The lights from cars streak past the Rock N Roll McDonald's restaurant in Chicago on April 20, 2009. The New Jobs Tax Credit could give McDonalds a competitive advantage over its other competitors because it may be able to offer lower prices and spend more on advertising thanks to lower payroll costs. (AP/Charles Rex Arbogast)
The lights from cars streak past the Rock N Roll McDonald's restaurant in Chicago on April 20, 2009. The New Jobs Tax Credit could give McDonalds a competitive advantage over its other competitors because it may be able to offer lower prices and spend more on advertising thanks to lower payroll costs. (AP/Charles Rex Arbogast)

With the U.S. economy having lost 7.3 million jobs since the start of the Great Recession, there are many ideas being put forward for job creation. One of those ideas is to offer a version of a policy that was last seen on the national level during the presidency of Jimmy Carter: the New Jobs Tax Credit.

Proponents of this idea deserve praise for pursuing the worthy objective of creating jobs. But there are some basic problems with this particular way of doing it. The first is that the New Jobs Tax Credit’s effectiveness and efficiency at creating new jobs relative to other proposals is questionable. The second is that it does nothing to protect existing jobs, which is as important as creating new ones and may be easier to achieve. And the third is that it would arbitrarily favor some firms over others in a way that could be damaging to economic growth.

The basic idea of the policy is that firms receive tax credits for increasing employment above the employment levels they had at a specified past point in time. To offer a simple hypothetical example of one possible form of the policy, a tax credit could be allowed for 50 percent of the first $5,000 in wages of every employee in excess of the number employed by the firm as of November 15, 2008. Leaving aside various possible complications, a firm that had 10 full-time employees on November 15, 2008 and 14 full-time employees now would get $10,000 in tax credit.

There are a number of variants possible on this basic theme. The tax credit could be a high percentage of a small share of each employee’s wage, such as 50 percent of the first $5,000, or a smaller percentage of a larger share of each wage, say 15 percent of the first $100,000. The credit could be made available only for hiring the currently unemployed or for all new additions to employment. There could be a single benchmark date or the date could be fixed relative to the time when the credit is being taken, perhaps one year beforehand.

Start-up firms could be included or excluded, depending on how Congress balances concerns about the gaming of the system versus inclusiveness. The tax credit could be refundable or not refundable depending on policymakers’ concern about the appearance of government sending cash to firms that aren’t paying any corporate income tax. The rules to restrict the gaming of the tax break could be made stringent, making the credit more administratively difficult, or less-stringent, making gaming more likely. And, of course, the value of the credit could be adjusted to be modest or generous to create greater incentives or to save the public purse. Authors of different proposals offer different twists.

Whatever the design details, the premise of a New Jobs Tax Credit is that it will reduce the cost of hiring and encourage employers to expand employment. The evidence on how effective such an approach has been in the past is—it’s probably fair to say—inconclusive. The tax credit undoubtedly creates some jobs, but how many relative to other uses of public resources to boost jobs growth?

The evidence cited by proponents that many jobs were created by the Carter-era program is not strong. It amounts to some correlations that are not very persuasive as to cause and effect, especially as it relates to the magnitude of any increases in employment. The experience of state versions of the New Jobs Tax Credit is also not terribly encouraging. Whatever one thinks of evidence from these prior experiences, it’s not clear how applicable they are to current circumstances.

In general, lowering the cost of employment would certainly create jobs. But that doesn’t mean lowering employment costs is the best and most efficient way to create jobs or that a New Jobs Tax Credit is the best way to lower the cost of employment. Spurring more demand in the economy by boosting government spending or direct government hiring may be more effective than lowering the cost of employment in a private sector that is resistant to adding to its labor force under current market conditions. And even if lowering the cost of employment for private employers is a good choice, it doesn’t mean that the unique feature of a New Jobs Tax Credit—only offering a subsidy to employers who have a workforce in excess of what they had at an earlier point in time—is the most effective way to lower employment costs.

In fact, there are reasons to have serious reservations about this approach. The problem is that the New Jobs Tax Credit is based on a false premise and would introduce some damaging distortions into the competitive market—distortions that could significantly undermine any positive effects.

