This is truly garbled theory. Payroll taxes are not similar to so-called consumption taxes: and they can be no more passed on in the form of higher prices than can taxes on profits. The only thing approaching reality in this dog’s dinner of a paper is the suggestion that “a payroll tax can be passed on to employees as lower wages”.

Let us do what the authors failed to do and that is base our case on basic economic theory, according to which factors of production tend to be paid the full value of their marginal product. Now marginal productivity theory is normally interpreted as meaning that if factors are paid in excess of their marginal product enforced idleness will emerge. What this amounts to is that a payroll tax is exactly the same as a union-enforced pay rise.

Strangely enough, some economists cannot accept the logical conclusion that payroll taxes are also part of labour’s wage on the perverse grounds that, unlike superannuation*, labour does not benefit directly from payroll taxes. By the same token, their logic concludes that if a government transformed super contributions into a payroll tax they would then cease to be part of the labourer’s gross wage.

Now the gross wage is what employers have to pay for labour. Where additional charges or oncosts have not been imposed on hiring labour then the gross wage (the price of labour) to the employer will equal the employee’s gross wage. However, when governments mandate additional labour charges, say medical benefits and social security taxes, the immediate effect is to lower firms’ net revenue. In the longer run the market factors these charges back to labour by creating a wedge between what employers pay for labour and what labour actually receives.

So while the gross wage the employer must pay remains the same, at least in the long run, the employee’s net wage will fall by the amount of the mandated oncosts. Therefore payroll taxes resolve themselves into income taxes.

Something that is never stressed but should be is the fact that in a free market the tendency for labour to earn the full value of its marginal product always reigns. Now anything in excess of this will cause unemployment to emerge. It follows that additional oncosts are either factored backwards into lower net wages for employees or unemployment must emerge if employees successfully resist the factoring process.

This is because the effect of resisting the wage rate adjustment is to maintain gross wage rates above their market clearing values, even though employees sincerely believe their gross wage rates have not changed. It is obvious that a payroll tax (or any kind of oncost) cannot influence the demand curve for labour, i.e., its schedule of descending marginal productivities, so how can labour costs be raised without generating unemployment?

(That employers should instinctively understand this process is to be expected. That some Australian economists have yet to come to terms with it leaves one in despair).

There are basically only two alternatives to this article’s thesis: either companies absorb the oncosts or they are passed on to consumers in the form of higher prices. The first alternative would make wages and profits indeterminate, which is what the Cambridge school wrongly argues, and marginalism a false theory. The second alternative has widespread support and owes its persistence to a lingering attachment to the discredited cost-of-production theory. Yet modern economics has demolished this as an alternative explanation.

That so many economists subscribe to this erroneous view bewilders me. For payroll taxes to be shifted forward certain conditions would have to be fulfilled, none of which contradict the argument. One condition is that companies must have been under pricing their goods: in other words, they had decided not to maximise their net revenues. As one would expect, no one uses this argument. This only leaves the demand for money and the money supply. If these remain unchanged then attempts to pass on additional labour costs will only cause output to drop and unemployment to rise.

America has provided us with a handy example of this factoring process. Anti-marketeers have in the past frequently pointed to the apparent decline in real wages in America as evidence that free labour markets depress real wage rates. Yet if we look at gross wages (what firms have to pay for labour) then real wages have been rising.

It is, in part, because American workers have been forced to take their rising real incomes in the form of mandated add-ons that made it appear real wages had fallen. (This fall has now been found to have been a statistical error because inflation was overstated). What clearly happens in America is that its comparatively free labour markets are allowed to factor additional labour costs back into lower take-home pay. Whereas in Australia the Industrial Relations Commission and trade unions have sabotaged this process resulting in these additional costs being factored into unemployment instead.

Anyone with some training in economics should quickly realise that what has been discussed here is just imputation. In other words, by applying imputation theory to labour one merely takes the concept to its logical conclusion. The ramifications for goods and service taxes should be self-evident.

*Superannuation is a pension fund to which employees and employers make regular payments. As we have seen, the reality is that it is the employee who actually pays all of the super contributions.

Gerard Jackson is Brookes’ economics editor

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