Wage Subsidies

Short Version: Cut payroll taxes!

Long Version:

America is almost certainly facing a period of persistently large unemployment. Nearly 15 million people are currently unemployed, while the CBO projects that the unemployment rate will not drop to eight percent until 2012, a rate more typical of a recession.

Broader measures of unemployment paint an even worse picture. A substantial portion of the unemployed workforce are not simply between jobs, but are facing a prolonged jobless period—including six million who have been out of the labor force for more than six months. A broader measure of underemployment accounting for discouraged workers who have stopped looking for work or can’t find full time work is above sixteen percent.

The recovery, then, will in all probability be jobless. Economists Carmen Reinhart and Kenneth Rogoff suggest that countries in the aftermath of systemic banking crises face stagnant output and employment growth. This may be due in large part to the unwillingness of financial institutions facing broken balance sheets to extend lending. TARP successfully recapitalized larger financial institutions, but it did not help smaller banks that are the dominant source of funding for small and medium sized businesses. A NFIB survey of small businesses found that regular borrowers had the greatest difficulty in finding credit since 1983. While few small businesses reported financing as their biggest problem, credit constraints may inhibit small businesses from creating jobs in the recovery stage—as they have in previous downturns.

Households, too, face balance sheet problems. Steadily rising home appreciation provided the impetus for debt-fueled growth in consumption over the past decade. Now, households are more inclined to save—a good long-term strategy, but bad for jobs in the short-run.
And with interest rates close to zero, the Federal Reserve is unable to easily boost growth through conventional monetary policy. More unconventional monetary policies like quantitative easing or NGDP targeting are not being seriously considered by the Federal Reserve. Ben Bernanke’s academic work (which earned him his present job) on the Japanese experience with the zero-rate bound emphasized exactly these policy responses, yet he has repeatedly removed these from the table.

Even robust economic recovery on its own may be insufficient to restore employment to pre-crisis levels in the near future. In the past, economic growth was strongly correlated with employment generation—a statistical relation known as Orkun’s law. This dynamic held during the steep drop in output and employment during 2008. Yet it has broken down for the recovery. The CEA, for instance, found that unemployment in the fourth quarter of 2009 was 1.7 percentage points higher than historical data would suggest. Even as the economy has resumed positive growth, the Administration projects that the economy will generate less than 100,00 jobs per month throughout 2010.

In the past, wage entrenchment was a driver of employment growth during economic recoveries. Inflation eroded real wages, encouraging employers to start hiring. Higher dollar wages encouraged workers to rejoin the labor force, even though these jobs paid less in purchasing power. Ben Bernanke found this process of wage adjustment through inflation to be a powerful global driver of employment generation after the Great Depression.

Estonia saw a huge economic drop after the crash, but has also seen a large readjustment in prices and wages. This price realignment was difficult, but has paved the way for recovery.
Yet dollar inflation is today close to zero, preventing wages from naturally adjusting. Forecasters and prediction markets agree that this will continue for the foreseeable future, much as Japan’s financial collapse was followed by over a decade of stagnant prices. Without inflation, the only way to maintain full employment in the future would be for nominal wages to fall. Yet wages are “sticky” and typically only readjust upward. Meanwhile, as Casey Mulligan has noted, policymakers have introduced a number of different work disincentives, like longer unemployment benefits, a higher minimum wage, and mortgage modification efforts. The result is a deflationary overhang that will depress job creation for years.

So what? Today’s unemployment levels merely move America towards a level typical of certain European democracies. But America has not seen a prolonged period of unemployment this severe since the Great Depression.
A recent Atlantic cover article noted a number of psychological, social, and economic consequences of persistent joblessness. Being out of the job market takes a heavy personal toll on measures of mental health by separating people from the institutional moorings of a stable job. Recent graduates facing a weak job market can expect lower compensation over a lifetime.

The potential impacts on family formation are also worrying. As James Julius Wilson observed, women prefer not to marry unemployed men, but do not forsake having children—leading to single family households and an inter-generational cycle of poverty. The relatively low national unemployment rates in the past have disguised substantial concentrations of unemployment. In inner cities, Appalachian communities, and among lower-income families more generally—male employment has plummeted while single motherhood has risen.

