Payroll Tax Cut

Labor cost as a share of business output is now at a post WW – II low. and has fallen about eight percentage points since 2000. This would suggest that the weak demand for labor does not stem from high labor cost. Actually since the third quarter of 2000 while labor cost as a share of total business cost has plunged, private payroll employment has also fallen from 111.2 million to 107.6 million in the second quarter of 2010. Yes, this data contradicts the theory taught in introductory economics.

But, if as this data series implies that weak employment is not because of high labor cost why should further cuts in labor cost via a cut in the payroll tax lead firms to hire more employees? I strongly suspect that those advocating cutting the payroll tax simply remember the theory they learned in their introductory economics class and have never actually looked at the data. If they had they would know that changes in the demand for labor and changes in labor compensation have a strong positive correlation. Of course this directly contradicts the theory they learned in introductory economics that labor demand is a downward sloping function of labor compensation. But remember, that theory is simply a massive over-simplification used to explain basic economic concepts to some teenagers. The theory assumes that all other things are constant and in reality that never really happens. In reality, the demand for labor is a function of many things of which labor compensation is only one factor and generally a relatively minor factor at that. In the real world the demand curve for labor is not a downward sloping function of compensation. Remember, when Alfred Marshall the great economist who did more to develop graphical analysis than anyone else was asked why he developed this approach his answer was,”so the gentlemen in the back row can understand what I’m talking about”.

Labor demand is a derived demand. Firms hire labor because they think they can profitably sell the goods and/or services the labor produces not because they derive some utility from hiring labor. Consequently, the dominant factor in the demand for labor is the firms perception of the demand for that firms output. Even if the cost of labor falls, firms still will not hire more labor to produce more output if the firms does not expect to sell the expanded output. Consequently, those claiming that cutting labor cost will induce firms to hire more labor are just spouting some ideological fantasy that has no basis in reality or even in advanced economic theory.

So what drives the demand for labor. If I want to forecast employment I make it a simple estimate of GDP less productivity. In this estimate labor cost does not play a enter the equation at all. In my experience labor costs is only important in the labor supply equation where higher labor payments induce individuals to enter the labor force.

In response to questions in the comments that if labor’s share fell, what rose, I’ve added this chart.
PS. The last time I published this chart it was of an index number that was derived by dividing one index number by another. So anyone could download the data from the BLS and reproduce it. But this chart is of the actual raw data that shows labor cost as an actual share of business output. BLS does not publish this raw data. Haver Analytics made special arrangements to get the raw data from the BLS so they could generate this data series. Consequently you will not be able to reproduce this data series from publicly available data.

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