Gavin R. Putland,  BE PhD

Saturday, April 27, 2013 (Comment)

Austerity without unemployment

(P.S.: See also Maximalist ‘fiscal devaluations’ for Greece and Australia.)

If you tax something, people buy less of it. If you tax labour, you get unemployment. By eliminating taxes on labour, you can reduce the marginal cost of labour for employers — so that they hire more workers — without reducing “take-home” pay or widening after-tax wage inequalities.

The simplest way to do this is to let employers retain the personal income tax that they currently withhold from wages — while continuing to credit workers for the withheld tax as if it had been paid to the government — and to abolish payroll tax.

Some of the lost revenue would need to be replaced (“some”, but not all, because the rise in employment would reduce welfare expenditure). If it were replaced by an alternative tax paid by employers, the new tax would be paid out of the same pool of income as the old one, so employers would not need to raise prices. If the alternative tax were on anything but labour, it would not negate the reduction of the marginal cost of labour for employers.

These conclusions hold even if the “alternative tax” is a VAT (or a VAT increase). Whenever it is said that replacing personal income tax by a VAT would raise prices, it is assumed that the personal income tax currently withheld by employers would instead be paid out in gross wages, so that the extra income needed to pay the VAT would need to come from elsewhere, namely higher prices. But if the personal income tax were retained by employers as proposed here, no extra business income would need to be found, so there would be no rise in prices of goods and services produced within the country.

This together with the preservation of after-tax wages and the rise in employment would lift employees' aggregate demand for the products of their labour. Demand from overseas would also rise, because exports would become cheaper: the fall in production costs due to removal of tax on labour would not be offset by the increase in VAT, because VAT is not applied to exports.

Of course the VAT would raise retail prices of imports. This is a small price to pay for the increased earning opportunities. It is austerity of the desirable sort — austerity that gets you out of debt by inhibiting spending but not earning.

[Comment at The Economist. Cf. “Full employment: how the euro can work for Ireland, not against it”, April 12.]

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