Employment tax credits as a fiscal policy tool


Material Information

Employment tax credits as a fiscal policy tool a study
Physical Description:
v, 25 p. : ill. ; 24 cm.
Fethke, Gary C
Williamson, Samuel H. ( jt. auth )
United States -- Congress. -- Joint Economic Committee. -- Subcommittee on Economic Growth
U.S. Govt. Print. Off.
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Publication Date:


Subjects / Keywords:
Tax credits -- United States   ( lcsh )
Fiscal policy -- United States   ( lcsh )
Unemployed -- United States   ( lcsh )
bibliography   ( marcgt )
federal government publication   ( marcgt )
non-fiction   ( marcgt )


Bibliography: p. 22-23.
General Note:
At head of title: 94th Congress, 2d session. Joint committee print.
Statement of Responsibility:
prepared by Gary C. Fethke and Samuel H. Williamson for the use of the Subcommittee on Economic Growth of the Joint Economic Committee, Congress of the United States, July 21, 1976.

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University of Florida
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All applicable rights reserved by the source institution and holding location.
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aleph - 025852079
oclc - 02384522
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Table of Contents
    Front Cover
        Page i
        Page ii
    Letters of transmittal
        Page iii
        Page iv
    Table of Contents
        Page v
        Page vi
    1. An overview
        Page 1
        Page 2
        Page 3
        Page 4
    2. Macroeconomic effects of employment tax credits
        Page 5
        Page 6
        Page 7
        Page 8
        Page 9
        Page 10
        Page 11
        Page 12
        Page 13
    3. The microeconomic effects of an employment tax credit
        Page 14
        Page 15
        Page 16
        Page 17
        Page 18
        Page 19
    4. Summary and conclusion
        Page 20
        Page 21
        Page 22
        Page 23
        Page 24
        Page 25
    Back Cover
        Page 26
Full Text
TE II --

2d Session f











JULY 21, 1976

Printed for

the use of the Joint Eeonomic







(Created pursuant to sec. 5(a) of Public Law 304, 79th Cong.)
HUBERT H. HUMPH REY, Minnesota, Chairman
RICHARD BOLLING, Missouri, Vice C airman

EDWARD M. KENNEDY, Masachusetts
CHARLES 1. PERCY, llinois

hENRY S. REUSS, Wisconsin
LEE 1. IAMILTON, Indiana
GILLIS W. LONG, Louisiana
OTIS 0. PIKE, New Y-rk
MARGARET M. HECKLER, Massachusetts
JOHN If. ROUSSELOT, California

JOHN R. STARK, Ezecutice Dirt cior


WnLtAM A. Cox

RICHARD F. KAUFMIN#, Gewerai Cou.tl






CHARLES H. BRADFORD (Selior Economist)

GEORGE: D. KR AA4<, Jr. (Gansel)


WII4*J-PROQ -I RE, wM'skn
ABIJATA f13tCOFF, Connecticut
llUBCl'i t HUMPHREY, Minnesota
EDWARDrM.KENNED Y, Masibusetts
CHIARLES 11. plvncYJ Illii



ENTSEN, JR., Texac, Chairman
MARGARET M. HECKLER, Ma.ssachusetts



JULY 14, 1976.
To th Members of the Joint Economi C ommitte:
Transmitted herewith is a study entitled "Employment Tax Credits
as a Fiscal Policy Tool," which was prepared for the Subcommittee
on Economic Growth by Profs. Gary C. Fethke and Samuel 1I.
Williamson of the University of Iowa.
Late last year, in response to our unacceptably high level of un-
employment, Senator Bentsen introduced the Employment Tax
Credit Act of 1975, and this study is based oil the ideas in Senator
Bentsen's proposed legislation.
Since the study by Professors Fethke and Williamson analyzes how
an employment tax credit could reduce unemployment during a
recession without increasing inflationary pressures, I believe the
members of the Joint Economic Committee and other Members of
Congress will find it most useful.
The views expressed in the study are those of the authors and do
not necessarily represent the views of the members of the Joint
Economic Committee or the committee staff.
Chairman, Joint Economic Committee.

JULY 7, 1976.
Chairman, Joint Economic Committee,
U.S. Congress, Washington, D.C.
DEAR MR. CHAIRMAN: Transmitted herewith is a study entitled
"Employment Tax Credits as a Fiscal Policy Tool" by Gary C.
Fethke and Samuel H. Williamson, Associate Professors of Business
Administration and Economics, respectively, at the Universitv of
In their study, Professors Fethke and Willimson provide evidence
indicating that an employment tax credit could be a powerful counter-
cvclical fiscal tool. Under their proposal, any employer would be
allowed to take a tax credit for all workers hired above a base elm)loy-
ruent level, with the base adjusted downward when the economy is
moving into a recession and adjusted upward when the economy is
doing well-a' variable base employment credit (VBEC). Such a
VBEC would give firms an incentive to retain workers during" a
downturn, thus minimizing unemnployvient, since each worker laid offl
would reduce the firm's tax credit and, couveire1I, it would u-ive fir;,,
an incentive to speed hiring during recovery, > 1('e each new woIkc"
would increase the tax credit.


1a -tanldar(d tmel4l of the AFeriCan ecOOnmy to test their
idea, Prfe'sors Fethke aII(I Wil1iam-son have reachedI a conclusion of
,() littIe imPortance to those of u n ongress-when roperly
aduini-4,red!, a variable ase empl()yment credit could reduce un-
(11)Iov1iNt, increase GNP, and reduce inflationary pressures.
Unlike ioiwe tr (itional expansionary measures which try to boost
('Ift)lo, lt1lt indirectly by increaIing the nation's demand for goods
alnol M',rVi( ( l, for example, through an income tax cut), and which could
>tiIIuate inflation, Professors Fethke and Williamson argue that
a VBE( 'oul(l reduce lahor co-t and thus induce firms to hire more
workers, prodie more goods and reduce inflation.
Right now, with the economy in the midst of a substantial recovery,
we iould begin to examine measures which could prevent future
reces-4i- o1 which could turn the economy back upward swiftly if
another re( e on dloes occur. Professors Fethke and Williamson have
analyzed one proposal that could be of great use in this effort.
La-t year, Iintroduced legislation to establish an employment tax
credit ai d with a few changes it would conform to the VBEC pro-
l)-ed by Pro)fe,-ors Fethke and Williamson. I hope the Joint Economic
Committee can examine this idea closely in the near future.
The views expressed by Professors Fethke and Williamson in their
study are tho-e of the authors and do not necessarily represent the
views ()f the members of the Subcommittee on Economic Growth.
lfCelCI ,
Ctalirrwn, Subcommittee on Ecoiiomic Growth.

C 0 N T E N T S

Letters of transmittal III
1. An overview__-- 1
1.1. Introduction_ 1
1.2. Background of employment tax credit policy.---------------- -2
1.3. Types of employment tax credits 3
1.4. Approach of this report4-----------------------------------4
2. Macroeconomic effects of employment tax credits------------------
2.1. Introduction-----------------------------------------5
2.2. Analysis of the macroeconomic model--------------------5
2.3. Estimated effects of a VBEC---------------------------
2.4. Comparison of VBEC with other programs-------------------10
A. Personal income taxes -----------------------------10
B. Payroll taxesl-------------------------------------11
C. Investment tax credit-----------------------------12
3. The inicroeconomic effects of an employment tax credit---------------14
3.1. Introduction---------------------------------------------14
3.2. The response of the individual firm to a VBEC --------------14
3.3. The relationship between a VBEC and the length of the work-
3.4. Administration of a VBEC--------------------------------18
4. Summary and conclusion------------------------------------------20

