Red Ink Rising, the Peterson-Pew Commission on Budget Reform’s report, presents the country with a fiscal/employment dilemma – Congress must act immediately to stem the federal debt, but it must move carefully lest it harm employment in the fragile economy. In short, we must act fast and slow – we must decrease the debt and increase employment. This is a difficult task.
The Peterson-Pew dilemma (notably its jobs-creation aspect) was taken to heart by both of the reform commissions that issued reports soon thereafter. The dilemma also appears to be have played a role in President Obama’s compromise with the Republican leadership in the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 (P.L. 111-312) – particularly the payroll tax cut enacted at section 601.
The Congressional Budget Office (CBO) places the payroll tax at the intersection of the policies that Peterson-Pew examines. CBO analysis suggests that by reducing the payroll tax we can increase employment. Payroll taxes are unique levies – employers and employees have shared burdens under this tax. If there is to be a reduction the important questions are: (1) which half should be reduced – the employees’ share, the employers’ share, or both, and (2) should the reduction be targeted generally (all employees, or all employers) or specifically (the unemployed)?
Section 601 of P.L. 111-312 provides payroll tax relief for employees (not employers). Relief is general, not specific. The CBO indicates that if the employers’ portion of the payroll tax had been targeted instead (and particularly if it had been targeted specifically at employers who increase employment), then both the jobs and the GDP impact would have been greater. Did President Obama’s compromise with the Republican leadership strike the right deal?
Section 601 creates jobs indirectly by providing workers with extra income to spend and thereby stimulate the economy. It reduces employee contributions to old age, survivor, and disability insurance (OASDI) under the Federal Insurance Contribution Act (FICA) tax by two percentage points to 4.2 percent for one year (2011). Similarly, the OASDI rate under the Self Employment Contributions Act (SECA) tax is reduced by two percentage points to 10.4 percent.
In light of the CBO study and the continuing need for employment, is a second shoe ready to fall? Should we expect to see a companion reduction in employers payroll tax contributions in a further jobs-creation effort in 2011? Will this work even better, or is section 601 really the best way to go?
Empirical evidence from the EU suggests that P.L. 111-312 got it right (as between general reductions in the employees’ and employers’ payroll taxes). The evidence gathered in a two-year policy experiment conducted in nine EU Member States also suggests that the CBO estimates of employment gains from employers’ payroll tax cuts cannot be supported (if they are targeted generally). If they can, risk-averse businesses almost always use tax cuts to increase profits, not reduce prices. The impact on employment is minimal to non-existent.
In addition, EU macro-economic simulations based on these findings also suggest that the best way to use payroll tax incentives to increase employment is to use them to directly reduce the cost of labor. This can be accomplished either (1) under mechanisms used in the HIRE Act (or as the CBO states, by limiting employers’ payroll tax cuts only to firms that increase employment) or (2) by targeting specific categories of workers (the unemployed) for an employees’ payroll tax cut that would be tethered to (used in conjunction with) an employers’ tax incentive to significantly reduce the cost of labor. This paper endeavors to bring EU analysis into the US payroll tax debate.
The CBO Study
The CBO study is drawn from earlier work. It has a comparative policy focus with cost metrics indicating both GDP and employment impact of eleven different options for increasing economic growth and employment in the short term. Three payroll tax options are considered. The least effective of these (measured in both GDP and job creation terms) is the one-time reduction of employees’ payroll taxes. Greater benefits are anticipated from a one-time reduction in employers’ payroll taxes.1 But, the greatest benefits are expected when a reduction in the employers’ payroll tax is closely targeted to firms that increase their payroll. This is essentially the option adopted under the HIRE Act.
The CBO did not consider a fourth option, eliminating the employees’ payroll tax
for select classes of workers (long-term unemployed) when they secure employment
under conditions that would warrant an employers’ payroll tax reduction under the HIRE
Act. Tethering an employees’ to an employers’ payroll tax reduction would lower the cost of labor by 12.4%, a reduction that approaches the estimates used in the EU macro economic simulations to produced the largest employment gains.
The CBO explains the GDP and jobs analysis as well as the differences in outcome among options. For example, the CBO analysis of a reduction in the employees’ portion of the payroll tax is straightforward.
A temporary reduction in employees’ portion of the payroll tax – would have initial effects similar to those of reducing other taxes for people below the 2010 income cap. The increase in take- home pay would spur additional spending by the households receiving the higher income, and that higher spending would, in turn, increase production and employment. Those effects would be spread over time, however, and the majority of the increased take-home pay would be saved rather than spent.
The CBO analysis of the impact of reducing the employers’ portion of the payroll tax is more involved. The CBO sees four likely permutations (or “channels”): Firms would probably respond to this temporary reduction in their portion of the payroll tax through a combination of four channels. First, some firms would respond to lower employment costs by reducing the prices they charge in order to sell more goods or services. Those higher sales would in turn spur production, which would then increase hours worked and hiring. Second, some firms would pass the tax savings on to employees in the form of higher wages or other forms of compensation, which would encourage more spending by those employees. However, wages tend to be inflexible in the short run because of negotiation and administrative costs, so that response is not likely to be very large. Third, some firms would retain the tax savings as profits. Higher profits would raise companies’ stock prices, and the resulting higher household wealth would encourage more consumption, although shareholders are likely to spend only a small portion of their gains. Higher profits would also dropped from 10.2 percent to 9.0 percent, a significant improvement. As the program expires in December, the rate, already at 9.3 percent, is rising again. According to the Treasury Department, businesses hired 5.6 million new workers who qualified for the HIRE Act between February and June. Also, businesses saved $6.2 billion in payroll tax reductions and will receive an estimated $4.2 billion in additional tax credits for retaining the formerly unemployed for at least one year.
