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

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