Digitized by the Internet Archive
in 2013

http://archive.org/details/ttaxcre00u nit


Recent experience with concurrent inflation and unacceptably high
levels of unemployment in the United States has provoked skepticism
and concern regarding the siort-term countercvclical effectiveness of
traditional fiscal and monetary policy tools. This dissatisfaction has
generated many policy suggestions by prominent economists, poli-
ticians, an(l businessmen onl how the Nation can meet the twin goals
of full employment and price stability expressed in the Full Employ-
ment Act of 1946. Four newer forms of policy which have been
explored are: (1) Direct controls or guidelines on wages and prices
(some form of permanent incomes' policy); (2) simultaneous deploy-
ment of expansionary fiscal policy and tight monetary policy; (3)
public service employment; and (4) wider use of tax credits, subsidies.,
and selective taxes as counter-cyclical fiscal measures. This paper
examines and evaluates one form of countercyclical credit policy,
known as an employment tax credit.
The basic rationale for a universal employment tax credit is straight-
forward. This program will provide employers tax credits on either
wage rates, wage bills, or employment levels. These credits will
directly reduce business labor costs without reducing labor incomes.
By stimulating the demand for labor and the aggregate supply of
goods and services, such a program would initiate increases in real
GNP, and thereby increase employment.
An employment tax credit program differs from the cmpha.i of
traditional fiscal and monetary policies which act directly to increase
aggregate demand, and only indirectly to increase aggregate output.
Furthermore, since the direct effect of the credit decreases business
labor costs, its use to stimulate employment does not place significant
pressure on prices or contribute, via Phillips Curve relationships, to
inflationary pressure. In the short-run, the stiiluIlus to em)loyMent
encourages firms to utilize otherwise idle capacity and therefore moves
the economy closer to full eMnI)l)oyment.
The program can be designed such that the level of tle tax credit
allowed can be varied in response to ecoionic coinlitions. The universal
nature of the program will not disrupt the operation of regional labor
markets, and if there is alixy iiimpact on the di-trlibution of income, it
will favor the low income and unemployed.
'Associate professors at the University of Iowa in business administration and eeco-
nomies, respectively. The authors are indebted to their ,olleagues Carol Oliven, who read
and hlIped revise much of the paper, and Andrew Policaio and Calvin Siebert for their

()l~ onI t I!f ,r I I I\ T It It p ( )i v iait tl t I p w l
-itlpl3I I t Nw.i I 1 15tl I) 1.( di)u in ,- it ort WI t alc to f
'(lrt'(,. 1o' di tiel to1 1 i', tilille, and II d to Wid I wi10'reIA t IheatiiI
I( I I ')rt-(, lt li ion Exan. El n iinati()l of each of t e ))-te I)oteIi l
S l o I I ( I)IIin- of ei)l)11ma11t cre(lit reve l- I I Iat at)t))1)ro liate ad-
iii i -trtio()II I I I()VI IchcI' tl-eIn, or that tIIeN ae exIag erated and of
minor) practical i[iIportance.
"o date, fl()st e'i1)lo*y lienf I IUxcre(lit pr()posals have been aimed at
inflencing the 'iiic pl()yIeiIt levels for particular group( or categories
,)f labor. ai thi:, are elective rather tlan universal in coverage. Selec-
tive wave (Te(it progrrani have been analyzed in a number of context"
1) IDepressed region of a developed country (Botts, Lind, Serck-
HaL-sen, Archibald) : (2) urban areas of developing countries (Hagen)
.8) income maintenance (Kesselman, Barth, and Eisner); (4) 3o)
training of low-wage workers (Hammermesh); and (5) alternatives
to tariff protection (Bhagwau and R amaswani).
Limited employment tax credit programs have been introduced in
developed countrie-, and some experience is available for review.
In Britain, the Regional Employment Premium and Selective Em-
ployment Tax provide labor incentives by industry and location. In
the United State-,, employment tax credits have been enacted under
the job opportunities program, the AFDC work incentive program,
and the training incentive payments program in New York City.
Tiesecategorical program, however, induce firms to substitute
eligible workers for ineligible ones; and their net impact on overall
employment, output, and prices is slight.
A universal employment credit program was first suggested by
Nicholas Kaldor who argued that a wage subsidy would reduce labor
cost, increase profit, and generally encourage private enterprise to
expand employment. Kal(or also attempted to provide some empirical
evidence regarding the net cost to government of a wage bill subsidy.
Ragnar Friseh constructed simulations of tax and subsidy programs
for the Norwegian economy, and was enthusiastic about possible
(ounter-cyclical implications of wage-bill taxe- and subsidies.
Most recently, Berndt, Kesselman, and Williamson simulated the
impact on U.S. manufacturing of replacing the investment tax credit
with an equivalant cost-to-government employment tax credit for
the period from 1962 to 1971. Their principal conclusions were that
total employment would have been one-half to more than 1 percent
higher in many of the years, and that use of capital would have been
1 to 6 percent lower. They also argued that an employment tax credit
would induce firms to substitute production workers for capital and
non-production workers. Subsequent empirical work by Berndt, using
the same data, revealed that the removal of energy price ceilings and
investment incentives and the adoption of a 4 percent employment
lax credit would have decreased energy use in manufacturing by 5
percent and increased employment by over 2 percent. Elsewhere,Nwe
have examined tle aggregate impact on employment, output, wages,
p cesz, and net Government revenue of alternative employment tax
credit programs (Fethke and Williamson).


In the United States, 1 universal eIniplovl l(t'! tax credit bill wa-
intr)dluced into (ongres. by Senator, Jacob J ,avit s in 1971 I eA'isla ti(11
has recently been submittedb bY Senator Iovl.y lentsen in 1(.75a tlt
Senator John Tunnev in 1976. ;lie concept has 1)een reviewed b)- t1le
U.S. Department of Labor, the Congressional budget Ofice, t1le
Coucil of Economic Advisers, and the ( onor'-essio11 l .Iceate
Service of the Library of (Congrcss.

Enploynent tax credits have I)een proposed in many forsnl. Ea(!l
type has a different impact iupon the price of labor services to the first
as well as a different impact upon aggregate supply and demand in.
the econolny. IIn structuring the credit there are two policy parameters1
to consider: First, the type and amount of the credit, and second, tlie
level of base employment beyond which the credit is offered.
One way of instituting the program is to offer a tax credit as a
specified amount per worker employed. A single, universal credit of
this form not only reduces labor cost but also lowers the cost of un-
skilled relative to skilled labor. This follows because a per worker
credit represents a higher proportion of wages for low-paid, unskilled
workers than for high-wage, skilled workers. This credit presumably
stimulates employment of young people, women, and minority workers
who comprise the major portion of marginally skilled workers and
who represent a disproportionate share of the unemployed during
periods of declining business activity.
An. alternative type of credit is one given on a specified percent of
the worker's wage. This form, which is actually a type of negative
payroll tax, is neutral as to its effect on skill categories of labor.
The second policy parameter is the base level of employment
beyond which employers qualify for the credit, and again there are
several alternatives. First, a subsidy can be offered on the entire
workforce. The advantages of this approach include ease of ad-
ministration, low monitoring costs, and minimal difficulty in estab-
lishing criteria for inclusion. On the other hand, an across-the-boar(!
credit may prove expensive relative to its incremental impact on
Second, a credit can provide a subsidy for newly hired workers who
are drawn from the ranks of the unemployed; that is, a marginal
employment tax credit. In this case, the base of the program is te
actual (current) level of employment.
Finally, a variable base employment credit (VBE() can be con-
sidered which permits a tax credit for workers ldred in excess of a
base level, with the base to be adjusted to reflect changing buine,>
conditions. During periods of rising uneniployinent, thle base can be
decreasel; then during periods of recovery, it can be aoljlisted II)-
ward; anl during boom periods, the credit can be at)olislied. It is al-.o
possible to adjust tile bae to reflect different emnplomInenl Condition,
in regional or sectorial lbor niarkets.
Marginal employment tax credits have received the most legislative
attention. These progranis appear attractive since they reward onil
net additions to the workforce rather than some percentage of WI~
and new workers. The marginal credit, therefore, does seem less


