession of 1973-1975, lawmakers enacted the New Jobs Tax Credit, offering a tax benefit to any company that increased its payroll by more than 2 percent.

Did it create jobs? Some studies, including one in 1979 by economists Jeffrey Perloff and Michael Wachter, suggest that it did, boosting employment by up to 3 percent at some firms. Other evaluations have been less positive. A joint report produced by the Departments of Labor and Treasury in 1986 concluded that the credit’s overall impact on employment was unclear.

In 1978, Congress replaced this credit with a more focused alternative, the Targeted Jobs Tax Credit. Designed to create jobs for disadvantaged individuals, it gave employers a break for hiring members of eligible groups, including welfare recipients, ex-convicts, Vietnam veterans and disadvantaged youths ages 18 to 24.

In theory, this sort of credit should have alleviated unemployment in groups where it was most intractable. But like its less focused predecessor, the TJTC produced ambiguous results. One 1991 study by economists John H. Bishop and Mark Montgomery concluded that the program did encourage some new hiring, but it also suggested that at least 70 percent of the credits were claimed for workers who would have been hired anyway.

And therein lies the problem with every sort of employment tax credit: they are inconsistently effective and notoriously hard to focus. Providing a general wage subsidy to all employers for all employees is relatively straightforward. In the aggregate, such credits might even help the economy. But painting with such a broad brush is enormously expensive.

Once lawmakers try to narrow the scope  -- targeting new jobs, say, or needy groups -- problems pile up. Some businesses continue to reap windfalls, claiming credits for jobs they would have created in any case. Others struggle with the complexity that comes with restrictive regulations designed to prevent abuse and mistargeting.

As the Congressional Research Service concluded last year, “incremental tax credits have the potential of increasing employment, but in practice may not be as effective in increasing employment as desired.”

Perhaps worst of all, even the best-designed credit would probably make little difference in hiring decisions. Ultimately, demand -- not tax credits -- drives employment.

“I don’t know if this is basic economics, basic capitalism or basic common sense, but businesses hire people to do work,” explained Chicago business owner Jay Goltz on a New York Times blog. “Businesses don’t hire people if they don’t need them, whether there’s a tax break or not. If companies don’t have work for new hires to do, they aren’t going to hire them even if they’re on sale for 6.2 percent off. Or even 20 percent off.”

Tax credits, in other words, are a second-best solution to unemployment, a mediocre replacement for the sort of direct demand stimulus that generally lacks traction in Washington.

“It’s about the only game in town,” observed Representative Pete Stark, an early champion of employment tax credits, in 1984. “But it’s a terribly inefficient way to take care of the social and economic needs of the disadvantaged.”

(Joseph J. Thorndike, a contributor to the Echoes blog, is the director of the Tax History Project at Tax Analysts and a visiting scholar in history at the University of Virginia. The opinions expressed are his own.)

To contact the author of this blog post: Joseph J. Thorndike at

To contact the editor responsible for this blog post: Timothy Lavin at

-0- Jun/28/2011 23:03 GMT