Tax Cuts and Employee Compensation

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.


[i]Investment Income and Universal Basic Income Are Not ‘Basically The Same’,” “Income Inequality Is More Than It’s Cracked Up To Be”, and “You will always have the poor among you. . . .”

[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.

4 thoughts on “Tax Cuts and Employee Compensation”

  1. A few comments:

    1) There are some additional factors that go into the formula. The first is immigration. There are obviously many significant positives from encouraging immigration, but one of the negatives is that it does increase the labor pool, and therefore potentially delays reaching the “full employment” tipping point after which wages increase.

    2) Rising wages are also often inhibited by what corporations are choosing to do with their record profits. While you ascribe corporate reticence to invest their profits towards growth to ‘animal spirits’ fear surrounding negative expectations of the short term economy or inhibitive government action, large companies are also discouraged from risk taking by the ease with which they can spend their profits on ‘non growth’ expenditures like stock buybacks and dividends. This sort of corporate spending is great for wealthy stockholders as well as corporate executives with their stock based compensations, but it is not growth oriented investment. If the government were to either directly restrict this, or disincentivize it by taxing it, corporations would face greater market pressures to invest their profits towards growth instead.

    3) Corporate executive wages have been growing, rapidly, even during the high tax high regulation era of Obama. To quote one article I read on this issue, “From 1978 to 2013, CEO compensation, inflation-adjusted, increased 937 percent, a rise more than double stock market growth and substantially greater than the painfully slow 10.2 percent growth in a typical worker’s compensation over the same period.” None of this gets explained by your analysis. It seems clear that what is also going on is that the folks that run these corporations are simply choosing to give themselves massive raises instead of the workers and not earning it based on productivity.

    I believe this phenomenon is referred to as “economic rents”, and the appropriate response is to alter the institutional structures that allow for such substantial rents.

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  2. “There are additional factors that go into the formula.” Of course you are correct. To cover every relevant factor of an economic issue would take a multi-volume treatise. Your points are on point. On the other hand, I was addressing what appeared to be a misunderstanding by the poster of the post I quoted. Your comments appear not to undermine the thesis of my post: Wages rise and fall based on the supply of labor and the demand for laborers, but can be buffeted by other factors. You are mostly identifying additional headwinds to rising wages. Nevertheless, you raise some interesting points. I’ll discuss them in turn. (Please post any responses in the blog comments, and on Facebook if you like.)
    1. Yes! Immigration of workers adds to the supply of workers. That additional supply puts downward pressure on wages. (Conversely, immigration of people/families whose after-tax income is less than the person’s/family’s consumption is a drag on the economy.) Because, however, Americans are not having enough babies to become the workers who will fill the jobs of a growing economy and fund medical care and maintenance of a rising number of elderly (over 65) Americans, immigration is essential to the vitality of the country. Japan, which has miniscule immigration and whose percentage of elderly has grown from 7% to 25% between 1970 and today, has had a stagnant economy for about 30 years and no solutions in sight. Even with America’s robust immigration, the percentage of elderly Americans has risen from 10% to 14.5%. The number of workers per social security recipient in America has fallen from 41.9 in 1945 to 2.9 in 2010 (Every worker must provide for her own family and 1/3 of the benefits of a person on social security!) In addition, immigration of highly skilled individuals is the immigration of “The Ultimate Resource” for any country.

    Because America’s economy and wages would stagnate before it collapses without immigration, I did not believe immigration was a pivotal issue with respect to wages in America.

    2. “Rising wages are also often inhibited by what corporations are choosing to do with their record profits.” True, but I take exception to most of your points.
    You incorrectly describe my views on “animal spirits.” Contrary to what you said, they are only one of many factors in investment decisions, can affect investment decisions either positively or negatively, and are affected by both short and long term considerations.
    I view the causes and effects of stock buybacks very differently than you do. It is in CEO’s best interest to create good returns for the company’s shareholders. If the company does not generate enough investment opportunities that have at least a 50/50 chance of to generate a risk adjusted rate of return greater than the return shareholders could reasonably expect earn on an alternative investment (say a bond), then cash will build up in the company. A company holding in excess of a reasonable working capital level is a waste of wealth that could be put to better uses. Stock buybacks are better for shareholders than dividends for several reasons, and, in theory, and usually in fact they cause stock prices to rise. (Despite such buybacks being a self-evident admission of management failure, management can only make matters worse by sitting on excess unproductively accumulated cash.) More important, for the most part all of the cash received in a stock buyback will be reinvested in companies that are generating profitable investment opportunities. Contrary to what you are suggesting, the relative ease of moving poorly used capital to more positive uses helps the economy grow.

    Add to this the fact that taxes, regulations, and corruption turn what could be profitable investments into unprofitable investments. Much less idle cash should be sitting around or used in buybacks if Trump’s administration can lower taxes, regulations, and corruption.

    3. “[CEO wages have been rising rapidly.] None of this gets explained by your analysis.”
    True. High and rising CEO compensation was not explained by my analysis. That is because it is irrelevant to the question I was answering. The question was about rank and file compensation. The supply and demand in the CEOs market is vastly different than the supply and demand for rank and file employees. By way of analogy: If I were discussing the wages for non-star professional athletes (including farm team employees), a discussion of the compensation of Kevin Durant and other stars would be a distraction.
    “It seems clear that what is also going on is that the folks that run these corporations are simply choosing to give themselves massive raises instead of the workers and not earning it based on productivity.”

    It is generally true that people’s compensation is correlated with the value of their production. That each employee is paid a little less than the value of her production is certainly a company goal. While the goal is roughly achieved overall, in reality, other than the bonus portion of compensation, an employee’s compensation is based on the expectation of the value the employee will produce in the future. Employers (e.g., boards of directors and sports team managers) must always guess how productive their employees will be, and, with rare exception, they do not pay more or less than the market dictates they must pay.

    Very few people have the combination of skills, personality, and other intangibles that are necessary to be a successful top executive (or athlete). The bigger the company, the more true that becomes. Because so many of those chosen do not meet expectations, it is obvious that there are fewer superstars than there are superstar positions. Nevertheless, all holders of superstar positions are paid superstar compensation because they were expected to produce superstar results. Such is not the case for non-superstar positions. The laws of supply and demand for labor works all the way up and down a company’s organization. The errors in guesses occur throughout the organization, but the top paid people get the most attention because the errors are more consequential and egregious.
    There are exceptions. There are situations in which the CEO has so packed the board with cronies (and the cronies so want to hang onto their board status and/or pay) that they kowtow to the whims of the CEO. Such is life.

    I submit, however, that the above situations are far less prevalent than your comment suggests. This is because even though a CEO may not be earning her keep, the firm must have a CEO. The issue before the board is not only whether the under-producing CEO should be fired. The issue is whether the company can find and hire a more cost effective CEO. That involves guessing at whether the current CEO or some other CEO (who knows vastly less about the company) would be more cost effective. This reality gives incumbent CEOs inherent advantages. This creates high risk of a “head I win, tails you lose” situation for boards of directors. (Consider how many football coaches keep their job after losing seasons because the team doesn’t believe they can find someone better. Perhaps more to the point, consider how many such coaches are fired only to be replaced by someone at a higher salary that produces poorer results.) This reality also gives incumbent CEOs inherent advantages. Because lower level employees are so much more plentiful, such is not the case with respect to lower level employees.
    It is a sad and sometimes egregious, but unavoidable state of affairs in the market for CEOs. That, contrary to your suggestion, is why most CEO’s make the big bucks!

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