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The Effect of the Payroll Tax on Earnings: A Test of Competing Models of Wage Determination

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  • Kevin Lang

Abstract

Under the standard competitive model, if a tax change affects a group of workers with highly inelastic labor supply, their earnings will fall by essentially the entire nominal employer share of the tax increase. Allowing the wage to play a motivational role but maintaining the market-clearing assumption broadens the range of possible outcomes. With a 50/50 split in the nominal share, given a reasonable estimate of the elasticity of demand, earnings could fall from anywhere between 0 and more than 100% of the employer's nominal share but would not rise. In contrast, because there is excess labor (involuntary unemployment) in equilibrium, efficiency wage models function very much like models in which the supply of labor is perfectly elastic, and thus earnings rise by more than the worker's nominal share. I argue that the 1968, 1974 and 1979 increases in the taxable earnings base for FICA provide good opportunities to test the models. This tax increase affected only those workers earning significantly more than the median earnings for male full-time/year-round workers. Such workers' labor force participation is likely to have been highly inelastic. In addition, low earnings workers did not experience this tax increase. I examine the effects of the earnings base increases using data from the March CPS and from the PSID. The results are supportive of models in which the motivational effects of wages are important but cannot clearly distinguish between the efficiency wage and market-clearing versions of those models

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 360.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:360

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Keywords: wage determination; efficiency wage; incentives;

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  1. Gibbons, Robert & Katz, Lawrence F, 1992. "Does Unmeasured Ability Explain Inter-industry Wage Differentials?," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 515-35, July.
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  3. Pisauro, Giuseppe, 1991. "The effect of taxes on labour in efficiency wage models," Journal of Public Economics, Elsevier, vol. 46(3), pages 329-345, December.
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  13. Krueger, Alan B, 1991. "Ownership, Agency, and Wages: An Examination of Franchising in the Fast Food Industry," The Quarterly Journal of Economics, MIT Press, vol. 106(1), pages 75-101, February.
  14. Cappelli, Peter & Chauvin, Keith, 1991. "An Interplant Test of the Efficiency Wage Hypothesis," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 769-87, August.
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  16. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-44, June.
  17. Rosen, Sherwin, 1987. "The theory of equalizing differences," Handbook of Labor Economics, in: O. Ashenfelter & R. Layard (ed.), Handbook of Labor Economics, edition 1, volume 1, chapter 12, pages 641-692 Elsevier.
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Cited by:
  1. Adriana Kugler & Maurice Kugler, 2003. "The labor market effects of payroll taxes in a middle-income country: Evidence from Colombia," Economics Working Papers 721, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Libor Dušek & Petr Janský, 2012. "The Impact of VAT Changes on the Households´ Real Incomes," Politická ekonomie, University of Economics, Prague, vol. 2012(3), pages 309-329.

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