Brandon Edwards, Congress: Don’t Wait to Extend HIRE Act Before it Expires, THE HUFFINGTON POST (December 21, 2010) available at: http://www.huffingtonpost.com/brandon-edwards/congress-dont-waitto-ext_b_799197.html improve cash flow, enabling firms facing borrowing constraints to buy new equipment. Fourth, some firms would use slightly more labor during a period when it was temporarily less expensive. However, most of the money forgone by the government would go to reduce employers’ taxes for existing workers, so-per dollar of forgone revenues-the added incentive to increase employment and hours worked would be small.
However, when the CBO then compares the employees’ versus the employers’ payroll tax reduction options, it not only selects the “first channel” on the employers’ side, it indicates that because the employers’ option mimics the economic effects of a cut in sales taxes that this option would have the greatest impact on spending, output and employment.
In comparison with the effects of reducing employees’ payroll taxes, the effects of reducing employers’ payroll taxes are somewhat larger per dollar of forgone revenues. Reducing employers’ payroll taxes for one year has an economic effect related to that of a temporary cut in sales taxes because a temporary reduction in prices (the first channel described in the section on reducing employers’ payroll taxes) would encourage purchases while the reduction was in effect. The effects on spending, output, and employment through this channel are estimated to be somewhat larger than the corresponding effects of increases in take-home pay from reducing employees’ payroll taxes.
Both this analogy (that an employees’ payroll tax cut is similar to a sales tax holiday) and its application to the payroll tax need to be refined. Critical in this review is the EU analysis under its multi-year experimental reductions in VAT for labor-intensive services. The EU effort was also directed at increasing employment.
The Moment of Truth
The National Commission on Fiscal Responsibility and Reform presented the results of eight months of deliberation on jobs and the debt crisis in December 2010. Among other recommendations it suggested consideration of “- a temporary suspension of one side of the Social Security payroll tax -” This is one of four provisions in The Moment of Truth that takes up the employment side of the Peterson-Pew dilemma. The plan accepts that it must foster an economic recovery simultaneously with its effort to solve the debt crisis.
The cost of this recommendation is estimated to be between “- $50-$100 billion in lost revenue (depending on the design).” This wide range of cost estimates reflects deep ambiguities in the proposal: (a) we are not told if this is a proposal for employer or employee tax relief, and (b) we have no idea if the intended relief is general or targeted.
These variables control the CBO’s cost estimates as well as the jobs created and GDP impact estimates of all payroll tax suspension proposals. The Moment of Truth appears to follow the CBO very closely, but it does not expressly say so. The most The Moment of Truth states is that, “- [the] CBO estimates that a payroll tax holiday of the magnitude [that is proposed by this plan] would result in significant short-term economic growth and jobs creation.”
Restoring America’s Future
The nineteen-member Debt Reduction Task Force of the Bipartisan Policy Center (BPC) presented its long-term plan for debt reduction and fiscal stability in November 2010. Chaired by Senator Pete Domenici and Dr. Alice M. Rivlin of the Brookings Institute the BPC plan, Restoring America’s Future, also responds to the “two huge challenges – recovery from the recession and restraining the soaring federal debt -[that] must be addressed simultaneously.”
In a pattern that is familiar, Domenici-Rivlin allocates the entire short-term economic revival as well as the jobs-creation function to a one-year payroll tax holiday. In this instance the proposal is for “- excusing employers and employees from paying the 12.4 percent tax (for one year).” Restoring America’s Future appears to advocate general payroll tax reductions – a complete payroll tax holidays for all employers and all employees. There is no stated effort to target employers’ tax relief, and no suggestion that employee relief could be tethered to targeted employer relief.
The statement of success in the effort to restore employment in Restoring America’s Future relies entirely on “- Congressional Budget Office (CBO) assumptions, [that] this will create between 2.5 and 7 million new jobs.” The Domenici-Rivlin proposal footnotes the February 2010 CBO study and underscores agreement with the CBO’s analysis:
The payroll tax holiday will apply to Social Security taxes paid by both employees and employers. For employees, the holiday will give workers a steady and predictable stream of additional take-home pay to boost their confidence and their consumer demand. For employers, the holiday will temporarily reduce their labor costs, giving them an incentive to hire new workers, or hire them sooner than they otherwise might have.
For such a critical aspect of the overall plan, one that is projected to cost $481 billion in 2011, one would have expected some independent analysis of the CBO’s study, or maybe a critical assessment of CBO assumptions. There is none. In fact, the entire payroll tax holiday discussion takes up no more than two pages in the one-hundred-andthirty-seven page report. Admittedly this is double the time allocated to the CBO’s assumptions in The Moment of Truth, but it does not pass scrutiny. What if the CBO is wrong, or what if the “reading” of the CBO’s analysis by these commissions is not accurate? What measure should we use to determine if these proposals make sense?