v I llflerahl(l to the (a that eml)lolyueIlt cimlits simply provide a
wVIn(lfall profit to )11j> e 1 .
A marginal credit i not as flexible a coon tcer-cy-lical fiscal policy
tool as the VBEC oil at least three roimnk-;. First, a marginal credit
i' less effective in staiizin existin ellplovment since iot does not
penalize firms for leaving off workers A-VBE with the base set
below the current cmIll)iovment level, would protect existing jobs,
-ine each worker laid off wNoulu redtice a Cfiriii's employment tax
cIedit earned. Second, establishment of tle base at last period's em-
)loynent, or ati the t)eviius peak of employment, may either nullify
a11V 11pactthe credit mav have, or worse, tirn the credit into a
procyclicalmeare. 'l'lli-ifollow< because firm,:,s-111wtypically ignore
a marginal employment credit when employment is declining and
rush to accept it when employment is expanding. Third, the more
tle cre(lit is restricte(l to particular workers or employers, the less
imlhuct the t)rogram will have.
For these reasons, we do not feel that the program should be limited
to presently unemployed workers. A reduction in unemployment will
come through an increase in demand for all workers, and our results
show that a VBEC is the most effective method of stimulating this
demand. For the same reason, we do not feel the program should be
restricted as to size or type of employer. A VBEC can be offered to
any employer that makes social security contributions, including local
governments, schools, and nonprofit organizations, as well as the
business sector. In this way, a VBEC would have an even impact
throughout the economy and would not distort employment patterns.
A difficulty with the VBEC is that administration will require the
ability and power to change the level of the base as the economy
moves through different phases of business activity, as well as the
ability to evaluate employment conditions in heterogeneous labor
markets. Given the track record of U.S. fiscal policy, this is no small
administrative task.
We prefer a variable base employment credit which provides a
percentage reduction in the wage rate. A flexible base program has
three desirable features: First, variation of the base can directly
stabilize employment over the business cycle: second, the ability of
administrators to set alternative bases for different sectors of the
economy will assist in eliminating windfall profits; and third, the
program'ss impact on aggregate demand can readily be altered through
base and credit rate adjustment. In our analysis, therefore, we select
a wage rate subsidy because it appears the least distortive, the most
direct, and the easiest to administer.
In section 2, the macroeconomic effects of a VBEC are examined:
in section 3, the impact of employment credits on the individual
firm is considered; finally, section 4 contains a summary and con-
cluding remarks.


This section describes the impacts of a VBEC program on ke,-
aggregate variables in the economy. In particular, we focu un. o 01
response of employment, real output, wages, prices, agregate dcia I I I
and net cost to the government. The analysis is based on an evalua-
tion of a multiequation model which is defined and briefly descriled
in the appendix. Section 2.2 presents the analytical results that derive
from mathematical analysis of the model. Of primary interest in
this section is the specification of the set of conditions under which a
VBEC can increase employment and output without increasing aggre-
gate prices.
Using the aggregate model and recent U.S. data, section 2.3 presents
a set of calculations of the numerical changes in the aggregate variables
in response to an employment tax credit. These calculations are
reported for different bases and for alternative forms of credit financ-
ing. Numerical results highlight the analytical findings, and indicate
the likely changes of those variables whose behavior cannot be pre-
dicted solely on the basis of an a priori reasoning. The final sub-
section, section 2.4, compares VBEC's with other fiscal policies.

The model we use differs from simple Keynesian representation' in
two ways: First, labor supply, even during recessions, is not asullned
to be infinitely elastic, but will increase as wages go up. Second,
employment, output, prices, wages, et cetera, are described as jointly
determined variables. This means there is feedback between labor,
commodity, and money markets.2
Mathematical analysis of the model leads us to the following
proposition: An increase in a VBEC will expand employment,
output, and real wages. These results hold for almost every configura-
tion of personal and business tax rates, levels of unemployment com-
pensation, labor supply responses, technological conditions, and forms
of Government financing.
The VBEC increases real demand for labor. Assuming some flexi-
bility in the short-run supply of labor, employment expands in re-
sponse to a rise in the real wage. The greatest rise in employment
I The derivations on which this section Is based are not presented in detail. They will be
provided on request by the authors.
Simple Keynesian models presume that real output is determined by real exiwndi tre
on consumption, investment, and government purchases. Given an infinitely o, I." -
run supply of labor and constant product prices, unemployment is determined a ( Ihe
difference between full employment work force andf the actual work force. The actual work
force is the level of employment required to produce demand-determined real output. Ti9ls
sequence can be modified to accommodate changing wages and prices by addini a l(I-
Instantaneously clearing labor market (Peacock and Williamson).

occurs when the increment in the credit is large, the program base is
low, and the short-run elasticity of labor supply is high.3
\latheiaticul analysis of the model, however, does not provide a
cleaU-tci t picture for the earate responses of moiey wages an(
u," ,r' Ote lce-. )n the one haind, an increase in employment and
thus reI out)Iut red uces Iw e. sure on prices. On the other hand, a
increa-e in aggregate demand, which would accompany the credit,
tenld- to j lace upward )ire-ire (it on prices. The'efore the response of
price. to a VBE(? (lepetnk on the relative increases of supply and
demand. We can show that. when the Government finances the pro-
graim by cutting expenditures by an amount equivalent to the credit-
initiated loss in tax revenue, aggregate prices decline when the VBEC
is increas-ed. But when Government expenditures are set independ-
ently of the VBEC, the effect on prices is analytically indeterminate.
Therefore, to determine if a VBEC is inflationary, it is necessary to
examine in detail the program's relative impact on aggregate demand
and supIlply. While these topics are best considered in section 2.3,
which oNers a selection of simulations under different strategies of
financing the credit program, a few anticipative comments are useful.
On the supply side, wage and price responses to the VBEC depend
on technological relationships between output and employment, as
well as on the flexibility of labor supply. In the short-run, these
responses are essentially empirically determined conditions, that is,
they are parameters not subject to direct control. On the demand
side, price and wage response to the VBEC depend upon the effect of
the credit on consumption, investment, and Government purchases.
These, in turn, depend upon the program base and the method selected
by the Government to finance the program.
Of the several ways a VBEC can affect aggregate demand, its
impact on consumption expenditure is the most obvious and impor-
tant. The VBEC influences personal income and thereby consumption
expenditure in three ways. First, there is a net increase in personal
income for each new worker added to the workforce; specifically, the
increase equals the difference between wage income and unemploy-
nient benefits. Second, if the credit increases money wages of existing
workers, personal income will rise. Third, after-tax profits will initially
increase by the amount of the credit.
It i'salso useful to explore the implications on aggregate demand of
alternative credit-financing strategies. If Government expenditures
are set independently of the VBEC, the credit is likely to be deficit-
financed. It is conceptually possible for tax revenue to increase and
unemplIoyment benefits to decline sufficiently from new jobs generated
by the VBEC that the deficit need not rise.1 For typical values of tax,
s The indirect effects on employment of changes in aggregate demand depend on the
structure of the labor market. If workers possess a degree of money illusion, increases in
aggregate demand and money wages act to Increase employment and output. Increases on
aggregate demand, however, have no impact on employment if the labor market exhibits
a classical structure. In this ease, while changes in aggregate demand affect wages and
prices take eparately, there is no relation between total spending and employment.
4In fact, Nicholas Kaldor argued that a general wage subsidy program would be self-
financina. We have extended Kaldor's analyses In another paper; see Fethke and
Willi ani sonl.

behavioral, and credit parameters, however, tilte deficit Nili expaiid
whenever Government expenditures are set, independenty Iof fis.cul
policy requirements. Thist- tyx-pe of j)rogra!,l will tliceref'ore I)e one of tie
more stimulative methods of financing. Alterenative Gover1,,ment stra-
tegies involve (1) reducing Gover nment expentlit uys bt an alnoulnt
api)proximately equivalent to the outlay oil tii(, credit, or ( 2) i nreainr
personal or corporate income taxes sufficiently to absorb the cost of
the program. These ap)p)roaches will typically not require ai large a
increase in the deficit as the case where exp)endittres are indepeml-
entlv specified, but would not generate as much eiploinentit.
The effect of a VBEC on gross investment appears to be of minor
importance. If the credit necessitates increased Government borrowil g
and the monetary authority does not accommodate this borrowing,
then the rate of interest will rise and investment will decllile. On the
other hand, increases in output and eml)loyment will enlarge the
usage of current capital stock and thereby stimulate gross investment.
These effects are probably small or cancelling.
We conclude that the impact on aggregate demand of the VBEC
can be controlled by appropriate selection of the employment base
and Government financing strategy. In general, there is no reason
why aggregate demand has to expand by more than the tax-credit-
induced increase in aggregate supply. Thus, it is possible to initiate
a VBEC that will augment employment, output, and money wages
without causing increases in the aggregate level of prices.
In the following section, alternative methods of financing are
examined in a series of numerical calculations. These results emphasize
the flexibility of the tax credit program when the size of the credit,
the program base, and the method of financing are jointly determined.

