Singapore: "Automatic Stabilizers" Done Right By Bryan Caplan

Tax cuts are a popular cure for unemployment, but there are strong reasons to doubt that they are a good way to achieve this goal. As I explained a while back:

Where does the money come from? If the central bank prints up $1000 and the government uses it to cut taxes, spending goes up; but that is monetary policy in disguise. The interesting question is: What if you raise spending (or cut taxes) and hold the quantity of money constant? The basic possibilities: 1. You raise spending by raising taxes. This seems like a wash for total spending. (There is a sophistical argument about the Keynesian multiplier that says otherwise, but I won’t bother with it here). 2. You raise spending by borrowing. Again, this seems like a wash for total spending. If the quantity of loanable funds stays the same, the government borrows more and the private sector borrows less. If the quantity of loanable funds goes up because of higher interest rates, the government borrows more and the private sector consumes less. 3. You raise spending by printing money. Oh, wait, we ruled this out by assumption.

(Alex Tabarrok concurs; for a contrary view, see Mankiw; here’s my reply to Mankiw).

Imagine my surprise, then, when I discovered that Singapore has figured out a stunningly clever way to use tax cuts to reduce unemployment. Instead of focusing on stimulating demand, Singaporean tax policy hits the margin that matters: labor costs. When there is a surplus of labor, they cut employers’ share of the payroll tax (known in Singapore as the CPF). Details appear in Henri Ghesquiere, Singapore’s Success:

The government directly intervened to temporarily lower the cost of business in Singapore through… its power to lower the CPF contribution rate of employers… Elsewhere, substantial nominal currency devaluation is often the last and only resort in the face of downwardly sticky nominal wages, often with higher inflation as an undesirable side effect. In contrast, Singapore uses the direct intervention methods at its disposal. In addition, there is built-in wage flexibility, because an important portion of workers’ remuneration is automatically lowered if GDP falls short of target.

With flexible wages, of course, it doesn’t matter who legally pays the a tax. But the whole problem with recessions is that wages are somewhat sticky – you can have surplus labor for years before wages fall enough to restore full employment. By cutting employers’ share of the tax, the Singaporeans greatly speed up the wage adjustment process.

We should expect the Singaporean system to work very well. Suppose we conservatively assume that labor demand elasticity is only -.4. Then a 1 percentage-point cut in employers’ share of the payroll tax will roughly increase employment by .4 percentage-points. With a more optimistic elasticity of -1.0, every percentage-point cut in taxation would raise employment by 1 percentage-point. This approaches the Lafferian dream of tax cuts that fully pay for themselves. (In savings-obsessed Singapore, unsurprisingly, they also raise the payroll tax during booms).

Non-economists may have a hard time appreciating the genius of the Singaporean policy, so let me spell it out. If you want to change behavior, the smartest approach is to change the price most directly relevant to that behavior. If you want to cut carbon dioxide emissions, the smartest approach is not to start spending money like a drunken sailor on anything vaguely related to carbon dioxide. The smartest approach is to raise the price of emitting carbon dioxide. Similarly, if you want to reduce unemployment, the smartest approach is to reduce the price of labor. By cutting employers’ share of the payroll tax, Singapore does precisely that.

Question for Discussion: What would happen in the U.S. to a politician who proposed a tax cut for employers to reduce unemployment?