The CBO itself identifies a standard for measuring the success of a temporary suspension of the payroll tax – success is actual jobs creation. The CBO says – look at what happens when there is a temporary suspension of the sales tax.
This is a good yardstick (even though it only works on the employers’ side). The CBO explains that a temporary payroll tax holiday (for employers) is the economic equivalent of a temporary sales tax holiday as follows:
Reducing employers’ payroll taxes for one year has an economic effect related to that of a temporary cut in sales taxes because a temporary reduction in prices (the first channel described in the section on reducing employers’ payroll taxes) would encourage purchases while the reduction was in effect.
We need to clarify one point before taking up the CBO’s yardstick – what kind of sales tax are we talking about? Under the US retail sales tax (RST) the prices for goods and services are exclusive of the tax. Suspending the employers’ share of the payroll tax impacts the cost of goods and services (the cost of labor) before prices are determined. Thus, the preferred sales tax comparison for the CBO’s yardstick is to a system where final prices are inclusive of the sales tax. Examples of tax-exclusive and tax-inclusive sales taxes are helpful in understanding this point.
Tax-exclusive example. Assume that a supply normally sells for a tax-exclusive price of $100. If there is a 10% sales tax, then customers will pay $110. The sales receipt will indicate a $100 purchase price and a $10 sales tax. A sales tax holiday will reduce the total amount paid by the consumer by $10. The receipt will now show only the $100 price of the product. This will (theoretically) increase demand. To meet this demand businesses will increase production. If this supply comes from a labor-intensive industry, there will be a larger impact on employment, than if the supply comes from a capital-intensive industry.
Tax-inclusive example. In the alternative, assume a supply normally sells for a tax-inclusive price of $110. If $10 of this amount is a sales tax, the sales receipt will not (normally) break out the amount of the tax nor will it indicate the rate. The final consumer will simply see a sales receipt with $110 on it. A sales tax holiday in this case could reduce the price paid by the final consumer to $100 (if the retailer is willing to use the tax holiday to benefit his customers).
The commercial dynamics in a tax-exclusive sales tax system is very different from the commercial dynamics in a tax-inclusive sales tax system. The degree of consumer knowledge about pricing and taxes is very different. This is critically important. Consumer knowledge of pricing decisions constrains merchants in their ability to adjust prices.
In a tax-exclusive system the final consumer has a great deal of pricing knowledge. He is very aware of the base prices ($100), the amount of the tax ($10), and the fact that a tax holiday is in place. In these situations retailers find it difficult to increase base prices when the state removes the sales tax. Consumers expect to receive the benefit of a sales tax holiday. If consumers know the measure of that benefit, merchants hesitate to raise prices.
In a tax-inclusive system, even though the consumer may be aware of a tax holiday, they are much less aware of base prices and the amount of the tax. Because the consumer has always paid a tax-inclusive price, the consumer may not even demand to receive the benefit of the holiday, if prices remain the same. But even if the consumer demands the benefit of the tax relief, he does not have good information about the amount of the benefit he deserves. In other words, baseline prices are not as “sticky” under a tax-inclusive system as they are under a tax-exclusive system.
Application to payroll tax holidays. When a tax holiday is a function of the labor element in a supply it resembles a sales tax holiday in tax-inclusive system (like the EU VAT). It does not resemble a sales tax holiday in a tax-inclusive system (like the US RST).
Consumer knowledge about the labor element embedded in the cost of a supply is like consumer knowledge about the baseline prices of supplies in a tax-inclusive system – both are extremely unlikely. How would a consumer be able to measure the payroll tax element that is part of the cost of production? Because the value of tax relief embedded in the price is unknown, consumers have no leverage with retailers to demand to receive the benefit of the tax holiday. Being aware of a tax holiday is a much different thing than knowing value of the holiday embedded in a specific supply.
The EU Experiment:
A Reduced Rate of VAT for Labor-Intensive Services
The EU VAT is a multi-stage consumption tax. At its final stage, the business to consumer (B2C) stage, the EU VAT is indistinguishable from the US retail sales tax, except that it is a tax-inclusive rather than a tax-exclusive levy. As a result, a reduction in the EU VAT at the B2C stage presents a much closer match to a reduction in the employers’ payroll tax than would a sales tax holiday under a US retail sales tax.
Fortunately for purposes of this study, in 1999 the EU began experimenting with reduced rates of VAT in labor-intensive services for the express purpose of stimulating employment. Council Directive 1999/85/EC indicated:
The problem of unemployment is so serious that those Member States wishing to do so should be allowed to experiment with the operation and impact, in terms of job creation, of a reduction in the VAT rate on labour-intensive services -
The EU truly considered this an “experiment.” In line with the experimental nature of this measure each Member State that wished to participate was required to analyze their results and submit their findings to the Commission on or before October 1, 2002. The Commission in turn was required to present a “global evaluation report” before December 31, 2002. Nine Member States participated, and the rate reductions ranged from 15% (Belgium) to 9% (Spain and Luxembourg).
These are very sizable rate reductions compared with the 6.2% exemption considered by the CBO – the Belgian reduction is even higher than a combined employer and employee exemption. Not only are the rate reductions larger, but so too is the overall tax impact. The EU VAT reductions are applied to the entire underlying price of the supply, whereas under the options considered by the CBO the tax reduction is applied only to the wage component within the cost of the supply.