The following calculations evaluate the impact of a VBEC on
important endogenous variables in the aggregate model. The results
represent the response of each variable to the implementation of a
tax credit equal to 1 percent of the wages paid to all workers in
excess of the firm's base level of employment. They are derived by
specifying the form of the behavioral equations, assuming average
rates and unemployment benefits, and using values of the endogenous
variables from the U.S. economy for the fourth quarter of 1975.
As such, the results are not statistical estimates or predictions, but
rather are simulated responses presented to illustrate possible impacts
on the economy of a VBEC.
5 The initial values for the variables are from the Fourth Quarter 1975; they are:
Y= GNP =$1,572.9 billion
O=real GNP =1,216.2 billion (in 1972 dollars)
P= GNP deflator=.29
L =employment =77.6 million employees
W=$10,700 per employee year.
The income tax is assumed to be t=0.25 percent, the corporate tax is 7'=0.39 percent the unteiiployment
benefits as a percent of the wage is b/W=0.36 percent, and the investment tax credit is k =7 pcru,( at. In th.
simulations, we assume money market and interest rate responses To the credit are very small So that gross
investment does not respond to the credit and is fixed in money terms.

Ihe alpproach taken involved ai-gning specific parameter values to
eII)or -)l)tl anl(l (lelncty, ela sticities. output elasticity, and the
IrIinal f.ro)en-ity to conIIe. I Then, the VBE( program is eval-
i '(eIl for three tlau1ib1e 11etlI( of Government financing strategy
1dl t1i&e c1Omjl)ete rilnge of describedd elployment bases. iThe calcu-
lItio i D are rIented i tlt{ t able. In case 1, Government expenditures
.1re ex(euII-s ((dterfiI ed in(leI)endently of the credit), aIll tax rates
,re a__1IneM- fixed, nn(l the deficit adjusts. Case 2 involves reducing
Government expenditIre 1)v tle full, cost of the em)loylnent credit
(tax r'tes are still lixed). In case 3, Government expenditure (ex-
clusive of transers) nd net tax revenue are held fixed, and the income
tax rte i increased( tw enough to cover the full cost of the VBEC.
The table records the percentage changes in the levels of employ-
eatI, re8l output, price, GNP, money wages, and profit. In addition,
1)rcl(t e' changes in wages and profits are deflated by the per-
centag he nci prices to show the impact of the credit on real
wages ni(l real profits. Profits are taxable profits plus employment
and investment tax credits. Each vertical entry in the table represents
the percentage change of the variable in response to a 1-percent
VBEC. Each row depicts different levels of the base. The first entry
for case 1, for example, indicates that a 1 percent credit, when the
base percentage (L 'L) is zero, employment will be 1.18 percent
For cases 1 and 2, the last column in the table is the increase
(decrease) in the deficit as a percent of tax receipts. For case 3, the
last column shows how much the income tax rate must increase if
tax receipts are to remain constant.
The calculations support the reported propositions of section 2.2.
A VBEC will result in higher employment, output (real GNP), and
real wage for all levels of the base and for each method of Govern-
ment financing. Also, for each program presented, expansion of
aggregate demand is never sufficient to cause prices to be higher.
This attractive combination of results, higher employment and a
lower level of prices, means that a VBEC is a fiscal tool that can shift
the Phillips curve to the left. Thus, a VBEC offers an alternative to
other fiscal programs which rely on rising prices to lower unemploy-
Other calculations, not reported here, indicate that a VBEC will
initiate expansion in the aggregate price level only when the elastici-
ties of supply of labor and output are much lower and the base is set
at low employment levels. Even under these conditions, manipulation
of the base can lead to reductions rather than increase in prices.
SThe behavioral equations used in the model as presented in the Appendix are specified as:
'7) C=aY,
10) O=AL5
(i) WI(l-j) = POAL-I
(12) L=qWaP'
where a is the marginal propensity to consume, 0 is the elasticity of output with respect to employment,
6 is the elasticity of labor supply with respect to the money wage, and 6 is the elasticity of labor supply with
respect to aggregate prices. The values assigned to these parameters are: a=0.8, 0=0.53, 5=3, and -Y=1.5.
The value of ae is arbitrarily assigned; however, alternatives do not change the results significantly. The
a, sumed Cobb-Dcugls I)roduction function with fixed capital resticts p to equal labor's share of total income,
which is 0.53 for the data used. Also, the Cobb-Douglas production relationship resticts the price elasticity
of demand to equal one. We experimented with several forms of labor supply. The one reported displays
sone money illusion. If -=0, then L =qW6 and prices would have no effect on the decision to supply labor.
If 5=--, then Lq(WIP)I, nd the supply decision depends on the real wage.

We now turn to a more detailed -examination of ech method of
fin ncin) the credit.
In case 1, where tie deficit adjusts, the (il-edit iinc ",,('ea .1 eq i uili)lril)
GNP for all bases except tie 100-percent base. 11ie increase in real
GNP, however, is greater' than itionev GNP an( prices fall. Thi,
it is conceptually possible for aggregate deinmand to rise, alld for
prices to decline.
In cases 2 and 8, a decline in Government ex.)en(littires or a coii-
pensating increase in income tax rates reduces ttie exp'nli10 in pact
of the credit on agriegate demand. Therefore, the increase in supply
is sufficient to achieve eqfuilibrium at a lower level of money GNP.
In ease 2, the fiscal impact of the credit will not be completely offset
by the reduction in Government expenditures. This follows because
tax revenue will be lower with lower taxable profits. The last columim
shows, however, that the effect is quite small. In case 3, increasing
the income tax rate to maintain constant tax revenues will actually
produce a reduction in the deficit. In addition, higher income taxes
reduce consumption expenditures. This case is the most deflationary
and therefore stimulates the least expansion of output.
The impact of the credit on most variables is tied to the impact
on equilibrium GNP. Employment, output, wages, and prices all
move in the same direction as equilibrium GNP. The real wage
varies inversely, reflecting the fact that workers are assumed to have
some decree of money illusion and therefore do not react completely to
the higher purchasing power of their wage.
A surprising result of the recorded calculations is that profit falls
at the higher employment base levels. A decline in profit is the result
of indirect effects of the VBEC and, specifically, the type of financing
method selected by the Government. The credit indirectly increases
wages received by workers and reduces product prices; at the same
time, it directly lowers the immediate cost of labor. If these indirect
effects outweigh the direct ones, profit will be lower. Thus, rather
than offering windfall gains, as many argue, a VBEC can actually
reduce profit.
Only for cases 1 and 2 are profits higher, and then only for low-base
programs. In case 1, where GNP is higher, profits increase for bases
less than 40 percent. In ca-e 2, real profit expands for a zero and 10-
percent base, and then displays ,negative changes. In case 3, the fall
in profit is largest. Here, a rising base is associated with smaller
declines in profit. The smallest fall in profit, for case 3, occurs at
the 100-percent base.
The calculations present comnparative static results which hold
other exogenous variables and parameters constant. In other words,
they do not mean that a 1-percent VBEC wol id, for example, (aise
prices and profits to fall, but tlat they will be o!fierent by the percent
in the table. Therefore, if this i1o(lel were a tlio rel1)IresenI t ation of
the U.S. economy, and a 1-1)ercelit marginal emnploymnent tax credit
had been adopted in 1975 with no other clzances in tax rate or ex-
penditures, then the GNP delator wouldl Iia-,e isen 6 percent il-
stead of 6.5 percent, and profits 5.5 percent instea ot 7 pe:wem.
The changes in the other variables would li ave differed accrdiig1v.



