LAFFER ASSOCIATES

Supply-Side Investment Research

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March 24, 2011

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EMPLOYMENT AND THE GOVERNMENT TAX WEDGE

By Arthur B. Laffer Ph.D., Ford Scudder CFA and Wayne Winegarden Ph.D. Summary

The past few months have produced positive employment reports, but these merely scratch the surface of a severely
depressed labor market.

A significant reduction of the government tax wedge could prevent the U.S. from experiencing an elongated high
natural rate of unemployment as in the euro-zone.

The Federal Reserves mandate as well as reelection considerations will drive monetary and fiscal policy, inevitably
resulting in inflationary pressure and a continued slow growth economy.

The failures of the current government will create the opportunity for pro-growth reforms in 2013.
Recent employment reports are showing increasing job gains and decreasing new unemployment claims. Many market participants believe that the job gains are the beginning of a virtuous cycle with strong economic growth and further employment growth reinforcing each other to create a strong recovery. We do not fall into that camp. Instead, we continue to believe that, barring any major exogenous shocks, we will see real economic growth on the order of 2% to 3% for the next few years. And, when you really look at the employment numbers, it is hard to take comfort in anything you see. While it is true the unemployment rate has fallen, the decline is not based on a huge surge in employment (Figure 1), but is due in part to a decline in the size of the labor force or, alternatively stated, an increase in the number of discouraged workers.
Figure 1

Total Weekly Hours and Total Non-Farm Payrolls

(monthly, thousands, SA, through Feb-11)

4,100,000

140,000

4,000,000

138,000

3,900,000
Total Non-farm Payrolls (RHS)

136,000

3,800,000

134,000

Total Weekly Hours (LHS)

3,700,000

132,000

3,600,000

130,000

3,500,000 2006 2007 2008 2009 2010 2011

128,000
Source: BLS

Without growth in the quantity of labor supplied, the only way the economy can grow is via productivity growth. For instance, throughout 2009 as employment was still collapsing, productivity growth soared (Figure 2). Yet generating long-term
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Laffer Associates

Employment and the Government Tax Wedge

productivity growth above its historical mean is very difficultand indeed productivity growth slowed over the second half of 2009 before going negative in the second quarter of 2010. Productivity growth has since recovered to slightly above its longterm historical mean.
Figure 2

Productivity Index Growth: Output per Hour for Non-farm Business

(quarterly, annualized % change from a quarter below, through Q4-10)

10%

10%

8%

8%

6%

6%

4%

4%

2%

2%

0%

0%

-2%

-2%

-4% 2006 2007 2008 2009 2010 2011

-4%
Source: BLS

The current economic recovery remains the worst on record as measured by the level of employment growth (Figure 3). Not only is employment well below the next worst cumulative result for recessions since 1940, but the current rate of employment growth is abysmal as well. Meanwhile, the apparent improvement in the unemployment rate as of late is due to the declining labor forcean unhealthy sign for the economy. Figure 4 shows the actual unemployment rate from its peak in October 2009 compared to the unemployment rate as it would have been had the labor force not contracted. If the labor force had stayed the same size from the peak in the unemployment rate until now, the unemployment rate would be 9.4%. These are not numbers that put the economy in a good light.
Figure 3

Employment - Path from Peak

(2007.12 2011.02 vs. Max & Min For All Recessions, By Month, Since 1947)

108 Best 106

108

106

104

104

Employment (% of Peak)

102

102

100 Worst 98

100

98

96 Current 94

96

94

92 0 5 10 15 20 25 Months Past Peak

2

92 30 35 40 45
Source: Federal Reserve Bank of St. Louis, BEA

Laffer Associates
Figure 4

Employment and the Government Tax Wedge

Official Unemployment Rate vs. Unemployment Rate with Constant Labor force
(monthly, through Feb-11)

11.0%

11.0%

10.5%

Unemployment Rate Constant Workforce

10.5%

10.0%

10.0%

9.5%

9.5%

9.0% Unemployment Rate 8.5%

9.0%

8.5%

8.0% Oct-09

8.0% Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11

Source: BLS

The focus will remain on the employment picture for the foreseeable future due to its central role as a barometer of the economys health. For politics, historically presidential polling numbers are inversely correlated with the unemployment rate (Figure 5). We do not believe that the 192,000 increase in non-farm payrolls registered in February will be a launching point for rapid employment growth. Accordingly, we would not be surprised to see additional attempts to stimulate employment growth from the White House, consequently. The economic impact will depend, obviously, on the merits of the policy. Suggestions for increased spending, or additional spending to help out state and local governments, will lead to greater economic turbulence, while fundamental tax reforms or effective deregulations could foster increased economic growth.
Figure 5