America has not seen labor force participation rates this low among prime-age men for decades. Just as the housing bust has seen habits previously excluded to subprime borrowers (like high patterns of delinquency on mortgage debt) spread to more people; a prolonged economic downturn will have the effect of pushing the employment and accompanying social problems previously limited to low-income workers across a much bigger cluster of individuals.

There are structural problems with the economy which make unemployment an especially tough problem today, and which will probably continue to change the structure of unemployment in future recessions.

First, the level of unemployment varies substantially across levels of education. The unemployment rate among those with a college education has leveled off at 5%. Yet for those without a high school education, it is over 15%. Many workers simply lack essential skills, and will find it difficult to adapt to the restructuring in skill demand that has evolved over the course of the recession. As Mike Mandel has pointed out, the recovery out of the 2001 recession was intensive in real estate and residential construction, which was a boon for low-skilled workers. In contrast, the recovery so far has been dominated by hi-tech sectors like Internet publishing and search, and communications. The skills mismatch between the abilities that low-skilled workers have, and the structural shift in job composition, will make it difficult for any sort of economy recovery to reduce unemployment among many groups of workers.

Second, there are also substantial geographic mismatches, made worse by housing price declines. Haya El Nasser notes that the migration rate last year was the lowest since 1948, and this year is only slightly higher. Most worryingly, the percent of moves that cross county or state lines has dropped. Less than 13% of moves cross state lines, compared to almost 19% in 2004. Many moves are simply people moving out of foreclosed homes into nearby rentals. Many workers are “underwater” and owe more money on their home than it is worth—an amazing 70% in Nevada. This deters people from leaving Nevada—unemployment rate 13.4%—to, say, North Dakota (unemployment rate 4%).

The low level of migration and high level of variation in unemployment across states mean that even robust recovery across large parts of the country would leave behind large classes of workers. Workers will be unable to move in response to changing opportunities around the country. Even substantial recovery across a broad swath of the country may leave behind substantial geographic clusters. Those states which were experiencing difficulties even before the recession will now face even more catastrophic problems.

The Democrat response has been to pass a fiscal stimulus comprising tax cuts, spending on infrastructure and other projects, and fiscal relief to the states. Many progressives emphasize a second such stimulus to tackle unemployment. Yet even if one accepts estimates of these programs’ effectiveness, it is clear that many of these projects are extremely cost-ineffective at generating new jobs. Felix Salmon for instance estimates that it costs the government $300,000 to create every infrastructure job.

Government-led initiatives to boost clean energy, physical infrastructure such as high-speed trains or social projects such as education and healthcare may well be superb ideas on their own. But all are intensive in capital and specialized human capital. They will generate comparatively little employment for the low-skilled workers most affected by the downturn. Such forms of public works may have worked in the ‘30s, when “labor” was a skill-undifferentiated amorphous category. Today’s economy demands highly specialized human capital for the jobs favored in the stimulus—healthcare, education, energy—and so will be relatively poor means of generating mass employment.

The scale of fiscal stimulus and government subsidized industrial policy required to seriously tackle the long-run unemployment problem would be staggering and politically impossible in today’s environment. Concerns about America’s debt capacity have dominated discussions over the role of direct government spending in reviving employment. Yet even if the government was assured low interest rates for an extended period of time, it’s not obvious that more fiscal stimulus is the first-best way to expand employment.

Traditional conservative ideas, too, are lacking. The stimulus checks sent in 2008 were largely saved, as were the tax cuts that were a part of the ARRA bill. Policy interventions in the past year such as the minimum wage hike and greater unemployment insurance may have reduced the willingness of businesses to hire and employees to seek work to an extent; but repealing them would hardly be a sufficient boost to employment. The scale and degree of today’s employment problem demand new solutions.

The academic consensus on the problems of long-term unemployment and underemployment centers on the role of education. Rising wages from the 1950s to the 1960s were accompanied by a corresponding growth in educational attainment across all levels. Stagnating wages since that period have been similarly matched with a decline in the rate at which Americans gain education. This fall-off has been masked by rising GED enrollments. As Economist James Heckman observes, GED graduates behave and earn like high school dropouts rather than high school graduates.

Persistent unemployment is concentrated among the lesser educated. The housing bubble disguised the worsening job situation for unskilled workers through an unsustainable increase in the demand for construction. These jobs are gone and are not coming back. Manufacturing similarly has seen a long-term secular decline in workers employed—even as manufacturing output has grown.