IPercent change



Employ- (real
menIt terms)





Profits profits

(Li L) (L)





(LaiL) (L) (Q) (P) (Y) (W) (WIP) (H) (nHP) (DEF)

0.00 0.75 0.40 -0.79 -0.40 -0.15 0.65 -0.53 0.26 0.10
.10 .77 .41 -.76 -.36 -.13 .64 -.63 .13 .08
.20 .78 .41 -.74 -.32 -. 11 .63 -.74 .00 .07
.30 .80 .42 -.71 -.29 -.09 .62 -.84 -.13 .06
.40 .82 .43 -.68 -.25 -.07 .61 -.94 -.26 .05
.50 .84 .44 -.65 -.21 -.05 .61 -1.04 -.39 .04
.60 .85 .45 -.63 -.18 -.03 .60 -1.14 -.52 .02
.70 .87 .46 -.60 -.14 -.01 .59 -1.24 -.64 .01
.80 .89 .47 -.57 -.10 .01 .58 -1.35 -.77 .00
.90 .90 .48 -.55 -.07 .03 .57 -1.45 -.90 -.01
1.00 .92 .49 -.52 -.03 .05 .57 -1.55 -1.03 -.02


(LB/IL) (L) (Q) (P) (Y) (W) (W!P) (11) (111P) Q)

0.00 0.46 0.24 -1.25 -1.01 -0.47 0.78 -2.87 -1.61 1.26
.10 .51 .27 -1.17 -.90 -.41 .76 -2.72 -1.55 1.15
.20 .57 .30 -1.09. -.79 -.36 .73 -2.57 -1.48 1.04
.30 .62 .33 -1.01 -.68 -.30 .71 -2.42 -1.41 .93
.40 .67 .35 -.92 -.57 -.24 .68 -2.27 -1.34 .82
.50 .72 .38 -.84 -.46 -.18 .66 -2.12 -1.28 .71
.60 .77 .41 -.76 -.35 -.12 .64 -1.97 -1.21 .60
.70 .82 .43 -.68 -.24 -.06 .61 -1.82 -1.14 .49
80 .87 .46 -.59 -.13 -.01 .59 -1.67 -1.08 .38
.90 .92 .49 -.51 -.02 .05 .56 -1.52 -1.01 .27
1.00 .98 .52 -.43 .09 .11 .54 -1.57 -.94 .16

In conclusion, the calculations show that if the credit is enacted
when other forces (Government or not) are expanding aggregate
demand, the equilibrium GNP can rise moderately without inflation.
The growing GNP will increase wages and profits as well as em-
ployment and output, and the cost to the Government will be slight.


A. Personal Income Taxes

A reduction in personal income tax rates is widely considered to be
a useful strategy for stimulating employment and real output during
slack periods of business activity. A cut in the personal income tax


(W P)












rate will increase conslnption expenditutre, aH(1 tlierelor(, sthwiinte
aggregate demand. 7The increase in aggregate delanl, a d( llore
specifically aggregate prices, leads to higher wage(, eillp)lov 71e 1t
and real output. Through hthe nlultiplier process la rger ijicoiln, lead
to higher levels of aggregate demand and ftlther rowth in enpl)oy-
ment. The entire scenario depends upon the i itai! li1wreae in p(re(
required to stimulate labor demaiid.s Labor stipply and pIhctive
capacity are presumed to be sufficiently flexible to a( ,(ointIIIodzte
these increases in demand.
These are familiar results of standard aggregate anialvsi-, adl
they describe a major disadvantage of a reduction iii per- olil taxes
as compared to an increase in the enplplopinent tax credit rate 1111(ler
similar economic conditions. With a VBE(C_, it is ls)05ible to (i(tly
expand emI)lovnent and real output withotit first stiintilatijug an
increase in aog regate demand and prices lts, eli)lowln(it tax
credit programs possess desirable features especially for those periods,
now commonly experienced by adIvanced industrial nations', wheN
prices and unemployment are concurrently rising.
A supposed disadvantage of the VBEC, as compared to personal
income taxes, is that employment credits will cause distortions 111
interfactor allocation of resources, favoring the hiring of workers
over capital. Thus, employment credits will p)resumably be les
neutral than personal income taxes with respect to their relative
impact on the allocation of resources.9 In our opinion, the temporary
nature of a VBEC will stimulate intertemporal reallocation of emlploy-
ment, rather than permanent substitution of labor for capital. The
subsidy will encourage firms to maintain employment and possibly
add to their work forces during slack periods. When the economy
expands, the base can be increased and eventually tle credit
B. Payroll Taxes
If there is any merit to an argument that selective taxes and credits
effect the long-term allocation of resources, it surely applies more to
payroll taxes which add over $100 billion annually to the cost of
labor. In the short run, however, an increase in payroll taxes is
analytically similar to a reduction in the VBEC. Both actions will
increase the cost of labor and contribute to downward pressure on
Our model predicts that the currently proposed policy of increasing
payroll taxes, while simultaneously reducing personal income tax
rates, will precipitate a decline in employment and an increase in the
price level. Basically, this proposal is the exact opposite of the numer-
ical calculation presented as Case 3. Given a reduction in the income
tax rate with a negative VBEC (that is, an increase in payroll taxes,
the signs in Case 3 will all be reversed.
7 In our model, personal Income taxes directly affect disposable in coime a ud~o v*,rnlnit
revenue; they do not directly affect either labor demand or labor supply. See the a piendix.
In a purely classical labor market, changes in the level ofa. agg.reate denia 1(1would
have no effect on employment and real output.
9 This argument has been offered in a recent Council of Economic Advisor's report v-w ic
is critical of job credit programs.


A short-run increase in labor costs resulting from higher payroll
taxes will encourage a reduction in the demand for labor. The stimu-
lus to aggregate demand provided by lower personal income taxes
may not be sufficient to offset the payroll tax promoted decline in
employment, and will contribute to rising prices. Thus, a Government
program intended to stimulate employment while simultaneously
increasing payroll taxes may instead contribute to unemployment and
rising prices. At the very least, the Government should consider the
timing of payroll tax changes and attempt to avoid increasing social
security and unemployment contribution taxes during periods of
declining economic activity.' We will say more about payroll taxes
in section 3.3.
C. IucNstment Tax Credit
The investment tax ('ledit reduces the price of capital goods and
thereby stimulates gross investment. Thus, an investment tax credit
seems to offer the same countercyclical advantages as the VBEC.1'
Compared to a VBEC, however, there are major drawbacks to using
an investment tax credit as a short-run stabilization tool.
The critical parameters for assessing the effects of credit policy on
capital and employment are price elasticities of demand and supply for
labor and capital, and the rates at which the use of these inputs can
be expected to change in response to changes in input costs. (Picou
and Waud.) Empirical evidence reveals that while price elasticities of
demand for labor and capital are of roughly similar magnitude, rates of
input adjustments are not. In particular, capital adjusts to changes in
relative prices, or to changes in output, at a much slower rate that
does employment 12 (Rosen and Nadiri, Hickman and Coen, Picou
and Waud.)
Therefore, the response by firms to a VBEC will be more rapid and
more complete than their response to an equivalent investment tax
credit. For example, it has been estimated that only 50 percent of a
once-for-all change in the relative price of capital will be absorbed
after five years; in contrast, nearly 80 percent of the adjustment
between actual and desired labor will be accounted for in the first
year.'3 Thus, the immediate impact of the VBEC on real output is
probably high, while the immediate impact of the investment tax
credit is slight.
An employment tax credit will stimulate many areas of the economy
where investment tax credits have little or no effect. For example,
such labor intensive' industries as services, wholesale and retail
trade have relatively small capital stock but employ twice as many as
the goods-producing sectors.

The pro-cyclical aspects of unemployment taxes are well-known. This tax, however,
is a small and declining portion of the wage bill while the relative Importance of social
security taxys,\ is ieceleratin z.
11 T he)reti Iasupport for selective investment tax credits and accelerated depreciation
was d ,rvid by Robert Hall and Dale Jorgenson ; an(d their work, which relies on neo-
chassical theory of capital accumulation, remains with only minor modification the basic
justification. See Hall and Jorgenson.
12 In our mod,. we assume that capital stock is fixed and that investment has no im-
mediate impact on aggregate supply. Thus, the only current effect that an increase in
the iveVtmont tax credit has in the model Is to increase aggregate demand. Even this
impct will e itigated if the government reduces purchases as a way to finance the
cre(i it.
3 Coen an iIickmiian (table 5, p. 297).

