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

Under the standard competitive model, a tax change affecting workers with highly inelastic labor supply, will lower earnings by the entire nominal employer share of the tax increase. If wages play a motivational role but the market still clears, the range of possible outcomes is broader but wages should still not rise if the tax is nominally divided 50/50. In contrast, because there is excess labor (involuntary unemployment) in equilibrium, efficiency wage models resemble models in which labor supply is perfectly elastic, and thus earnings rise by more than the worker's nominal share. 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 be highly inelastic. The results support 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.