Guest Post by Arpit Gupta: Cut Taxes for the Long-Run Unemployed

by Arpit Gupta

The American labor system was once stingy but fair — unemployment benefits were low, but a tight labor market helped unemployed workers find jobs. 

That system has broken down entirely. With the unemployment rate persistently high for years — and the employment/population rate barely budging — there’s a new persistent class of long-run unemployed who face difficulties finding work. These workers benefit from extended unemployment benefits, but these are costly to the public and come with some moral hazard effects which discourage job-seeking. And now many workers are seeing terminated extended unemployment benefits without finding a job.

Several years of separation from the workforce induces hysteresis effects among workers. Psychological habits of diligence and effective work habits tend to break down and human capital starts to depreciate. Employers are reluctant to hire someone who has failed to find employment for several years, worrying that these workers will be less productive than a new graduate. 

This is one of the key reasons keeping job finding low for this group — the wage that employers are willing to pay for the long-run unemployed has plummeted, while the wages that such employees demand tends to be somewhat more sticky and hasn’t adjusted down enough. The labor market should clear at some wage; it’s just hard to find a wage mutually acceptable by both parties. 

One simple solution would be to break the wedge between the wage that employees get and the wage that employers pay. To do that, the government could announce that no income or payroll taxes would be collected for a period of several years among workers who have been unemployed for a certain period as of today. 

This way, job creation effectively carries a greater surplus that can be negotiated between employees and employers. Employers can simultaneously offer lower wages, while employees can take home a greater take home wage. Hiring the long-term unemployed suddenly becomes competitive with hiring new workers. While the government has to deal with foregone income; continued unemployment would have resulted in no tax revenue anyway besides generating a host of other public costs. This works as a direct boost to job creation that doesn’t require any additional fiscal allocations, and targets the precise friction keeping people unemployed. No subsidy is paid out unless a job is actually created. 

A key criticism is the worry that people might avoid employment in order to qualify for the no-tax benefit. That’s why it’s important to set the benefits for a clearly defined group of people — those who are unemployed for a certain period as of this date. There is the worry that governments will become addicted to the practice and extend the dates forward, and people will anticipate that and further avoid work. But these moral hazard problems exist with the current system anyway, since people can’t collect unemployment benefits while working. Hopefully creating incentives for working instead of incentives for not working will create a system with less moral hazard.

It’s hard to guess how effective this plan would be. Economists have studied work responses to wages — and many studies find that job entry and exit is responsive to wages. True, the long-run unemployed are already in the workforce, but evidence suggests the time they devote to job search is relatively small. Raising the incentives to work and hire would presumably be at least somewhat effective in boosting employment rates.