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Are the Tax Cuts and Increased Wages and Bonuses Connected?

Summary:
They might be. Veronique de Rugy of the Mercatus Center has an excellent piece at Reason on the connection, if any, between the recent cut in the corporate income tax rates and the spate of bonuses, pay increases, and increases in employer contributions to employee 401(k)s. Her article is titled "Is Tax Reform Already Working?" First, she lays out some basic facts:The legislation, which permanently slashed corporate tax rates from 35 percent down to 21 percent, was only signed into law last month. But more than 100 companies have already indicated that they will make big moves to benefit workers and the economy--including raising wages, handing out bonuses, granting 401(k) increases, and committing to

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They might be.

Veronique de Rugy of the Mercatus Center has an excellent piece at Reason on the connection, if any, between the recent cut in the corporate income tax rates and the spate of bonuses, pay increases, and increases in employer contributions to employee 401(k)s. Her article is titled "Is Tax Reform Already Working?"

First, she lays out some basic facts:

The legislation, which permanently slashed corporate tax rates from 35 percent down to 21 percent, was only signed into law last month. But more than 100 companies have already indicated that they will make big moves to benefit workers and the economy--including raising wages, handing out bonuses, granting 401(k) increases, and committing to increased capital investment--while citing the law's reduction in the corporate income tax rate as at least part of the reason.

Here's a list of over 200 companies that have made these pro-employee moves; the list is compiled by Americans for Tax Reform, an organization that strongly favors the tax cut.

The puzzle for an economist is not that we thought these things wouldn't have happened as a result of the tax cut. Instead, I would bet that most of us, certainly I, would not have expected them so soon. Normally, I get directions of effects of policy correct but err on the side of predicting them to happen sooner than they typically do. This time, it's the opposite.

Here's why I would have expected a slower effect, in Veronique's words:

The recent burst of activity isn't at all in line with the standard economic theory of how reductions in marginal federal business tax rates affect workers' compensation. Economists usually argue that lowering marginal tax rates on investment gives companies an incentive to earn more taxable income leading them to invest in other businesses and the expansion of their factories. This in turn raises workers' productivity, and ultimately leads to higher wages.

In other words, it takes time for companies to invest new capital, and reap the benefits of their investment.


Exactly.

So why did it happen so quickly?

Veronique writes:

[Scott] Greenberg [of the Tax Foundation] also offered another, more cynical theory. "Companies may have been planning on raising labor compensation anyway, due to increasingly tight labor market[s], and chose to attribute bonuses and wage increases to the tax bill, as part of an effort to build public goodwill for the legislation." With Moody's estimating that the unemployment rate will drop to 3.5 percent by the end of the year, the raises probably indicate a tighter labor market, and employers taking steps to retain their employees.

That's plausible. I'm not sure how cynical it is. Economic theory predicts that with new investment, there will be more capital per laborer and, therefore, an increased demand for labor. That would lead to a tightening labor market. So maybe some employers are trying to stay ahead of the market by raising employee compensation now. If the employers attribute that to the tax bill, and it can reasonably be attributable to the tax bill, is that cynical? Of course, if the labor market were going to tighten anyway so that the employers would have seen the need to increase employee compensation even absent the tax bill, then yes, it would be cynical. I don't know enough at this point to distinguish between the two explanations.

Veronique writes that "many of the bonuses were announced after the House and the Senate passed the tax bill but before the president even signed it." She uses this fact to cast doubt on using standard economic theory to explain the increases. But virtually everyone was sure, despite Trump's often being a loose cannon on policy issues, that he would sign the tax bill. So once Congress had passed it, it was as good as done. So, again, with employers anticipating a tightening labor market tightening even more with passage of the tax bill, it's reasonable to attribute some of the increase to forward-looking employers trying to get ahead of the labor market.

The above is a little too strong a statement on my part, because bonuses, by definition, are one-time. Why would an employer pay a bonus now to keep an employee in the future?The employee gets the bonus and then, when labor markets tighten, leaves. But just as employers are often loyal to employees, employees are often loyal to employers. An employee who otherwise might have thought of leaving when labor markets tighten might be slightly more willing to stay because of his good feeling about the bonus.

But why would so many of the bonuses be awarded in 2017? Again, this could be due to the tax bill but in a way that has little to do with increased labor demand that is driven by increased investment in capital. Imagine that a company is going to give a bonus and is choosing whether to do so in 2017 or 2018. If it gives the bonus in 2017, it deducts that cost of labor from corporate income that faces a marginal tax rate of 35%. If it gives the bonus in 2018, it deducts it from corporate income taxed at a marginal tax rate of 21%. So, all else equal, it makes sense to give the bonus in 2017. (I'm ignoring state taxes on corporate income.)

Veronique warns:

On the other hand, the narrative that the bonus frenzy is a direct result of successful tax reform legislation could backfire. For one thing, Americans and employees may incorrectly expect for it to happen year after year. And while tax reform will indeed grow wages over time, it will never be as visible and marketable as the rollout of these announcements at the end of last year. When that doesn't happen it could be used as evidence that tax reform is a failure.

That's a good point. It applies, though, as she says, to bonuses. It doesn't apply to wage increases and increases in 401(k) contributions because those are likely to be more permanent.


David Henderson
David Henderson is a British economist. He was the Head of the Economics and Statistics Department at the OECD in 1984–1992. Before that he worked as an academic economist in Britain, first at Oxford (Fellow of Lincoln College) and later at University College London (Professor of Economics, 1975–1983); as a British civil servant (first as an Economic Advisor in HM Treasury, and later as Chief Economist in the Ministry of Aviation); and as a staff member of the World Bank (1969–1975). In 1985 he gave the BBC Reith Lectures, which were published in the book Innocence and Design: The Influence of Economic Ideas on Policy (Blackwell, 1986).

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