Presidential Approval Rating vs. Unemployment Rate

(approval rating frequency varies, unemployment rate monthly)

100 Unemployment Rate (RHS)

11%

90

10%

80 Approval (LHS)

9%

70

8%

60

7%

50

6%

40

5%

30 Reagan Obama Bush Clinton Bush 20 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
3

4%

3%

Source: Gallup

Laffer Associates

Employment and the Government Tax Wedge

The health of the employment market also has great implications for monetary policy. Through its actions, the Federal Reserve has illustrated that it is extremely focused on the full employment portion of its mandate. Consistent with our belief that mediocre employment growth will persist, the Federal Reserve is likely to continue with its damaging excessively loose monetary policy until inflation is no longer contained. This bias toward excessively loose monetary policy is only worsened by the current benign trends in the core CPI and PCE measures of inflation. The Government Wedge As we survey the results of the anti-growth policies put in place in the United States over the last four-plus years, it is hard to imagine that those same policies havent contributed to the devastating economic performance of the U.S. Moreover, the policies truly have had the worst effect on the poor and disenfranchised. Its a tragic cycle that reminds us of Milton Friedmans old joke about the child who killed his parents and asked for mercy from the court on account of being an orphan. The solution can be found in the price theory section of any economics textbook. It's basic supply and demand. Employment is low because the incentives for firms to hire new workers are too small and the incentives for workers not to work too high. Workers' net wages are down, so the supply of labor is limited. Meanwhile, demand for labor is also down since employers consider the costs of employing new workerswages, health care and moreto be greater today than the benefits. A Primer on the Economic Implications of the Tax Wedge For employment, a firm looks at the total cost to the firm for employing a person. The all-in cost includes all taxes paid. All-in costs also include incremental regulatory costs of hiring a new person, such as the need to add a new elevator or what the additional risks are for a class action lawsuit or a workers compensation claim. Firms consider all of those expenses, both current and future, associated with hiring a worker. If gross wages paid are higher than the market productivity of the worker (the added value that worker will provide the company), the firm will not hire the worker. If, on the other hand, the value of productivity of the worker is greater than the gross wages paid plus a little room for profits and costs of running a business, the worker will be hired. Companies make the decision to employ a worker based on that workers productivity and the total cost to the firm for hiring that worker.1 The worker, on the other hand, could care less how much it costs the firm to employ him or her. What the worker cares about is how much he or she gets netnet of all taxes, including sales taxes, property taxes, tariffs, including all impediments to the purchases of those goods and services and the receipt of those wages. The worker looks at net wages received in terms of foreign goods, current goods, and future goods. The worker considers all tariffs, all quotas, all restrictions, all income taxes, all sales taxes, all property taxes and all future taxes on savings, capital gains taxes, dividends taxes, estate taxes, etc, to determine how much he or she receives net from working. Once that worker looks at the net wages received for working, he or she then compares that amount with how much that worker would receive were he or she not to worke.g. unemployment benefits, welfare benefits, the value of leisure, the value of being home with family, and the value of working in the underground economy. In short, the worker looks at net wages received and compares those wages to the alternative he or she would get for not working. If net wages received exceed the benefits for not working, the worker will choose work. If the benefits for not working exceed net wages received, the worker will choose not to work. So, putting all components of the labor market together, we have a demand for labor that depends upon gross wages paid and a supply of labor that depends upon net wages received. For employers the higher gross wages paid are, the less workers they will hire. For workers the exact reverse is true only for net wages received: the higher net wages received are, the more willing workers are to work. And, of course, the difference between gross wages paid and net wages received is the government tax wedge. But knowing the shape of the labor demand curve and the labor supply curve doesnt tell us where those demand and supply curves are located on the wage/worker axes. The location of the employers demand curve for labor occurs at the points where gross wages paid equals the workers marginal value product. If gross wages paid are higher than a workers value productivity, that worker wont be hired. If gross wages paid are less than the value product, the worker will be hired. The location of the supply of labor on the other hand is predicated upon the potential payments workers would receive for not working. The higher the payments are for not working, the less work will be supplied and vice versa. Therefore, in addition to the tax wedge there is also a shift in the supply of labor that results from unemployment and welfare benefits. To get more people to work, work has to be more attractive for firms to hire workers and work also has to be more attractive for workers to work. Increased employment requires a reduction in the government tax wedge and unemployment benefits.

Arthur B. Laffer, A Growth Agenda for the New Congress, The Wall Street Journal, November 11, 2010.