The idea of just subsidizing firms that are adding jobs above a baseline number seems to be based on the conceit that the credit would only go to new and additional jobs and would avoid subsidizing jobs that already exist or would have been created anyway. But, of course, the design of the tax credit doesn’t avoid the problem of subsidizing employers that would have created the jobs anyway. Indeed, most of the subsidy will certainly go to such firms. Just because an employer is hiring above a level it previously had doesn’t mean it wouldn’t have done that hiring without a tax credit. Even in a recession, firms are expanding all the time.

Sophisticated proponents of the tax credit recognize this, of course, but argue that the windfall to employers who would have hired anyway is worth the gain in jobs from those who hire only because of the tax credit. But once the idea that the credit is only supporting “new” jobs is discarded, then there’s little rationale for the New Jobs Tax Credit over other approaches that would more universally lower the costs of all jobs—a reduction in payroll taxes being the most obvious example. And there is a significant reason to prefer such approaches to the New Jobs Tax Credit. There simply isn’t any reason to treat jobs created by firms that have more employees than at some prior point in time as better than jobs saved through foregone layoffs or jobs created by firms that are growing but are at a lower level of employment than at some arbitrary benchmark date.

The New Jobs Tax Credit does nothing to reduce layoffs at shrinking firms or spur employment at firms that are growing but still have employment below previous levels. This is unfortunate as there is reason to believe it’s easier to get employers to keep employees that business conditions are making hard to keep than to get them to hire ones that business conditions barely suggest they hire—the tax credit, after all, will only influence close calls unless it is extraordinarily generous and expensive.

But there is a final and potentially more significant problem with the New Jobs Tax Credit—it arbitrarily favors some employers over others in a way that could undermine economic growth. At any given point in time—including even in a very weak labor market—there is a huge amount of variation in hiring within the private sector. Some employers are engaging in massive layoffs while others are increasing hiring. There are firms that cut back prior to the recession while others are cutting back through the recession and after. There are employers who have kept their employment constant during the economic downturn, firms that expand throughout the slump, and still others that start expanding part way through. By picking a benchmark date, and only offering the credits to firms that have more jobs than at that date, a New Jobs Tax Credit can give substantial competitive advantages to some firms over others for no sound economic reason. This could prove to be a substantial problem.

A specific case in point: The McDonalds food chain has announced that it intends to open 1,000 new restaurants in 2010. Most of the owners of these new franchises probably would qualify for a New Jobs Tax Credit for every employee hired to staff these restaurants. Of course, since McDonalds already unveiled its plans, those jobs are obviously not the result of a yet-to-be-passed tax credit. But leaving that aside, there’s another problem. The credit would give McDonalds a competitive advantage over Burger King, Wendy’s and its other competitors. McDonalds would be able to offer lower prices and spend more on advertising thanks to lower payroll costs due to the New Jobs Tax Credit. It would have a competitive edge not because it’s producing a better burger but because of the tax credit.

Indeed, the New Jobs Tax Credit could in fact end up costing jobs in the U.S. fast food sector as Burger King and others that could have competed against insurgent McDonalds close in the face of a competitive handicap.

The McDonalds example is handy because we know of McDonalds’ expansion plans. But, in general, the New Jobs Tax Credit creates winners and losers in the market based on an arbitrary line. It offers a cost advantage that has nothing to do with the efficiency of the firm. One can imagine a range of situations where this will create undesirable outcomes. Take a small manufacturing company that because of the timing of its contracts ends up with low employment at the benchmark point for the credit. Its competitor, however, happened to be in the middle of a contract at that time and hadn’t cut back significantly on production or laid people off. So when it’s time to bid on new contracts, the U.S. government would have just handed one company a significant labor cost advantage over the other even though the lucky manufacturer isn’t necessarily the better company—the timing of its employment ups and downs just was fortuitous.

This certainly isn’t just a problem in manufacturing. Let’s say a new office building opens next to an old one and gets the tax credit for all its staff while the pre-existing building doesn’t. The new building can undercut the rents offered by the existing building. A competitive advantage granted for nothing in return.