In language that closely echoes the CBO’s reasoning of the benefits of reducing the employers’ side of the payroll tax, the EU Commission sets out the underlying economic rationale for its experimental reduction of the VAT as follows:
The economic mechanism underlying the measure is based on the fact that if the final price of a product falls sufficiently, demand for that product will rise, all else being equal.
It is therefore essential for a reduction in VAT to lead to a fall in the consumer price of the service concerned. This price reduction should generate increased demand for the service. Increased demand should, in turn, lead to increased production. To increase production, jobs will be created, provided there are not other ways of increasing production.
Clearly, the link between reduced rates of VAT and job creation is not a direct one. The mechanism only works if certain conditions are fulfilled.
In particular, the reduction in VAT must be passed on in the consumer price by the vendor. Consumer prices must fall sufficiently to increase demand. The maximum possible price reduction is determined by the difference between the standard rate of VAT and the reduced rate applied. The increased production must be covered by hiring new staff, and not by raising productivity (which would mean producing more with the same number of employees) or increasing the working time of the staff already employed.
If the fall in the VAT rate is used by the vendor to increase his profits, the mechanism can no longer work as intended. In this case the reduced rate of VAT acts as a subsidy for a particular sector by reducing a tax which does not represent a cost to the firm.
Results of the EU Experiment
As required under Council Directive 1999/85/EC, the nine Member States that participated in this experiment submitted their findings to the EU Commission. The Commission submitted its “global evaluation report” to the Council and the European Parliament on June 2, 2003, along with Commission Staff Working Papers on the same day. A standard methodology for evaluating individual Member State experiences was
proposed by the Commission in April 2002, and the analytical framework was discussed and adopted at a July 2002 meeting. “The assessment [by the Member States and the Commission] was to test the validity of the assumptions and the effectiveness of the economic mechanisms on the basis of which the VAT reduction measure was introduced.”
The results were not expected to be good, in large measure because this topic had been explored before in the EU. The Staff Working Papers indicated that “[a] number of empirical studies have examined the effects of a cut in the rate of VAT, usually in comparison with other instruments. All have shown that VAT is never the best instrument, and that it is not very cost-effective.” Nevertheless, the Commission indicated that it was obligated to apply the new data to both steps in the analysis to determine if Council Directive 1999/85/EC was warranted or not. It needed to know: (a) if the reduction VAT passed through to final consumers, and (b) if the pass-through occurred, did it have a measurable impact on employment.
VAT reduction reflected in B2C prices. The results at the first stage are not encouraging. Frequently, the VAT reduction did not pass-through to consumers as a price reduction. The reason appeared to be that business owners tended to be risk averse. They preferred a sure profit today rather than waiting for increased demand to bring them gains down the road. The Commission indicated:
The first, essential step is for the reduction in rates of VAT to be passed on in consumer prices. If this does not happen at all, any increase in demand that might be observed would necessarily be the result of factors other than the VAT measure. When they conducted price surveys, Member States found that reduced rates of VAT were never fully reflected in consumer prices. Part of the VAT reduction is used to increase the margins of service providers.
In Luxembourg, for instance, 40% of hairdressing services and 80% of shoe-repair businesses did not pass on the VAT reduction in their prices. One possible explanation may lie in vendors’ aversion to risk. They prefer a risk-free approach (maintaining their prices at the same level and increasing their profits) to an approach involving risk (lowering their prices and hoping that increased demand will then increase their profits).
Employment impact from VAT reduction pass-through. The commission also found that there was no substantial impact on employment from the tax reduction. The countries that did report employment gains could not attribute the gains to the VAT.
France and Italy were the only countries to report sizable employment gains. The sector that benefited in both cases was the construction industry, but in both cases the gains came at a time when other direct tax incentives encouraged remodeling of homes. Spain experienced a similar effect, but in the small business renovations market. In Portugal and the United Kingdom increases in demand were not met with increased employment either because of difficulty in recruiting new workers or an inclination to resort to overtime. The Commission concluded:
Under these circumstances, none of the reports of the Member States that participated in the experiment provide any solid evidence of the VAT reduction measure having an impact on employment.
Overall conclusion. As a result the Commission concluded that Council Directive 1999/85/EC was not based on realistic assumptions about the impact of reduced rates of VAT on employment. It stated:
Price surveys carried out by the Member States indicated that the lower rate of VAT is passed on in consumer prices only partially or not at all. Furthermore, its impact on prices is generally only slight and does not appear to last. The mechanism of substantial price cuts leading to increased demand does not therefore work as envisaged by the Directive.
These results are also in line with the conclusions of previous studies. Compared with measures that directly target labour costs, the budgetary cost per job created by VAT cuts is always higher. What Does Work
The EU Commission did not stop with an analysis of the data submitted by the nine Member States that participated in the two-year VAT reduction experiment. It went further, and developed simulation hypotheticals for use in the Commission’s QUEST macro-economic research model. The question the Commission asked was:
How effective is a reduction in the VAT in terms of job creation compared with reducing labour taxes?
In other words, the question the Commission asked is: what is the most effective tax mechanism to increase employment – a direct or an indirect tax incentive? Should a direct reduction in the cost of labor be used to increase employment, or should indirect tax incentives be used (lowering prices that will increase demand for supplies and the employees that make them)? For purposes of the simulation the Commission assumed that under the indirect approach the reduced VAT was fully passed-through to consumers in a lower price.