[aiiv proponents of ilV-esttiie .nt tax credits -defenld them h ot as a
short-run fi- cal tool, but for ttleir' growth iilltplicatioi s; however, in an
era when economists and conet'lvationists are (qulesiliifi 1ir e long-
tern emphasis on capit am f'eu'l t eeoloes, pub"c
policy ainedat increasing capital stock rat her than direct ,-tiiiill-
lating employment may be nii-lsguided. We recogi ize the n1100( ir new
capital for economic growth. Permanent invest men t tax credlit-
accelerated depreciation schemes, depletion lllowam iee as well as
con-inued increases in payroll taxes (the fastest growing soirce of
Federal revenue), act in the long run to encourage increases in file
capital/labor ratio. Recent empirical evidence reveals the elasticity
of substitution between capital and production labor, and between
energy resources and labor to be significantly positive. As an economy
develops it will continue to try and reduce the cost of its mnost ex-
pensive inputs; therefore, a policy to stimulate only investment miay
contribute to lower long-run employment as firms substitute toward
capital-intensive (and energy-using) techniques of production.

The primary purpose of an employment tax credit is to stabilize
and expand employment by encouraging firms to retain present
employees and to hire additional workers. Therefore, determination
of labor demand and supply conditions isimportant in predictingZ:7
the impact of a VBEC. In developing the aggregate model in section
2. some specific assumptions are made about the behavior of aggregate
demand and supply of labor as well as the prescribed employment
base. In section 3.2, the implications of these assumptions are ex-
amined at the level of the individual firm. In section 3.3, we discuss
two commonly cited aspects of labor markets which are not directly
incorporated in our aggregate model. The first of these concerns the
impact of the VBEC on the length of the workweek. The second
involves the effects of a VBEC when there is labor hoarding; that is,
when labor is treated as a quasi-fixed input possessing attributes
similar to those of capital. Finally, section 3.4 addresses the question
of administration and scope of the credit.
Under competitive conditions, the quantity of labor demanded
by a business firm is determined by wages, other labor costs, and the
value of the product labor produces. A reduction in the price of
labor, ceteris paribus, increases the quantity of labor demanded as
long as the net contribution to profit of the additional employment
is positive.
This is illustrated in figure 3.1. The short-run equilibrium level of
employment, L1, is determined where the market wage rate, W,
equals the demand for labor, D,.1 At this point, the cost of an addi-
tional worker, W, just equals that marginal worker's contribution
to the value of the firm's product.
Introduction of a VBEC can encourage the individual firm to
maintain or even increase employment when there is a decline in the
demand for labor. For example, if the price of output falls, then the
value of each worker's output is lower at all wage rates (the demand
for labor declines to D2). Under these conditions, employment is
ordinarily reduced to L2. If the firm receives a credit on the wage
rate, however, employment need not decline. If the credit reduces
'The demand curve for labor, known as the value of the marginal product of labor,
Is found by multiplying the price of the firm's product by the incremental output con-
tribution of each worker. Short-run demand for labor Is presumed to be downward sloping
because of diminishing incremental returns to labor.



LB L2 L1 employmen

the wage rate paid by the firm by s percent of the wage (to l(1-. )),
then employment remains at L1, rather than declining to L2. Larger
credits will induce employment increases beyond L1.
It is not necessary to credit the wages of all workers in order to
maintain employment at L1. In particular, whether the firm can be
induced to continue employment at L, depends on the prescribed base
of the program, LB. For all bases from zero to L2, (O>L, >L2), the
credit will be accepted and employment will remain at Li. This follows
because for employment rates from zero to LB, the fitm pays VV, which
is below the value of labor's marginal product. Once LB is reached, the
effective cost of labor drops to W(1-s), and employment will continue
to be profitable until L, is reached.
If the base is greater than L2, however, the credit may or mayr not
be accepted. As seen in figure 3.2, for LB>L2, the wage of LB-L2
workers will exceed the value of these workers' contribution to output,
by Area I. The question then becomes whether or not this loss in
profit is offset by the gain attributable to the employment of credit-
subsidized workers.
The maximum base under which the firm will accept the credit, an(
still be willing to hire L, workers, is where the profit lost by paying
LB--L2 workers a wage which exceeds the value of their added product
is just equal to the gain in profit attributable to employment L-LB.
If area I equals area II, then LB is that base.



W (l- s) .e.. . . . .- -D 2

L2 -T B L1 employment



A parallel ilVli- al)llie ( ilo dete,1Hni i11 the n1iiimber of additional
workers a firm wll hire when a credit is itrodluced without there first
beinz a decline in labor demand. For exaniple, in figure'3.2, if current
employlnent is L2, the firm would hire L, -L2 additional workers if a
\B E(i i introduced with base LB and credit rate of s percent of the
w ag e.
Thus far the anal ,-is has been confilned to the response of an idivi-
du1:al competitive firm which perceives the supply of labor as being
infinitely elastic. With over 7 percent of the work force currently
uuemploved, it is tempting to assume that the general level of wages
will not have to rise to prompt an increase in the quantity of labor
,-i pplied.
The short-run ao rebate supply of labor, however, is unlikely to
)e perfectly elastic. This follows because labor markets are hetero-
Zeneous, job information is imperfect, anl the opportunity cost of
entering the work force is the loss of transfer payment. Empirical
evidencesuilgrests that short-run elasticities of labor supply, while
appreciably higher than lonr-run elasticities, are finite. Estimates
made bv Lucas and Rapping, for example, indicate that a 1 percent
increase in the real wage will increase the quantity supplied of labor
from 1.7 to 4 percent. Therefore, if the VBEC increases aggregate
demand for labor, the wage rate must rise if employment is to in-
crease. The increase in the tax credit rate required to achieve a specified
increase in employment will be larger than for the infinitely elastic
case and will depend, as it (lid in the macroeconomic model, on
elasticities of supply and demand for labor. In general, the more in-
elastic labor demand and supply, the greater must be the credit to
achieve a given increment in employment.

The labor market analyst is presented in previous sections presumes
a direct, constant relationship between employment (number of
workers) and man-hours of labor services. Man-hours, however, are
the productive input which firms hire to produce goods and services
and are the conceptually correct measure of labor services. A definition
of man-hours is: man-hours equals utilization multiplied by employ-
ment, where utilization is measured as hours per day (week) and em-
ployment is measured as number of workers. Given constant utiliza-
tion (for example, an 8-hour workday), an increase in the number of
workers directlyy translates into higher man-hours and greater real
output. Whenever it is possible for firms to substitute hours worked
for employment, this simple, direct link no longer holds. Specifically,
man-hours will decrease if utilization falls and employment stays con-
stant; thus, there are different combinations of employment and
utilization which equal the same number of man-hours. For example,
80 employees working 7 hours per day yield the same man-hours as
70 employees working an 8-hour day. While man-hours in the above
cases are identical, 560, employment is 10 workers greater in the first
2Technically, manhours is a flow of labor services and employment Is a stock. Utiliza-
tion transforms the stock variable into a flow.

