The tax-rates-affect-hiring-decisions fallacy

If you listened to the debate about whether to let the temporary tax breaks expire on earners in the top income bracket, you might have heard an absurd assertion over and over again. The assertion is that higher tax rates discourage hiring. Now, there are many, many ways to demonstrate this is an absurd assertion--my favorite is simply looking at the empirical evidence of historic unemployment rates vs. top marginal tax rates. (Conclusion: unemployment is actually lower historically during the periods with highest marginal tax rates.) However, in this post I want to point out a basic fallacy in the argument that is commonly presented to "prove" higher tax rates discourage hiring.

The argument goes something like this: When business owners and managers decide whether or not to hire a new employee, they look at how much extra income they expect to make from that employee and compare it to how much the employee will cost the company. If the employee is expected to result in net income to the company after considering costs, then the employee will probably be hired. Of course, most companies will expect a certain minimum level of expected profit to justify the risk being taken, and many times the numbers aren't exactly precise calculations on paper, but more a general sense of expected returns and costs. But the basic idea is always there.

So, the argument continues, if we reduce the expected return by taxing some of that additional income, then we reduce the incentive to hire, and fewer people get hired.

To use an example, if hiring an employee is expected to cost $100,000, and that employee is expected to bring in $150,000, the net income is expected to be $50,000. Of course, there's a risk the employee won't pay off, and the decision to hire will actually cost the company money. But assume in this case that the expected return of $50,000 is worth the risk. However, if a tax rate of 50% is in place, then the $50,000 in net income will actually only result in $25,000 income to the owner, not $50,000. And in this example, the owner might decide the risk of losing $100k by hiring a worthless employee is too great for a return of only $25,000, even though the risk would have been worth taking for an expected return of $50,000. Makes sense up to a point, right?

But here's the problem: The above argument and example don't consider that taxes also reduce the real cost of hiring an employee. If the employee costs $100k, and generates $0 additional income, then the employer simply deducts the $100k from his taxes and (at 50% rates) sees a $50k reduction in his taxes. So the analysis should actually look like this:

With no taxes, the employer is risking $100k for an expected net return of $50k. That's earnings of 50% of the investment ($50k earnings/$100k cost). But with taxes of 50%, the employer who incurs $100k of costs to hire an employee has actually only incurred a real cost of $50k because of the tax deduction available. The expected net return is now only $25k as a result of taxes. But the expected real earnings remains 50% ($25k net earnings/$50k real cost).

This analysis holds regardless of what tax rate you use. Increasing or decreasing taxes does nothing to change the fundamental Return On Investment ratio that owners, investors, or managers will use in making hiring decisions. Anybody who attempts to claim increasing taxes will reduce incentives to hire employees using the argument outlined above is either being very dishonest or very foolish.

Businesses don't create jobs

I recently hired my first employee. I may be hiring two more by the end of this month. Most people would say I've just created 3 jobs.

They would be wrong.

My business provides a service in a more efficient way than the competition, allowing one person to do the work of two. So whenever I get enough new business to hire another person, the competition has to lay off two people. So rather than creating jobs, as my business is successful it accomplishes a net destruction of jobs.

And that's the way business works. Every business innovation since the Industrial Revolution has been about destroying jobs by deploying labor-saving techniques. (Actually, that's probably been true since before the Industrial Revolution, but things really took off at that point.)

You see, the true source of jobs is demand, i.e. the desire of people to receive goods and services. People have practically unlimited wants, and it takes work to satisfy those wants. The purpose of competitive enterprise is to find ways to satisfy those wants using less and less work. The more jobs business destroys, the more society is able to satisfy the wants of people using the limited resources available.

The problem is, demand is more than simply somebody wanting something. For business to take the initiative to find a better way to do something, they must believe that they are going to receive something in return, usually money. Simply wanting something by itself is not enough to generate demand...a person must want something AND have something to give in exchange. Then you have demand, and it's that demand that actually creates jobs.

So in a perfect world, businesses destroy jobs, freeing those people up to do other jobs and meet other needs by performing new jobs...more productive jobs. As long as they are able to transition into new jobs relatively quickly, then overall demand will be maintained and more jobs will continually be created for the people whose jobs are destroyed by business. But, in the real world, it's entirely possible that people whose jobs are destroyed in this process might not be able to find a new job for some time. This would happen if the wealth from the new processes accrues to a small group of people, and the demand for goods/services from this small group of people does not rise fast enough to offset the lost demand from the people who lost jobs. As a result, the overall level of demand might drop, or at least not rise fast enough to create jobs at a fast enough pace to replace the jobs being killed by business. The wealth will steadily accrue into fewer and fewer hands as fewer people are needed to satisfy the overall demand of society.

In fact, looking at history would suggest that what I've just described is the natural order of things. The Great Depression occurred just as the US reached historically high levels of income disparity. The Great Recession occurred when the US returned to such historically high levels. Looking at other nations around the world and through history does not reveal many examples of highly affluent societies with high levels of income inequality.

The obvious solution when the system gets "gummed up" in this way would seem fairly logical. A massive redistribution of wealth.

In fact, this is exactly what occurred to end the Great Depression. First, New Deal programs were enacted that raised taxes and provided jobs for many unemployed people, and this created real GDP growth of about 10% annually for almost a decade, a feat never matched before or since in this country. However, the New Deal was followed by WWII, which in economics terms was simply a larger version of the New Deal. Even more wealth was confiscated from the richest members of society, and even more jobs were created for everybody else, and furthermore people had very little to spend money on because so many materials were going to the war effort. Once WWII ended, wealth had been massively redistributed in our nation, and healthy long-term growth returned to the economy for decades.

Of course, the idea is not new...it's actually at least as old as the Old Testament of the Bible. Even in ancient Hebrew society, the law called for a Jubilee to occur every 50 years. During this jubilee year, debts were cancelled and land was redistributed. It's interesting that for well over 3,000 years now, it has been obvious that societies "naturally" experience a concentration of wealth that becomes unhealthy for the entire economy. Over 3,000 years ago, societies saw the need to periodically push the "reset" button on the economy.

Businesses destroy jobs. Demand creates jobs. When business does its job well, it will destroy nearly all of the jobs in society, which will eliminate nearly all of the demand in society. For a competitive free enterprise system to work in the long run, it has to be reset from time to time. So why does our society continue to strongly resist such policies even though they're the obvious solution to our current economic problems?