In a US context this question is comparable to asking about the effect on employment of (a) directly reducing the cost of labor under programs like the HIRE Act, (or in terms of the CBO study the option of reducing employers’ payroll tax ONLY when that firm increases its payroll) or (b) indirectly using the payroll tax under the other two options in the CBO study (reducing all employers’ payroll taxes, or reducing all employees’ payroll taxes).
The results of the simulation strongly favor using tax incentives directly reducing the cost of labor to increase employment. The Commission Staff Working Papers explain:
In the first year, the impact on employment of a cut in labour charges is11% greater than that of a cut in the VAT rate. In the second year, there is a 55% difference in the effectiveness of the two measures in stimulating employment. Over the long term, there is a 52% difference in favour of reducing labour charges.
In other words, for the same investment by the State (1% of GDP) and assuming that a cut in the VAT rate is passed on in full, the impact on employment of reducing labour charges is 1.52 times greater than that of reducing the rate of VAT. Cutting labour charges therefore appears to be markedly more efficient as a means of job creation than reducing the rate of VAT.
What Happened Next in the EU?
Shown to be a failure as a method for increasing employment in the EU, one would have expected the experimental application of reduced rates to labor-intensive services to be abandoned, or replaced with a mechanism that would directly reduce the cost of labor. Instead, the experiment was extended several times, and eventually became permanent in 2010. Eighteen Member States have now taken advantage of applying reduced rates to labor-intensive services.
Additional studies, including a very comprehensive assessment of reduced rates by Copenhagen Economics, find no reason to continue the experiment. Supporters of reduced rates for labor-intensive services now support the provision on environmental grounds – encouraging labor-intensive repair services promote conservation efforts. The provision is now a classic tax expenditure item, supported on political not economic grounds.
The Peterson-Pew Commission’s Red Ink Rising made the US fiscal/employment dilemma very clear – debt must be lowered and employment must be increased simultaneously. The Moment of Truth report and the Restoring America’s Future report both accept this premise. Both suggest that some form of payroll tax holiday is necessary to solve the employment side of this dilemma. Both also appear to accept the GDP and employment metrics of the CBO on the impact of payroll tax holidays. However, in both reports the treatment of the CBO analysis is cursory, and does not reflect a great deal of independent assessment of the merits of the CBO assessment.
Fortunately, in 1999 the EU faced similar employment concerns, and sought similar indirect tax remedies in reduced rates of VAT for labor-intensive services. The EU studies confirm parts and contest other parts of the CBO assessment. In 1999 the assumption under EU Directives was that by reducing rate of VAT national governments could increase demand through lower prices, which would translate into increased employment in targeted sectors of the economy. The EU “experimented” with this theory for two years in nine countries. Although the experiment was a failure, a number of very relevant studies were produced at the national and EU levels of government as well as at independent research institutes.
Section 601 of the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 (P.L. 111-312) adopts one of the tax holiday options considered by the CBO. A partial (2%) one-year remission of the employee’s share of the payroll tax is less than the solution proposed in The Moment of Truth and the Restoring America’s Future reports, but it suggests that Congress may re-visit the CBO payroll tax options if a greater boost to employment is needed. As a result, it is appropriate to consider the EU assessment of similar tax-based solutions to unemployment. Applied to the CBO options, the EU studies suggest the following:
(1) Employers’ payroll tax holiday. A payroll tax holiday for all employers will most likely not lower prices for supplies and not lead to increased employment. Employers tend to be risk-averse, particularly in recessions, and in the nine EU countries that adopted these measures, employers used the tax relief to increase their profits, not to reduce prices.
This occurs in large measure because consumers are not able to determine the retail value of a tax holiday in a tax-inclusive VAT. When consumers lack the leverage to compel price reductions, retailers feel free to maintain pre-tax holiday prices. Retailers retain the benefit of the tax margin. This is exactly what occurs when suppliers are granted payroll tax holidays on wages that are embedded in the cost of supplies. Without pressure to lower prices, the retailers keep the tax relief as profit.
(2) Employees’ payroll tax holiday. The EU studies offer no insights here. There is nothing comparable to an across-the-board employees’ payroll tax holiday under the EU VAT. However, if wage earners are more likely to spend payroll tax holiday amounts on new consumption than are the employers at (1) above, then an employees payroll tax holiday would have a greater impact on demand in the economy, and possibly a greater impact on employment.
This seems to be the policy premise behind section 601 of P.L. 111-312. If anything, the EU “experiment” in reduced rates of VAT suggest that rather than being more significant than an employees’ payroll tax holiday, the employers’ payroll tax holiday has a much less (if not non-existent) impact on employment.
(3) Targeted employers’ payroll tax holiday. If a tax holiday is targeted to reduce the cost of labor the EU macro-economic models indicate that the impact on employment is 52% higher than what would occur under a general tax cut. This result confirms the finding of the CBO that a payroll tax cut for employers-that-increase-their-payroll produces significantly greater employment gains than any of the other options. This was the approach under the HIRE Act, and it appears to have worked.