Laffer Associates

Employment and the Government Tax Wedge

Over the past four years the government tax wedge has grown dramatically. In order to recoup the job losses of the past four years, the tax wedge has to be reduced equally dramatically. Gimmicks like the Feds quantitative easing as contained in QE1 and QE2 dont do anything to reduce the tax wedge or increase employment. The stimulus packages of the past four years only make the wedge greater and employment worse. These stimulus funds were used to pay people not to work and to bail out failing companies and wasteful projects. If were going to get serious about meaningful job creation well have to make work more profitable to employers and more attractive to workers. Spending cuts, low rate flatter taxes, deregulation, freer trade and sound money are the answers. In setting policy, simply remember the five dicta of a prosperous economy: 1. 2. A low rate flat tax: a la Jerry Browns flat tax when he ran for president. Spending control: a balanced budget amendment whereby spending is restricted by tax receipts without raising tax rates. In other words, I dont mind government raising spending on one product as long as government reduces spending on another product. I do mind increasing government spending with a deficit in mind or by raising tax rates as a consequence. Sound money: The Fed should restrict the supply of money, thereby making money valuable. Do what Paul Volcker did in 1979 to make the dollar once again as good as gold, and then people will hold dollars rather than gold. Trade: The least impediments to the free flow of goods and services across national boundaries is the key to good foreign economic policy. Ratify free trade agreements with Korea, Panama and Columbia, aggressively pursue other free trade agreements, and get rid of buy America provisions as contained in the stimulus packages. Regulatory reform: Everyone understands the need for regulations; you cant choose every morning which side of the road you drive on. But you want regulations, restrictions and requirements to be directly focused on the issue at hand and not to overreach, not to go beyond their purpose and do collateral damage to the economy. Regulations should be reasonable, focused and direct, but not too broad.
2

3.

4.

5.

The problem is that the government has driven a massive wedge between the wages paid by firms and the wages received by workers. While tax rates are much lower today than they were in the 1960 and 1970s, the wedge is being expanded via other factors. For instance, ObamaCare dramatically increases the size of the wedge by increasing the cost of health care; restrictions on carbon emissions (whether via Congressional action on cap and trade or via Environmental Protection Agency regulations) would increase all-in employment costs; increased regulation and government interference in the enforcement of contracts ( la GM and Chrysler) lead to higher compliance and legal costs; more favorable government treatment of unions increases costs to the firm without increases marginal revenue product of the labor supplied, as does the higher minimum wage (see appendix for in depth discussion of the effects of the minimum wage); and repeated stimulus programs penalize workers and producers. In our view, the reason we are seeing decent job growth is that there have been a few items that have closed the wedge or have limited the amount to which it can grow over the next few years. Particularly, the Bush tax cuts were extended for two years in December; the tax compromise also included a cut in the payroll tax and immediate expensing of capital purchases; 3 stimulus funds are drying up; and the Republican control of the House ensures no further negative policy until at least 2013. To make work and employment attractive again, however, this government wedge has to shrink a lot more. Until that time, dont expect strong employment growth. Investor Ramifications As long as Congress and the administration refrain from reducing the size of the government wedge, there will not be meaningful and sustained growth in employment. Indeed, without reducing the size of the wedge, the United States should expect a higher natural rate of unemployment, much like in the euro-zone. The results of this are two-fold. First, we would anticipate both the Federal Reserve and the administration to look to do everything they can to increase employmentthe Fed on account of their mandate and the administration in order to gain reelection. Unfortunately, unless the Fed returns to seeking a stable value of the dollar, they will not reduce the wedge but instead continue their zero interest rate policy and possibly pursue further asset purchases. Meanwhile, the administration has shown very little desire to effect any pro-growth changes, and we dont anticipate them starting now. Under those circumstances, the end result would be increased inflationary pressures and a continued slow growth economy. The second factor is that each of those outcomes lend themselves to a continuation of the replacement of the current government in the 2012 election, creating the opportunity for truly pro-growth policy reforms in 2013 and a resultant bull market of historic proportions.

2 3

Arthur B. Laffer, The Complete Flat Tax, Laffer Associates, February 22, 1984. Arthur B. Laffer, Conference Call Summary, Paving the Way for 2013, Laffer Associates, January 6, 2011.

