Author’s Note: Two posts ago I said that the next two posts would be about FDR. I have already deferred those posts once. Please excuse another deferment because of the relative urgency of this post. Discussion about the tax bill on Facebook and elsewhere is ablaze and is jammed with misunderstandings. Discussion of the tax bill is urgently in need of some sorting out. I’ll get back to FDR soon.
The following is a prime example of what is being questioned about tax cuts and employee compensation on Facebook right now:
“American businesses are making record high profits. If corporations making more money equals more jobs and higher wages, why are we not seeing it and what makes you think that they will suddenly raise wages and hire more people if their taxes are lowered?”
This question reveals a misunderstanding of how employee compensation is set. I’ve commented on aspects of this issue in earlier posts.[i] This post will sort out some of the interplays between taxes and compensation.[ii]
Contrary to what is implied in the question, employers do not set employee compensation levels. If a firm sets its employee compensation higher than the market price for the labor, the firm cannot make as much profit as its competitors and will eventually, if no really soon, lose business to competitors.[iii] If it sets compensation too low, it will not be able to retain or attract the laborers it needs to effectively run the business.
When it comes to purchasing things, people and corporations have an important thing in common (which shouldn’t be surprising given that corporations are run by people). Neither people nor corporations generally pay a higher price for things than they must in order to purchase what they want. This is true no matter how rich or poor the purchaser is. Consequently, corporations do not pay any more for employees (labor) than they must in order to entice laborers to work for them and otherwise meet corporate objectives. So the fact that corporations, with a few notorious exceptions[iv], are not raising compensation immediately after the tax bill was passed is to be expected.
Unless the government gets involved,[v] like the price of everything else, supply and demand for employees set employee compensation. When there are more people wanting jobs than the number of jobs available (jobs are exceptionally scarce), there is little, if any, need for companies to raise nominal compensation. So they don’t. On the other hand, as the number of jobs increases relative to the number of people wanting to fill those jobs (labor is exceptionally scarce), companies must increase compensation to attract new employees and to prevent competitors from hiring away their existing employees. All other things being equal, as the number of jobs rises, the more employee compensation will rise.
So a key to wage increases is to increase the number of jobs. In general, as the economic climate for growing businesses improves, the more businesses will grow and the more jobs will be created. There are two big factors to a good business climate: 1) The potential profits from risking capital, and devoting time and effort to grow a business is large enough to make it worthwhile to attempt to grow a business, and 2) Doing business is not so constrained by regulations that growing business is too hard, too expensive, and/or takes too long to grow businesses quickly and efficiently. (For this purpose, “regulations” includes the published rules imposed by governments, but also includes government corruption in the form of unpublished quid pro quo requirements of bureaucrats that must be met in order to get a permit, actual or implied threats of differential enforcement of rules, and favoritism in the form of subsidies for certain companies or industries (all of whom compete with every other company for funds, employees, and the purchase and sales of goods and services).
Each of those two factors can cancel out the other. The extremes reveal the certainty of this assertion: 1) Even if business income tax rates were zero, business would not start or grow if regulations prevent there being a high enough probability of making a good profit within a reasonable amount of time to justify the risk and effort, and 2) Even if there were no regulations, businesses would not start or grow if income tax rates were 100%. The reasonableness or modesty of regulations that constrain starting or growing new businesses is irrelevant if they make the possibility of good profit within a reasonable amount of time too remote to risk giving a new business a go. Similarly, if too much of any potential profit will be taxed away, then cutting regulations is less likely to kick-start new businesses.
So increasing either income taxes or regulations will cause there to be fewer jobs than there would otherwise be. Also note that increasing one and holding the other constant increases the negative effect on jobs of the one held constant, thereby compounding the negative jobs effect of increasing either.
The reverse is even more important. Improving the business climate with reductions in both taxes and regulations multiply the positive effects on jobs of each factor. To its credit, Trump’s administration appears to be working on both factors. Doing a static analysis of any tax cut (as the CBO did) is not very helpful in predicting the effects of a tax cut (or increase). Not including in the analysis the multiplying effect of simultaneous reductions in regulations and taxes in a static analysis was particularly unenlightening and unhelpful.[vi]
Although John Maynard Keynes was wrong about much, his observation about the economy being moved by “animal spirits” (confidence and expectations are important factors in determining the future behavior of businesspeople and other economic agents) was largely correct (though usually incorrectly applied). In general, if the animal spirit, fear (of a worsening business climate in the future), dominates the thinking of most businesspeople, they will be less likely to risk starting new businesses. If hope (of a better business climate) dominates the thinking of most businesspeople, they are more likely to risk starting a new business. Increases in the rate of new business starts tend to validate “everyone” else’s confidence that the business climate is improving (or at least not likely to worsen), which causes there to be more hope, more investment, and more jobs. As a larger percentage of the population with jobs grows, business and payroll taxes will increase. As important, the percentage of people on “welfare” will shrink, thereby reducing government outlays to that purpose. With two major deficit factors improving, the government’s finances, and more hope that the business climate improvements will not be repealed will generate additional pro-growth animal spirits.