The complexities of targeting the employer who does the hiring runs into a number of difficulties including (1) would start-up be eligible for the tax holiday; (2) how would an increase in employment be determined – on a quarterly basis where employment would be compared to the previous quarter, or to the same quarter the previous year; (3) how would the comparison be carried out in cases of layoffs, termination of workers for cause, downturns in demand for products or services that resulted in employment cut-backs, (4) would a previously terminated worker be considered a “qualifying new hire” if he was re-hired, or would there be rules on “churning” of employees, (5) what would the treatment be for reorganization, mergers, spin-offs, business closures, or “new starts.”
(4) Targeted employees’ payroll tax holiday. This option is not considered by the CBO. The EU models however suggest that if a payroll tax cut is fashioned so that it lowers the cost of labor then it will have a significant impact on employment. To accomplish targeting like this under an employees’ payroll tax cut would amount to “targeting” the unemployed. As such, each qualified unemployed individual would be allowed to retain the payroll tax upon securing a position for a designated period of time (a flat period grant could be adopted, or a graduated measure indexed to the period of unemployment). Although an individual in this position would be inclined to lower his/her demands for compensation (lowing the cost of labor), this might not be a strong incentive for an employer to make a hiring decision.
(5) Tethering an employers’ payroll tax holiday to a targeted employees’ payroll tax holiday. This option is also not considered by the CBO. Targeted individuals (certain classes of the long-term unemployed), could be granted a payroll tax holiday both for themselves and for their employer. The employer’s holiday would continue as long as the employment relationship continued (but not more than a year, or some other period), and would move with the employee to a new employer if employment changed. Tethering in this manner would resolve the complexities under the option at
(4) above. It would be sufficient under this option for the unemployed individual to continue to be employed for the benefits to continue. The impact of this option would similar to that under the HIRE Act, but the relief would be doubled to 12.6%, and would represent a considerable reduction in the cost of labor.
 Peterson-Pew Commission on Budget Reform, Red Ink Rising: A Call to Action to Stem the Mounting Federal Debt (December 2009) available at: http://budgetreform.org/
 Six steps are specified in the Peterson-Pew study. The first two – commit immediately to stabilizing the debt at 60% of GDP by 2018 and develop a specific and credible debt stabilization package in 2010 – convey urgency, but neither requires spending cuts or tax increases. Real action is delayed until 2012. The third step – begin to phase in policy changes in 2012 – is where real fiscal change occurs. The reason for the delay is clear. “- [M]aking aggressive changes any earlier could harm the economic recovery, particularly with unemployment reaching a 25-year high in 2009.” Id., at 5. The same measured steps and concern with the economic recovery is apparent in the follow-up report, Peterson-Pew Commission on Budget Reform, Getting Back in the Black (November 2010) available at: http://budgetreform.org/
 National Commission on Fiscal Responsibility and Reform, The Moment of Truth (December 2010) available at: http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_20 10.pdf; The Debt Reduction Task Force (Domenici/Rivlin), Restoring America’s Future (November 2010) available at: http://www.bipartisanpolicy.org/library/report/restoring-americas-future.
 Eric Kroh, Obama Signs Tax Cut Compromise Package into Law, TAX ANALYSTS (Dec. 20, 2010) 2010 TNT 243-1; Doc 2010-26894 (“Originally the president had hoped to extend the Making Work Pay credit but dropped the provision in favor of the payroll tax cut during negotiations with Republicans.”)
 Douglas W. Elmendorf, Director, Congressional Budget Office, Policies for Increasing Economic Growth and Employment in the Short Term (February 23, 2010) [Testimony prepared for the Joint Economic Committee, U.S. Congress] available at: http://www.cbo.gov/ftpdocs/112xx/doc11255/02-23Employment_Testimony.pdf; Congressional Budget Office, letter to the Honorable Robert P. Casey Jr. providing information on various approaches to reducing employers’ payroll taxes to encourage employment (February 3, 2010) available at: http://www.cbo.gov/ftpdocs/110xx/doc11042/02-03CaseyLetter.pdf.
 Mark Robyn, The Impact of the Payroll Tax Cut on the Economy, in Tax Foundation Press Release, Tax Foundation Experts on Passage of Obama Tax Package (December 17, 2010), available at: TAX ANALYSTS Doc 2010-26987 (“If consumers spend all or much of the extra cash it would definitely be a boost to the economy, but we don’t really know if taxpayers will actually spend the extra money. The Congressional Budget Office and many economists are optimistic about the stimulative effects of such a policy, but there is some uncertainty.”)
 Congressional Budget Office, Policies for Increasing Economic Growth and Employment in 2011 and 2011 (January 2010).
 The eleven options are: (1) Increasing Aid to the Unemployed, (2) Reducing Employers’ Payroll Taxes, (3) Reducing Employers’ Payroll Taxes for Firms that Increase their Payroll, (4) Reducing Employees’ Payroll Taxes, (5) Providing an Additional One-Time Social Security Payment, (6) Allowing Full or Partial Expensing of Investment Credits, (7) Investing in Infrastructure, (8) Providing Aid to States for Purposes Other than Infrastructure, (9) Providing Additional Refundable Tax Credits for Lower-and-Middle Income Households in 2011, (10) Extending Higher Exemption Amounts for the Alternative Minimum Tax, and (11) Reducing Income Taxes in 2011.
 Among the eleven policy options considered those dealing with reduction in payroll taxes are the second, third and fourth best. Only increasing aid to the unemployed has a greater impact on employment. Douglas W. Elmendorf supra note 5 at 13, Figure 2.