Another issue is how to treat start-up companies. It may well be necessary to exclude new firms from the New Jobs Tax Credit because of concerns about employers gaming the system by creating “new” companies that, of course, start with no employees, to avail themselves of the new tax credit. But if that happens then it would put bona fide new firms at a substantial disadvantage in labor costs to their established competitors.

There are entire industries where market distortions created by the New Jobs Tax Credit could play a significant role. Wal-Mart, for example, is expanding into more and more geographic areas. The competition waged between Wal-Mart and older grocery chains is intense. Wal-Mart in the past has won many of these battles, but the older grocers today are adapting and finding ways to compete—both on price and quality. Nevertheless, the older grocers are not in expansion mode. They are established enterprises filling long-established roles in their markets. Thus, should a New Jobs Tax Credit be enacted, Wal-Mart stores are much more likely to be able to benefit from it than the established grocers. Why should the U.S. government give Wal-Mart an edge? And if Wal-Mart simply replaces the older grocers, there won’t be any additional jobs created and might be fewer.

Another example is the automobile industry. General Motors, Ford and Chrysler are very unlikely to be able to benefit from a New Jobs Tax Credit, but that may not be the case for Toyota, Kia, Honda, and other manufacturers that are expanding production in the United States and have factories poised to open. U.S.-headquartered automakers today have to share a domestic market that they once entirely owned while also shedding multitudes of workers left over from an era of less productive manufacturing. And they are still suffering from a period when they offered poor products and lost market share.

In contrast, many foreign-based automakers are relative newcomers to the U.S. market—inevitably still in growth mode—and operating without the overhang of workers from a less productive manufacturing era. There’s no reason to give these foreign-based automakers a big break in their cost structure beyond what they earn from sound business practices. The success or failure of these automakers should be dependent on their business practices, on their ability to innovate, and on the quality and value of their products—not on the basis of them being in different places in their business lifecycle.

None of this would be good for the economy. In a constantly churning labor market, with some firms expanding, some contracting, some holding steady—and with the timing of when different firms are doing each constantly in flux—a New Jobs Tax Credit could cause close to as much harm as good.

Another problem with the credit is the potential for gaming, especially how to treat new firms. If one includes new startups then the potential for cheating to get the credit is huge. Firms that would otherwise be ineligible will re-constitute themselves as new ones so all jobs are “new” jobs in the new business for purposes of the tax credit. Or, at the very least, firms will separately incorporate new projects. Problem is, if new firms are left out, then that’s a potentially significant competitive disadvantage for startups.

Many employers, of course, already have various corporate entities, so one can picture them moving investments around to maximize their tax credit. Or work now done by contractors could be brought in house. Rules can be imagined to avoid the gaming of the system, but it’s hard to imagine that there wouldn’t be a lot of gaming that wouldn’t be stopped. There will undoubtedly be contracting done, lease back arrangements, and all the usual tricks of tax avoidance to get jobs to a corporate entity that can get the tax credit. And to the extent there are more rules it makes the credit harder to administer and harder for employers to take advantage of.

The bottom line on proposals for a New Jobs Tax Credit is that its peculiar design may create more problems than solutions. If the aim is to reduce the cost of employment in the private sector, then it might be better to just reduce the cost of employment for all jobs. Offering a tax credit for any firm against its payroll costs would encourage firms to both keep and grow their workforces. Even for those employers who get a tax credit for employees they were going to keep anyway, it takes pressure off wages at those firms. That is, it makes it more likely that employees won’t be subject to wage or benefit cuts and more likely they’ll receive wages increases. And that is also good for the economy.

The problem, of course, with both this idea and the New Jobs Tax Credit is that a great deal of the money would go to firms that don’t change their behavior. That’s true of virtually all firm tax incentives. The good news is that there are plenty of other ways to create jobs that don’t create large distortions in economic markets and that don’t give tax breaks to firms that are not creating any additional jobs.

Michael Ettlinger is Vice President for Economic Policy at the Center for American Progress. To read more about the Center’s job proposals please see our latest report, “Meeting the Jobs Challenge: How to Avoid Another Jobless—or Job-Loss—Economic Recovery.”

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Michael Ettlinger

Vice President, Economic Policy