The tax deal struck by Senator Mitch McConnell – after leading bipartisan negotiations for lawmakers in Congress – improves on the last four years but falls short in potential for restoring the prosperity of the 1980s and 1990s, due to weakness in its framework.
One example is in the two-percentage-point cut in Old-Age, Survivors, and Disability Insurance (OASDI) taxes. A first impression of the payroll tax cut reveals a lower rate and obvious benefit.
But Obama disappoints with a closer look at three basic elements relevant to OASDI, or Social Security, taxes in the economy.
The first relates to the payroll tax burden, or tax incidence. The idea of tax incidence means that contrary to Barack Obama’s claim that the OASDI reduction is an “employee payroll tax cut for workers,” businesses that employ those workers also have a stake in the tax burden.
Figures above show that the quantity (Q) and price (P) of employees, without the burden of a payroll tax, are balanced at respective equilibrium values for Q* and P*, following the economic law of supply (S) and demand (D). With a payroll tax, the price of buying labor (Pb) increases, and the price at which employees sell their labor (Ps) decreases, resulting in a tax wedge that leads to a smaller quantity of jobs (Qt) in the economy.
Exposing how a reduction in the burden of OASDI taxes is divided between employees and employers through tax incidence, Professor N. Gregory Mankiw of Harvard explains Obama’s failure to understand the economy:
Lawmakers can decide whether a tax comes from the buyer’s pocket or from the seller’s, but they cannot legislate the true burden of a tax. Rather, tax incidence depends on the forces of supply and demand.
The second element is the concept of elasticity, a measure of sensitivity to changes in P. A change in P falls more heavily on the market factor, S or D, which is less elastic. The upper figure shows that when D for employees is less elastic than S, as in times of low unemployment, employers bear most of the burden of a payroll tax (upper figure).
In contrast, higher unemployment shifts more of the payroll tax burden to the less elastic S, the people (lower figure). Elasticity thus further shows how an “employee payroll tax cut for workers,” in theory, differs from economic reality in which employers share a portion of the tax burden.
The third element is the fact that the framework only applies to the half of OASDI taxes attributed to employees, since employer contributions make up the other half of the payroll tax. In light of economic effects due to tax incidence, elasticity, and the unchanged tax rate for employers, it’s easy to see how Obama’s claim for the OASDI reduction fails to meet its true potential.
N. Gregory Mankiw, Principles of Economics, 5th Edition (Mason: Cengage, 2008).
Barack Obama, “Statement by the President on Tax Cuts and Unemployment Benefits,” The White House, December 6, 2010.