In terms of capacity of the ecnofiy, tl c n(feeptll'y pref(.rred
definition of unemployment is also a flow of man-hours of labor
services equal to the difference between in an -Iours offered (supplied)
and man-hours actually worked (demand1ed1). Reported uneinploy-
ment statistics, however, present a stock of workers rather tlman a
flow of man-hours. Unemployment, as reported by the Bureati of
Labor Statistics, is the difference between those who are ofFerino
labor services and those who are actually sellinii Sohe positive anlutiloi
of labor services. Specifically, a person wlio is willing to work inore
hours at a given wage than firms are willitig to I)lurcllase at that wage
is unemployed by the above definition; yet this unemployment isnot
reported in unemployment statistics.
During periods of declining business activity, many firms initially
reduce the number of hours worked per day per worker. Only after
this adjustment in utilization has been made are firms likely to begin
to lay off workers. Consequently, unemployment as a flow of man-
hours, will rise more quickly during contractions 'and fall more quickly
during expansions of business activity than reported unemployment.
There is substantial empirical support for this proposition. For
example, Rosen and Nadiri (p. 268) report that "* * patterns of
adjustment indicate that utilization rates are truly variable input ts
and that there is a hierarchy of adjustment speeds among stock-,
ranging from fairly rapid adjustment of production employment to
rather slow adjustment of capital stock."
Even after short-run utilization adjustments have been made
during a recession, firms may retain currently unproductive workers.
This behavior can be explained by the existence of certain nonwage
related labor costs which are associated with changing the level of
employment. The willingness of firms to hoard labor, that is, to main-
tain the level of employment even though these workers are not
producing real output, depends upon the hourly wage, and nonwage
costs of hiring, training, and firing (Clark). In general, the higher
the ratio of nonwage costs to wage costs, the longer it is profitable
for firms to hold nonproductive labor.3
Given this brief discussion of the relationship between man-hours,
utilization, and employment, what are the implications for a VBEC?
The answers depend, in part, on the policy objectives of the program.
If the purpose of the credit is to reduce the reported rate of unem-
ployment, it is possible to do this without increasing, and possibly
decreasing, man-hours worked. If the purpose is to maintain or expand
man-hours, this conceivably could be accomplished without large,
initial effects on the number of unemployed workers.
If a credit is offered as some amount per eligible worker, firms may
hire additional workers and reduce the length of the workday. That
is, firms might replace full-time with part-time workers, and thereby
receive tax credit even when man-hours and real output are falling.
Here, an employment tax credit will simply encourage substitution
of the eligible component of man-hours for the ineligible. Also, part
3 Extensive literature Is developing which treats employment as a quasi-fixed input and attemps to -
plain the apparent "labor hoarding" that occurs during contractions of business activity; see Oi, Ti Ih-
and Clark. Under a rather restrictive set of production conditions, Clark derives the maximum leiit (
time that it i profitable for a firm to keep a worker on the pdyrol! without having him work a9 t, equals ,,
plus f divided by W, where h is hiring cost, fis layoff cost, and W is the wage rate. In this formulatio., I
reduction of wages will increase the length of time a firm will honird labor.

of the program's cost will fall on employed workers who are forced
to take a reduction in hours worked. While it is unlikely that unions
will tolerate significant reductions in the workweek which penaze
established members and reward newer workers, this phenomenon
might develop in less organized sectors where the credit is likely to
have the largest impact.
If the credit is offered as some percentage of the hourly wage,
as we propose, it is possible that a firm will increase man-hours by
raising utilization for its current work force. Here, even if employment
does not change, there is an actual increase in labor services. Further-
more, as employed workers begin to work the normal hours per week,
the number of employed will be gradually adjusted upward.4
Specifically, firms begin to hire only when there is upward pressure on
utilization. As utilization begins to approach the normal rate, employ-
ment will typically increase since further efforts to expand utilization
will entail increases in the hourly wage.
Legislative proposals sometimes suggest offering a credit on the
hourly wage of eligible workers for a normal length workday.
While this approach may avoid some abuses, for example, substitution
of full with part-time employees, it also reduces a firm's ability to
shorten the workday while maintaining employment, or at least to
substitute utilization decreases for decreases in employment. A
VBEC that credits the hourly wage permits firms to decide for them-
selves the appropriate nix between utilization and employment.
Also, a percentage reduction of the wage rate will not distort the pat-
tern of expenditure between unskilled and skilled workers, in contrast
to a credit paid on each eligible worker.

The most efficient way to administer an employment credit program
is through the existing payroll tax system. As previously discussed,
an increase in a VBEC, which offers a percentage reduction on the
hourly wage, is identical to a short-run reduction in payroll taxes.
Thus, the most comprehensive way to administer a VBEC is to provide
employers a rebate against payroll tax liability. In effect, payroll
taxes are thereby adjusted to stabilize employment and output, that
is, they take on a countercyclical fiscal role. For political and psy-
chological reasons, the rebate can be called an "employment tax credit,"
and the bookkeeping can be separately kept from social security
Payroll tax rebates are preferable to providing a credit against cor-
porate profit tax liability since many firms have zero or insignificant
taxable income during periods of declining business activity, and those
are the periods when the VBEC is most needed. While a credit against
corporate profits can be deferred, it is easier and more immediate to
reduce payroll taxes which must be paid regardless of business
Another advantage of attaching the credit to the payroll tax structure
is the possibility of extending the coverage to encompass employment

For a complete. conceptual discussion of possible relationships between utilization and
employment, :el Grossman.


in nonprofit organizations and possibly State and local governments.
These institutions employ a growing percentage of the labor force and
presumably would respond to a wage bill subsidy in the same manner
as profit-motivated businesses. For State and local governments,
the subsidy against their wage bill can he considered a cheaper and
more efficient alternative to public service employment.


The purpose of this paper has been to examine policy implications of
a universally applied employment tax credit. The program is intended
to be a short-term supplement to existing fiscal and monetary policy
tools. The basic rationale of the program is to reduce the cost of labor
to business firns and thereby initiate an increase in the utilization of
labor. Presumably, the credit will be instituted during periods of
declining business activity, and during periods when actual employ-
ment is below potential employment. The major conclusions in this
investigation are:
(1) In the context of a standard multiequation macroeconomic
framework, our analysis and numerical calculations indicate that a
variable base employment tax credit will increase employment and
real output without necessarily increasing the aggregate level of
(2) In contrast to reductions in personal and corporate income taxes,
which act to expand aggregate demand and thereby aggregate prices, a
universal employment credit will increase both aggregate demand and
aggregate supply. Thus, under a variety of financing strategies, the
employment tax credit will have a dual impact on employment and
output, expanding both supply and demand. This dual impact will
typically help to mitigate price rises usually associated with an ex-
pinsionarv fiscal program.
(3) Much of the criticism of employment tax credit policy is predi-
cated on the assertion that short-run labor demand relationships are
not responsive to the price of labor services. We offer the following
response to this argument. There is not a body of empirical evidence
which points to zero price elasticities of demand for labor in the short
run. Even in the more capital intensive sectors of the economy such as
manufacturing, empirical evidence indicates that while price elasticities
of demand for labor are low, they are not zero (Coen and Hickman,
Rosen and Nadiri, Tinsley and Berndt, Kesselman and Williamson).
Also, given the general pattern of rising wages and employment ex-
perienced in the United States during the postwar period, it is un-
likely that price elasticities of demand can even be identified statis-
tically. Further, there are no reasons to believe, either conceptually or
empirically, that demand for labor is not responsive to changes in
price in the more labor intensive sectors of the economy where over
half the U.S. work force is employed.
(4) Another criticism of employment tax credit policy is that it will
provide windfall profits to business firms, particularly during the
expansion phase of business activity when firms are intending to
increase their utilization and hiring rates anyway. There are three
re'.ponses to this criticism. First, a variable base program calls for
adljustment of the credit base to accommodate changing business
conditions. The base can be decreased during declining periods of

business activity, and can be sharply increased during expanding
phases. Adjustment of the base requires careful administration, bult
will reduce the likelihood of windfall profits. Second, the full effect on
profits is a macroeconomic as well as a microeconomic phenomenon.
In all numerical calculations on the macroeconomic nodel, labor
income always increases in response to the credit; profits increase only
when the credit base is quite low, and only then under the more ex-
pansionary forms of government financing strategies. Finally, base
adjustment of the program appears to be an easy, immediate, and
effective method of changing the level of aggregate demand in the
economy. The program deserves consideration on this basis alone.
(5) Both employment and investment tax credits are intended to
encourage intertemporal substitution of inputs rather than permanent
substitution of one input for the other, that is, the credits are intended
to encourage firms to increase current levels of employment and
investment. There is considerable empirical evidence, however, that
employment tax credits will be more effective in this regard than
investment tax credits. In particular, employment adjusts to changes
in prices at a much faster rate than capital, and this characteristic of
employment will improve the performance of the employment tax
credit as a short-run policy measure. Also, employment credits may
stimulate employment of low income, marginally skilled workers who
make up a disproportionate share of the unemployed. It will also
stimulate employment in many areas of the economy where invest-
ment tax credits have little direct impact.
(6) The cost to the Government of an employment tax credit will
depend on labor market characteristics, the credit base, and the
method selected to finance the credit. A number of our calculations,
which use current U.S. tax parameters, reveals declines in the Govern-
ment deficit in response to a ceteris paribus increase in the credit, that
is, the credit-induced expansion of tax receipts and contraction of
unemployment benefits more than offset the loss in tax revenue at-
tributed to the program.

