Monday, April 2, 2007

Greg's Not Quite Right

Greg misses transition costs and disequilibrium effects in his analysis on tax incidence. He says it doesn't matter who is required to pay the tax, the final incidence is determined by supply and demand.

That's not quite right for a couple of reasons. First and foremost Illionis's requirement that the cost not be passed on to employees means that the payment shock falls on employers. There is a cost to changing the number of workers that a firm has or renegotiating wages.

If the firm cannot immediately pass the cost on to the workers then it must absorb the costs until the market re-equilibrates.

Furthermore, the labor market is prevented from reaching equilibrium in some cases. The most obvious is the minimum wage. This legislation effectively then raises the minimum wage and causes real effects.

In addition, my guess is that public employees are also affected. There is no particular reason to think that public employees are paid equal to their marginal product or that there is a smooth downward sloping labor demand curve. In this case there can be real effects for public employees.

The devil is details and the details are always messy.

21 comments:

loogel said...

Good analysis.

Funky Disposition said...

Karl,

This is a much better picture of you ... Why did you keep that bad picture up so long .. the blue background was funky.

Aaron Swoboda said...

Even if you are right, I still think the law as it is being advertised is misleading about its effects. The tax will eventually be felt by most employees in the form of lower wages. True, this won't happen until sticky wages can be unstuck, but it will happen. Except for those employees earning the minimum wage. Good point. But, the purported impacts will only occur at minimum wage paying firms. Would the law receive support if people knew/understood the true implications: strongest impacts on minimum wage paying businesses, smaller impacts on all other business, and reduced wages for most employees?

Karl Smith said...

Why did you keep that bad picture up so long .. the blue background was funky.

funky - I figured you would like that. Also, I didn't think that anyone would take note of the picture.

dWj said...

I'm guessing the effects are small; if it takes a couple of years for the labor market to reequilibrate, then the fact that all of it falls on the employer initially might mean, in present value terms, that an employer who was going to pay 50% of it will pay 55% or 60% instead.

Some of the cost will be passed through to public employees as well. As you note, in their case it's less clear what determines the demand-for-labor curve, but whatever it is -- the political considerations of how much people are willing to pay in taxes, for example -- will have an elasticity between 0 and infinity, exclusive of both endpoints, just as the demand curve does in a better-functioning market.

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