Indiana’s Jobless Recover; Sticky Wages and the Tax Wedge

April 9, 2012

For immediate release (804 words).

The Indiana Department of Workforce Development reports that the unemployment rate in Indiana dropped 0.3 percent to 8.4 percent in February 2012. The nation’s unemployment rate is 8.3 percent. Compared with a year ago, Indiana’s labor force grew by 40,600 or 1.3 percent, outpacing the national growth and in sharp contrast to neighboring states that saw their labor forces shrink.

Unemployment in Indiana, however, remains high. In particular, the private sector failed to add new jobs during the previous month.  

No one is more trouble by this jobless recovery than economists who reflected on the problem at the recent Midwest Economics Association Meetings in Evanston.  Like every unemployed worker pounding the pavement or Internet, economists puzzle over why firms do not seek out unemployed workers at reduced wages. “Sticky wages” is the term generally used to describe what appears to be disequilibrium between the quantity of those willing to work at existing or lower wages and the quantity of labor demand by firms willing to hire available workers at lower wages.

Reaching into the tool kit of economists, expansionary fiscal policy was expected to increase aggregate demand for goods and services inducing firms to add on to their current work force. This has not worked to the degree expected. In addition, traditional monetary tools were employed by the Federal Reserve to lower interest rates and thereby increase private investment and job creation. Neither fiscal nor monetary tools have been effective in the post Great Recession to restore full employment, defined as 94 to 95 percent of the labor force holding a full or part-time job.  

The president of the Minneapolis Federal Reserve Bank admitted in his speech to economists at the meetings that firms have pulled back on hiring due to uncertainty, and that monetary tools are powerless in reducing present joblessness.  He advocates hiring subsidies paid by government to firms for hiring workers. Such policies have some small vocational-training value but do not address the fundamental reasons for high unemployment.

In the United States, a major worker subsidy is the Earned Income Tax Credit (EITC). For a family with two qualifying children, the EITC initially can increase household income by a 40 percent. The maximum benefit level is $5,236, which is eventually phased out through the taxation of additional household earnings.

The EITC was intended to encourage people to accept paid employment. The unintended consequence is that, in families with multiple earners, the EITC creates incentives to exit the labor market, as partners are paid twice for almost identical expected health and retirement benefits.  

The American Jobs Act (AJA) attempts to subsidize hiring in two ways: exempting employers from the payroll tax and providing a $4,000 credit for hiring those unemployed more than six months. Hiring credits present several complications, according to David Neumark at the Center for Economics & Public Policy at the University of California, Irvine. First, a hiring credit may pay employers for hiring they would have done anyway; and secondly, hiring credits that target disadvantaged workers tend to stigmatize these workers. Finally, the payroll-tax holiday applies to businesses that merely increase hours without adding new employees.

Temporary tax abatements and subsidies are designed to lower the “tax wedge.” In labor markets the tax wedge is, from the employee’s perspective, the difference between before-tax and after-tax wages. From the employer’s perspective, it is the difference between the total cost that the firm is willing to pay and the amount the employee takes home after deductions.

For 2010, the U.S. tax wage is calculated at 26.2 percent of medium income. Consider an employer willing to pay and an employee willing to accept weekly compensation of $1,000. After required social security contributions and taxes on wages, the amount is reduced to $738. If, in addition, the firm with the employee jointly purchases group health insurance, take-home compensation falls again by several hundred dollars.

Policymakers, in need of tax revenue to finance government, try to foster employment. Generally, paid employment increases both household and firm income, but the tax wedge acts so as to restrict the labor market’s movement towards full employment.   

Hiring credits for employers and earned income credits for employees certainly reduces taxes for certain firms and households. Such tinkering, however, does not address the real problems associated with national economic recovery. Firms invest in new plant and equipment and hire if they can be reasonably assured that the marginal productivity of additional workers will generate revenue in an amount equal to the cost of additional workers over the next several years.

Individuals enter into formal full-time employment if somewhat certain that net income from wages permit them to maintain a reasonable standard of living and save. Such assurances are needed for the United States, including Indiana, to fully recover from recession and regain its footing on the long-term growth path.

Maryann O. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation living in South Bend, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.


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