If all of these factors come into alignment, we can reasonably expect there to be many more jobs (demand for labor to increase), and the supply of workers to become more scarce. Companies will have no choice but to raise employee compensation. In light of the above, we could be on the verge of a wonderful virtuous cycle of prosperity.
There are headwinds that must be overcome in order to create a greater scarcity of labor. The country’s population increased by 2.3 million in 2017. Many able-bodied people are choosing not to work for the wages currently available to them in the job market. As wages rise, some of those unemployed people (but not in the “unemployment figures” because they are not looking for a job at current wages) will compete for the new, higher paying jobs, making labor more plentiful. Because tax revenues will likely fall until a more robust economy is generated, a rising deficit and debt will put upward pressure on interest rates, which impedes growth. The economy must overcome all of these headwinds to create enough jobs to create greater job scarcity. Doing so will require a very much more robust economy than the one extant when Trump took office.
The jury is, of course, out as to whether or how much of the above possibilities will come to pass. What can be said with a reasonable degree of confidence is that had we stayed with the policies that resulted in more and more onerous regulations, too few jobs, puny growth, stagnant compensation for middle and lower income people, and rising deficits, debt, unfunded liabilities, then continued lower and stagnant middle-income compensation would have persisted. Sadly, Trump’s “fair trade” policies (corporate welfare), inability to repeal Obamacare, and unbalanced budgets portend the retention of too many of the bad policies of the past. On the other hand, with the aggressive undoing of many of the Obama era regulations and the new tax bill, there is a reason for hope things will get better.
Consider again the opening question: “American businesses are making record high profits. If corporations making more money equals more jobs and higher compensation, why are we not seeing it and what makes you think that they will suddenly raise compensation and hire more people if their taxes are lowered?” The answer is that there has not been enough job growth to create significant labor scarcity which is the only thing that will put upward pressure on employee compensation. There is now a chance that will change.
[ii] While the relationship between taxes and employee compensation discussed in this post are the most salient to the question addressed being addressed, many other things that affect employee compensation will not be explored here. In particular, we will not discuss here: 1) how minimum wage laws affect the compensation of low skilled workers, and 2) the role of employee productivity on employee compensation and how employee productivity is improved.
[iii] It is no different than what would happen if a gas station were to set the price of its gasoline noticeably higher or lower than its competitors. Set the price too high and drivers will drive on by. Set the price too low and the company will be on the road to bankruptcy.
[iv] I don’t know the extent to which the reasons AT&T and other companies that boosted bonuses and wages after the tax cut bill passed were 1) to improve employee morale, 2) get out ahead of their competition (who will as a result of the tax bill have more money to hire away AT&Ts employees), 3) to improve public relations, 4) to gain favor with the administration, or 5) to gain some other business advantage. The apparently gratuitous payment was surely done to meet a corporate objective other than keeping and attracting employees unless they were addressing a preexisting employee hiring or retention problem, i.e., it was no more likely to have been motivated by the goodness of the executives’ hearts any more than you are to offer to pay more than the sticker price of a car because you believe the owner of a dealership deserves more for the car.
[v] An example is when government imposes minimum wages. Fortunately, minimum wage earners constitute less than one percent of U.S. employees. While the effects of minimum wages ripple up a few levels in an organization, the compensation of at least 70% of all employees is unaffected by minimum wages. Because very few of the people affected by minimum wage laws pay income taxes, they can be safely ignored for the purposes of this discussion of income taxes and compensation.
[vi] If you believe the multiplier effects may be insignificant, take a look at some climate change research. The catastrophic projections are typically the result of piling multiple compounding effects on top of each other (usually ignoring any mitigating factors, much less their multiplying effects).
UPDATE: An excellent article that corroborates much of what is said in this posts (and in other posts), “‘Economists Say’ a Lot of Things. Many of Them Are Wrong” By David Harsanyi, was published after this post was published.