 According to the CBO, reducing employee payroll taxes (in 2010) will positively impact GDP somewhere between $0.30 and $0.90 per dollar of payroll tax foregone. The CBO also estimates that new jobs will be created. For each $1 million in employee payroll tax foregone 2 to 4 new jobs would be created in 2010 and 3 to 9 new jobs in 2010 to 2011. New jobs creation is expected to be short term, as over the 2010 to 2015 time frame the jobs creation impact will fall to between 2 to 7 new jobs per $1 million in payroll tax foregone. The CBO explains this drop as follows: The estimates include the effect of fiscal policy actions on monetary policy actions on monetary policy, reflecting an expectation that the Federal Reserve would gradually begin to offset such fiscal policy actions at the end of 2011 in order to avoid increasing the risk of inflation; as a result, some policies would generate cumulative effects on employment that were lower for 2010 through 2015 than for 2010 through 2011. See: Douglas W. Elmendorf supra note 5 at 11-15, Table 1 & Figure 2.
 The CBO indicates that reducing employer payroll taxes (in 2010) will positively impact GDP somewhere between $0.40 and $1.20 per dollar of payroll tax foregone. The CBO also estimates that new jobs will be created. For each $1 million in employee payroll tax foregone 3 to 5 new jobs would be created in 2010; 5 to 13 new jobs in 2010 to 2011; and 4 to 11 new jobs in the 2010 to 2015 time frame. Id.
 The CBO indicates that reducing employer payroll taxes for employers that increase their payroll (in 2010) will positively impact GDP somewhere between $0.40 and $1.30 per dollar of payroll tax foregone. The CBO also estimates that new jobs will be created. For each $1 million in employee payroll tax foregone 5 to 9 new jobs would be created in 2010; 8 to 18 new jobs in 2010 to 2011; and 7 to 16 new jobs in the 2010 to 2015 time frame. Id.
 The Hiring Incentives to Restore Employment (HIRE) Act (P.L. 111-147) was signed into law March 18, 2010. Under the Act employers are eligible for a payroll tax credit when the employer hires certain new employees after February 3, 2010, and before January 1, 2011. In order to take the payroll tax credit, the employee must have either been unemployed for at least 60 days prior to hire or worked fewer than 40 hours for another employer during the previous 60 days. Employers do not pay the employer portion of social security tax on wages paid to eligible new hires. The HIRE Act was not “extended” in the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, and was effectively replaced by the employee payroll tax cuts under section 601. There are indications that the HIRE Act was effective in increasing employment: The numbers show that the program may have been a factor in the drive for increased employment. In the first eight months of the program, the national unemployment rate
 Id., at 16.
 The four “channels” are not equal. Only the first, reducing prices, is not qualified by a “however” expression reflecting the CBO’s belief that the first channel is the most likely to occur.
 Id., at 14 (emphasis added).
 Id., at 17 (emphasis added).
 The Moment of Truth, supra note 3, at 43 (emphasis added).
 The other three elements are far less specific: (1) reduce the debt gradually to avoid “shocking the fragile economy,” (2) put in place a credible plan to stabilize debt (the “announcement effect”), and (3) implement pro-growth tax and spending policies (simplifying the code, broadening the tax base, and moving to a territorial system). Id.
 Restoring America’s Future, supra note 3, at 2.
 Sustaining the economic revival over the longer term is the function of the simpler, pro-growth tax system that Domenici-Rivlin develops, and that involves corporate and individual income tax rate reductions, tax expenditure eliminations, and a 6.5 percent VAT (called the Debt Reduction Sales Tax).
 Restoring America’s Future, supra note 3, at 16 (emphasis added).
 Id., at 16 (emphasis in original).
 Id., at 27, n. 2.
 The Domenici-Rivlin proposal does not mention, analyze or comment on the CBO observation that there could be four “channels” open to employers that received a temporary exemption from the payroll tax – they could use the funds to (a) lower prices, (b) increase wages, (c) increase profits, or (d) hire temporary labor. (Douglas W. Elmendorf supra note 5, at 13-14). Instead, the Domenici-Rivlin proposal echoes the CBO’s later assumption that employers will use the tax remission primarily to lower prices (Douglas W. Elmendorf supra note 5, at 17).
 Id., at 27.
 Douglas W. Elmendorf supra note 5, at 17 (emphasis added).
 In fact, the rate in this example would need to be 9.09%. Where a tax-exclusive rate refers to the amount of tax paid as a proportion of the pre-tax value of what is taxed, a tax-inclusive rate refers to the amount of tax paid as a proportion of the after-tax value. A tax-inclusive rate is always lower than the tax-exclusive rate. The tax-inclusive rate is determined by dividing the tax (in this case $10) by the total cost to the consumer (in this case $110).
 This is a fortunate turn of events. Not only are there no studies on the impact on employment of a sales tax holiday under the US retail sales tax, there are also no instances where a US sales tax holiday has lasted more than a week-end or two. The normal US sales tax holiday is designed to assist parents in purchasing back-to-school supplies for their children in late August. Most proposals for payroll tax relief are for a full year. Thus, not only is this “experimental” reduction in the VAT a better theoretical “match,” but it is (like the payroll tax holiday proposals) an effort to stimulate employment through tax relief over a sustained period of time (two years or more).