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Papers, Joint Econoniie Comimittee, U.S. Congress, pp. 497-540, W ashington,
D).C.:U.S. Government Printing Office, 1972.
Berndt, Ernst R., Jonathan R. Kesselman, and Samuel H. Williamson. "Tax
Credits for Employment Rather tha n Investment." Discussion Paper 297-75,
Institute for Research on Poverty, University of Wisconsin, 1975.
Berndt, Ernst R. "Tax Policy, Energy D~emand and Economic Growth." Full
Employment on a Small Planet, Mason Gaffney, Ed., Madison, University
of Wisconsin Press, 1976.
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and the Theory of Optimum Subsidy." Journal of Political Economy, 71
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Clark, C. Scott. "Labor Hoarding in Durable Goods Industries." American
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)emand and Production Functions." Review of Economics and Statistics
52 (August 1970):287-300.
Eisner, Robert. "Proposel for a Job Development Credit: A Tax Credit for
Investment in Human Capital." Working Paper, July 14, 1975.
Fethke, Gary C. and Samuel H. Williamson. "The effects of Employment Tax
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ployment on a Small Planet, Mason Gaffney, Ed., Madison, University of
Wisconsin Press, 1976.
Frisch, Ragnar. "Price-Wage-Tax-Subsidy Policies as Instruments in Maintaining
Optimal Employment: A Memorandum on Analytical Machinery to be Used in
Discussions on Causes of and Remedies to Unemployment." United Nations,
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Journal of Economics 72 November (1958):'496-514.
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V. 117: 34431-34432.
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We present here the aggregate model used for our analysis. There are 16 equa-
tions which include 6 identities, 8 behavioral equations, and two equilibrium
conditions. There are five parameters and nine qualitative restrictions.
The endogenous variables are:
Y =GNP or aggregate demand,
C = consumption expenditures,
I gross investment,
=government expenditures,
P =aggregate price level,
Q Ireal output (real GNP),
Y, personal income,
disposable income,
W =money wage,
L = actual work force,
LU =unemployed work force,
H = profit,
R =net government receipts,
D =deficit (+), or surplus (-),
i = interest rate, and
MD=demand for money.
The exogenous variables are:
Go =exogenous government expenditures,
L= =ful-employment work force,
Ln =base employment work force,
Ms= supply of money, and
K. =initial capital stock.
T=profit tax rate
The parameters include:
T=personal income tax rate,
k =investment tax credit rate,
s =employment tax credit rate, and
b = unemployment benefit, per worker.
Given these definitions, the model contains the following identities and be-
havioral equations.
(a) Accounting Identities:
(1) Y=C--I+G
(2) Y = WL+(l-T)w+Ws(L-LB)-,kI
(3) Yd=(1-t)Y+bLu
(4) n=PQ-WL-I
(5) It=tYpTH-Ws(L-LB)-kI
(6) D=G bLu-R
(b) Aggregate Demand Equations:
(7) C=C(Yd)
(8) I=I(i,k)
(9a) G= G 0
(9b) G= Go-Ws(L-LB)
(c) Aggregate Supply Equations:
(10) Q=F(L, K,)
(11) W(1-s)=PFL
(12) L=L(WP)
(13) LU=LF-L
(d) Money Market Equation:
(14) MD=M(Y,i)
(e) Equilibrium Equations
(15) MD= MS
(116) Y=PQ
Conventional assumptions are made regarding qualitative properties of the
model. These are: the marginal propensity to consume disposable income is
greater than zero and less than one; investment is a decreasing function of the
interest rate and an increasing function of the investment tax credit rate; the
marginal product of labor is positive and decreasing; labor supply increases


with respect to the money wage and decreases with respect to the price I(e-el;
and demand for money increases with respect to GNP and decreases with r e ct
to the rate of interest. The condition can be summarized as (subscripts indicate
partial derivatives):
OO, FL>O, FLL The first six statements in the model are identities which define aggregate de-
mand, personal income, disposable income, taxable profit, tax receipts and
government expenditures, respectively. Several explanatory comments are nee -
sary. Personal income, Equation 2, is wage income plus after-tax business profit-,
where after-tax profits include employment and investment tax credits. Employ-
ment tax credits, Ws(L-LB), are granted on that portion of the wage bill which
exceeds the prescribed base. An across-the-board credit on the entire work force
occurs when LB=O; and a credit on new workers only occurs when LB=L. Ihe
latter is termed a marginal employment tax credit. Intermediate cases occur with
O tion, a transfer payment dependent on the difference between the exogenously
defined full employment work force land the actual work force. Tax revenue,
Equation 5, is personal and business income taxes net of employment and invest-
ment tax credits. Equation 6 defines the deficit (or surplus) as government expendi-
tures plus transfers minus tax revenues.
Equations 7, 8, and 9 specify consumption, investment, and government ex-
penditures. Consumption varies with disposable income, while investment is
assumed to respond to the interest rate and the investment tax credit. Two alterna-
tives are offered as possibilities for explaining the behavior of government expendi-
ture. The first, Equation 9a, assumes government expenditures are set independ-
ently of the credit. The second representation, Equation 9b, has government
expenditures reduced by the loss in tax revenue associated with the credit. A
third possibility, which is not listed but which receives some attention in Section
2.3, is to have income taxes adjusting upward to offset the cost of the employment
tax credit.
Equation 10 postulates real output as a function of variable labor and initial
capital stock. With capital fixed in the short-run production function, gross
investment has no immediate impact on real output.' Labor demand, Equation 11,
presumes competition in the labor market, diminishing marginal productivity of
labor (FL), and includes the employment tax credit rate as a "shift" parameter:
an increase in the credit rate increases labor demand for all eligible workers.2
Labor supply, Equation 12, depends on the money wage and the price level.
Labor supply can be varied to take into account the relative awareness workers
have concerning the impact of prices on purchasing power.3 If workers are com-
pletely unaware of the impact of changing prices, they have "money illusion."
If, however, employment decisions are made on the basis of real purchasing
power, then aggregate prices are just as important as money wages in affecting
labor supply.
Demand for money, Equation 14, depends on the level of income and the
interest rate. Equations 15 and 16 are equilibrium conditions. Demand equals
the exogenously determined supply of money, and the value of real output equals
The variable base employment credit (VBEC) has a direct effect on several
key variables in the model, and these direct effects can readily be stated. First,
in Equation 11, an increase in the credit will reduce the wage cost to the firm for
eligible workers and thereby initiate an increase in labor demand. Second, in
Equation 2, an increase in the credit increases the after-tax-profits component of
personal income and therefore consumption. Finally, in Equation 5, the credit
reduces government revenue; and if Equation 9b is used, the credit also reduces
government expenditure. While it is possible to postulate these direct effects, the
complete response of these and other variables in the economy to an mncreate in a
VBEC depends on the full interaction of labor, commodity, and financial inarkets.
I This seems to be a plausible and empirically defensible short-run assumption. The implcation ef this
particular formulation will be considered when the investment tax cru(Lit is compared ,,ith an ernj o,,a a
tax credit in Section 2.4.
2 The likely impact of a wage reduction on short-run demand for labor is the most controversial asp
the program. Needless to say, if labor demand is unresponsiVi to changes in the wage rat,, n empho in 1
credit would have no effect. The response of the firm to the credit is consiIrd by Berndt, K:ssekn ., and
Williamson (1975). We discuss this question in Section 3.
3 More specifically, the labor supply function has the property OipLt : UPt. Claisica supply ocurs
when 6=0, which implies L w---LP. In this cse, the supply of labor is dt rmined by the r wag" .
In contrast, a complete "money illusion" occurs when =L, 11hich_ imples L.=0. In this case, worker
ignore the effects that aggregate prices have on purchasing power and vary tieir omfer of labor services only
in response to changes in the money wage. Intermediate cases oc'cur for ()


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