Yet even rapid improvements in educational attainment—which would in any case be difficult to achieve—it would do little for today’s workers. Programs designed to improve the educational level of adult workers—like the GED program and other job training programs—have an abysmal track record—in part due to the fact that education comprises not only cognitive fluency, but also the attainment of certain psychological and non-cognitive skills difficult to build after adolescence. While improving educational attainment should remain an important long-term goal, it remains a too-distant option for those presently unemployed.

A more timely solution comes in the form of wage subsidies, an idea widely popularized by Economist Edmund Phelps. Unemployment happens when employers are willing to pay workers less than the amount workers demand. Wage subsidies bridge that gap by offering a government stipend to those willing to work. Effectively, a wage subsidy replicates the wage entrenchment necessary for businesses to hire again in lieu of inflation; while ensuring that workers can continue consuming.

The precise operation of that stipend can vary. A negative income tax, which provides workers a subsidy in negative relation to their earnings, would effectively subsidize work. A payroll tax cut would also have many features of a wage subsidy.

Wage subsidies in various forms have worked remarkably well in this last recession across a range of countries—in particular, in many European countries more typically known for sclerotic labor markets. In Germany, the Kuzarbeit, has offset the pay for workers facing lower hours. The Netherlands has a similar program of subsidizing workers in struggling firms. Singapore has seen enormous swings in its GDP during the crisis, yet has maintain an unemployment level in the mid-single digits—in large part due to its wage subsidies. Overall, 16 out of the 29 countries in the OECD have cut payroll taxes—mostly in Europe.

As a result, many European countries have kept employment losses far lower than America at a far lower fiscal cost. The 2009 ARRA bill, as a percent of GDP, was one of the largest fiscal stimulus in among developed countries. Yet the United States has also seen one of the greatest increases in unemployment.

However, while wage subsidies are ideal and usually prescribed during times of recession, their unemployment-busting powers make it ideally suited to dealing with the coming period of persistent joblessness.

While more direct wage subsidy programs like those common in Europe are absent from American policy evaluation, the CBO has evaluated a number of different tax credit policies. Along with increasing aid to the unemployed, the CBO found that reducing employers’ payroll taxes was the most effective and immediate job creation strategy. The EPI has estimated that a job creation tax credit could generate 5.1 million jobs over the next two years, at a cost of $27 billion.

The costs of such a targeted employment program need to be weighed against the enormous benefits resulting from fuller employment. Measured relative to other stimulus projects, a wage subsidy is a far more cost-effective way to curb unemployment.

Even if growth and employment growth unexpectedly resumed, this is a flexible policy that can be easily cut or expanded to respond to overall conditions. The downward tail risk of a ‘W’ shaped recession, or second downward bust—say by unexpected Chinese recession, or Euro collapse, or renewed economic problems stemming from the housing market—demand a flexible policy response that no current set of policy tools can provide.

A common critique of wage subsidies is that they cannot work because firms are cutting back because of falling demand, rather than worker compensation; or that they are simply uninterested in hiring unskilled workers. Yet millions of jobs were created even during the worst economic times, and many more firms were at the margin between choosing to hire or not; or choosing to fire or not. For instance, labor market guru Robert Hall argues the following:

The important feature that controls the job-finding rate is the incentives to employers to create jobs. At any given time, if the incentives are not very strong—it could happen for many different reasons—then employers will do relatively little to try to recruit workers. Job seekers will then have trouble finding jobs, will see themselves at the end of a long line of people waiting for the job....

So that’s the first thing to think about: job creation incentives.

Firm hiring decisions may radically change if companies faced a different structure for compensation. Even unskilled workers have some value to companies, and more would be hired if it were cheaper to do so.

There should be room for a bipartisan compromise on job creation. Progressive goals involving redistribution will be difficult to sustain politically if fellow feeling and solidarity are shaken by chronic economic insecurity. This loss of faith will also hit private institutions like marriage—a fact that ought to be of great interest to conservatives. If political elites fail to develop tactics to tackle the greatest period of economic chaos since the Great Depression, populism could make a comeback—with disturbing implications for trade and immigration policy. Recently, a group of economists of all stripes wrote a letter advocating wage subsidies. Hopefully politicians will follow.