In addition, the EU VAT reductions were targeted at “labour-intensive services.” The reduced rate of VAT is aimed at the same factor of production as the payroll tax – labor. In the EU VAT “experiment” we are looking at a 15% to 9% tax reduction almost entirely on labor and the underlying economic assumption is that this reduction in tax on labor will lead (through marketplace reactions) to a demand for more labor, and therefore for more employment in this sector.
 Council Directive 1999/85/EC of 22 October 1999 amending Directive 77/388/EEC as regards the possibility of applying on an experimental basis a reduced VAT rate on labour-intensive services, 1999 O.J. (L 277) 34, Preamble (2).
 Id., at Art 1.
 Id., at Art 1.
 Belgium (reducing rates from 21% to 6%), Greece (reducing rates from 18% to 8%), Spain (reducing rates from 16% to 7%), France (reducing rates from 19.6% to 5.5%), Italy (reducing rates from 20% to 10%), Luxembourg (reducing rates from 15% to 6%), Netherlands (reducing rates from 17.5% to 6%), Portugal (reducing rates from 17% to 5%), and the United Kingdom (reducing rates from 17.5% to 5%).
 Report from the Commission to the Council and the European Parliament, Experimental application of a reduced rate of VAT to certain labour-intensive services, COM(2003) 309 final.
 Commission Staff Working Paper, Evaluation report on the Experimental application of a reduced rate of VAT to certain labour-intensive services, SEC(2003) 622.
 Id., at ANNEX
 Id., at 4.
 Id., at ∂ 5; citing The Potential Impact on Employment Creation of Fiscal Instruments (namely of a reduced VAT rate for selected sectors), Cambridge Econometrics and the Institute for Employment Research, University of Warwick (September 1996); Effets macro-èconomiques et budgètaires de l’application du taux de TVA rèduit ‡ certains services, Belgian Federal Planning Bureau, Working Paper No 6-98 (July 1998); and a Irish VAT reduction from 21% to 20% applied generally in 2001.
 This pass-through element is probably the critical difference between a tax holiday in a tax-inclusive sales tax (like the EU VAT) and a tax-exclusive sales tax (like the US RST). As indicated above, tax-exclusive systems have “sticky prices” when a tax holiday is introduced. It is relatively safe to assume in these systems that the full amount of the tax holiday is passed-through to final consumers in a price reduction. The same is not the case under tax-inclusive systems like the EU VAT or like the payroll tax holidays considered under the CBO study, The Moment of Truth and the Restoring America’s Future proposals. In these situations the benefit of the tax holiday can more easily be captured by the business owner through a price increase that the final consumer will not resist.
 COM(2003) 309 final, supra note 36, at 23 (emphasis added).
 Id., at 24.
 Id., at 25.
 QUEST is the global macro-economic model of the Director General of Economic and Financial Affairs of the European Commission (DG ECFIN) that is used for macro-economic policy analysis and research. See: http://ec.europa.eu/economy_finance/research/macroeconomic_models_en.htm
 SEC(2003) 622, supra note 38, at 26.
 This assumption is clearly unrealistic, based on the results of the nine countries that participated in the EU experiment. It does however give the advocates of indirect tax incentives the full benefit of the doubt, and converts the simulation exercise to an assessment of what would happen under a tax-exclusive system (like the retail sales tax).
 Id., at 27.
 Council Directive 2004/15/EC, 2004 O.J. (L 52) 61, extending the “experiment until December 31, 2005; Council Directive 2006/18/EC, 2006 O.J. (L 51) 12, extending the “experiment” until December 31, 2010. 48 This assumption is clearly unrealistic, based on the results of the nine countries that participated in theEU experiment. It does however give the advocates of indirect tax incentives the full benefit of the doubt,and converts the simulation exercise to an assessment of what would happen under a tax-exclusive system(like the retail sales tax).49 Id., at 27.50 Council Directive 2004/15/EC, 2004 O.J. (L 52) 61, extending the “experiment until December 31, 2005;Council Directive 2006/18/EC, 2006 O.J. (L 51) 12, extending the “experiment” until December 31, 2010.
 Council Directive 2009/47/EC, 2009 O.J. (L 116) 18.
 Council Directive 2006/774/EC, 2006 O.J. (L314) 29, adding the Czech Republic, Cyprus, Latvia, Hungary, Malta, Poland Slovenia, and Finland. Council Decision 2007/50/CE, 2007 O.J. (L 22) 14, adding Romania.
 Copenhagen Economics, Study on reduced VAT applied to goods and services in the Member States of the European Union, final report, (June 21, 2007) 6503 DG TAXUD, available at: http://ec.europa.eu/taxation_customs/resources/documents/taxation/vat/how_vat_works/rates/study_reduce d_vat.pdf.
 As of the writing of this paper there are signs that the employment picture in the US is improving. “Surveys showing faster-than-expected jobs growth and a boost for the services sector bolstered confidence that the US economic recovery has shifted into high gear.” James Politi & Shannon Bond, Jobs Data Increase Confidence in Recovery, Financial Times 1 (January 6, 2011).
 This task is not easily accomplished, and may account for the preference in section 601 of Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 (P.L. 111-312) for general payroll tax relief for all employees.
Previously published by the Boston University School of Law, January 2011