Factor Market Dynamics and the Incidence of Taxes and Subsidies

We extend work on payroll tax incidence by recognizing that labor markets adjust slowly because of the slow adjustment of both labor demand and supply to their equilibrium values. We modify the basic model of the incidence of payroll taxes with variable factor supply to include dynamic adjustments. We find that, under reasonable assumptions about the magnitudes of the lags in adjustment, it takes several years before half of the distance to a new equilibrium in wages and employment is reached. Thus, even if payroll taxes are borne by labor in the long run, a large part of any increase in the tax will be borne by capital for some time. For purposes of policy, the effects of payroll tax increases must be analyzed as if part of their effect is on profits, regardless of the long-run distribution of the burden.