Pure Price Effects of Nonwage Compensation

This paper discusses the pure static price effects which are engendered by tax preferences for nonwage compensation. Section II demonstrates that, because of these price effects, optimal consumption bundles will contain larger quantities of the goods included in nonwage compensation, and smaller quantities of other goods, than they would in the absence of tax preferences. In the presence of preferences, the cost of a compensation package to an employer usually differs from its value to an employee. Under proportional taxation, compensation packages which contain optimal quantities of nonwage compensation may be between 4% and 13% less expensive than cash compensation sufficient to purchase, at retail, consumption bundles providing similar utility. This difference represents a substantial savings to employers. It is largely attributable to reductions in tax payments, and may represent substantial foregone tax revenues. Optimal provision of nonwage compensation confers greater advantages under progressive taxation, advantages which increase with the degree of progressivity.These considerations are important in the analysis of any issue to which employee 'income' or employer costs are relevant. As examples, Section III demonstrates that conventional definitions of income unavoidably generate incorrect conclusions with regard to evaluations of welfare distribution, tax progressivity, and returns to human capital.