Laffer Associates

Employment and the Government Tax Wedge

Appendix: A Discussion of the Minimum Wage One of the anti-growth policies was a three-stage increase in the federal minimum wage from $5.15/hour in July of 2007 to 4 $7.25/hour in July of 2009. While increasing the minimum wage is a seductive populist agenda item, it is incredibly harmful to the economy. When times are good, the minimum wage is not a large concern. In economic parlance, the equilibrium price for unskilled labor is above the price floor set by the minimum wage. When the economy turns south, however, a high minimum wage is often above the market-clearing wage for unskilled labor, meaning there is a surplus of labor, which shows up as higher unemployment among the least qualified workers. All an increase in the minimum wage succeeds in doing is pricing people out of the job market, and particularly those people who have no ability to defend themselves, such as the poor, the minorities and the disenfranchised. The people who need entry-level jobs in order to gain the requisite skills to earn above the minimum wage are precluded from ever getting jobs in the first place if the minimum wage is too high. And that certainly seems to be the case today. Teenage unemployment has surged from 15.1% in July of 2007 to 23.9% in February 2011. Meanwhile, black teenage unemployment has risen from 26.4% in July of 2007 to 38.4% in February 2011, down from an astounding 49.2% in September of last year (Figure 5). Even though teenagers represent a relatively small portion of the labor force, we find them a valuable and useful proxy for the least employable demographic. All of this helps demonstrate that the negative policy changes have driven up the cost of labor in terms of output, pricing many people out of the labor market and leading to high unemployment.
Figure 6

Minimum Wage vs. Teenage and Black Teenage Unemployment

(Real Min Wage: monthly, Jan-11 $, through Jan-11; Unemployment: seasonally adjusted, three month-moving average, through Feb-11)
$10

Real Minimum Wage (LHS)

Black Teenage Unemployment Rate (RHS)

50%

$8

40%

30% $6

20%

$4

Overall Teenage Unemployment Rate (RHS)

10%

$2 1950

0% 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010

Source: Bureau of Labor Statistics, Department of Labor

To wit, using BLS and CBO data, one can approximate just how many people were priced out of the market due to the increase in the unemployment rate.5 In 2006 (the last full year with $5.15 as the federal minimum wage), approximately 6.6 million people were earning $7.25 (the current minimum wage) or less per hour. That number fell to approximately 4.4 million people earning $7.25 or less per hour in 2010. Thus, approximately 40% of the jobs lost from 2006 to 2010 were directly affected by the minimum wage (Figure 4).

States set their own minimum wage, with the higher of the state minimum wage and the federal minimum wage providing the minimum for any given state. The current state minimum wages are given at: http://www.dol.gov/esa/minwage/america.htm The Minimum Wage and Job Loss from 2006 through 2010, Political Calculations, March 9, 2010. http://politicalcalculations.blogspot.com/2011/03/ minimum-wage-and-job-loss-from-2006.html
5

Laffer Associates
Figure 7

Employment and the Government Tax Wedge

Number of Hourly Workers Earning $7.25 or less per Hour

(yearly, nominal)

7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

0 2006 2010
Source: Political Calculations, Bureau of Labor Statistics

Starting with the supply-side policies put in place by President Reagan, for about a quarter century the U.S. government paid less and less attention to increasing the minimum wage. Instead, the government focused on policies that would encourage production, thereby increasing employment. This pro-growth focus caused the percentage of the labor force paid the minimum wage or below and the ratio of the federal minimum wage to the average wage to fall dramatically. Unfortunately, the recent change in the direction of policy and the economy has caused each of those trends to reverse (Figures 6 and 7) and helped fuel the increase in the unemployment rate.
Figure 8

Real Minimum Wage vs. Percentage of Hourly Paid Workers Paid At or Below Prevailing Federal Minimum Wage
(Real Minimum Wage: monthly, Jan-11 $, through Jan-11; Percent of Workers: yearly, through 2010)
$10 16%

14% $8 12%

Real Minimum Wage (LHS)

10%

$6

8% $4

6%

Percent Paid at or Below Minimum Wage (RHS)

$2

4%

2%

$0 1979

0% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Source: Bureau of Labor Statistics, Department of Labor

Laffer Associates
Figure 9

Employment and the Government Tax Wedge

Ratio of the Federal Minimum Wage to the Average Wage*

(Wage per hour, monthly, through Feb-11)
0.55 0.55

0.50

0.50

0.45

0.45

0.40

0.40

0.35

0.35

0.30

0.30

0.25 1964

0.25 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

*Average hourly earnings of total private production workers. Source: Bureau of Labor Statistics

Back in mid-2009, in analyzing the policies of the Obama administration, we wrote: While the poor policies started under President Bush, the current administration has only expanded upon them. Unfortunately, they will soon come to realize that their policies are most detrimental to those they 6 profess to want to help the most. We hope they are beginning to take note.

Arthur B. Laffer, Ford M. Scudder and Mark A. Wise, Through the Laffer Lens: A Note on Incomes Policies, Laffer Associates, July 16, 2009.

2011 Laffer Associates. All rights reserved. No portion of this report may be reproduced in any form without prior consent. The information has been compiled from sources we believe to be reliable, but we do not hold ourselves responsible for its correctness. Opinions are presented without guarantee.