On Tuesday, President Obama put forth ideas, some good and some not as good, to create jobs. The more misguided proposals involve using the tax code to reward businesses, while the best ideas involve direct spending.
For example, he proposed the elimination of capital gains taxes for small business investment and an extension of the break that lets small businesses immediately deduct (expense) a larger amount of their capital investments.
The capital gains break is particularly problematic. If this provision works as existing similar capital gains breaks work, it would mean that anyone who buys an interest in a company that qualifies as a "small business" within a certain time period can hold onto that interest for as long as they like -- say, 20 years or longer -- and then sell it without paying any tax on the gain.
Of course, no investor knows whether or not a small company will grow and last that long. The company could go out of business in a couple years. Or the company could be Microsoft.
But, more to the point, it's not obvious that this would help a small business today to create jobs. Investors don't want to put their money in a venture unless they think there is some demand for the goods or services that would be produced. So, what's needed now to create jobs is a boost in demand for goods and services. Investors would respond by creating or expanding business, meaning they would hire more people to work more hours. Business owners only expand like this if they can profit, and that resulting profit is what causes stocks to become more valuable, which is what causes shareholders to have capital gains.
The President's capital gains proposal gets this all backwards by aiming a tax cut at the very end of that process, at the capital gains, and assuming that demand will materialize on its own as long as a tax cut encourages an increase in the supply of capital. At risk of drawing an alarming comparison, the proposal is, well, supply-side in its logic.
The President also says he wants to work with Congress to "create a tax incentive to encourage small businesses to add and keep employees." This could be a mediocre idea or a bad idea, depending on exactly what he's thinking.
If he's thinking of a payroll tax holiday, this could, in theory, produce some increase in demand if it means that workers who pay less in payroll taxes will spend the increase in their take-home pay. But to the extent that they save the extra money, it doesn't produce the boost in demand that is needed right now.
If the "tax incentive" the President is thinking about is a tax credit that goes to businesses for creating jobs, that could be even more problematic. There has been a lot of talk about giving businesses a credit for the amount by which they expand their payroll, and even making the credit refundable so that companies that are not currently profitable can benefit from it. Like the capital gains tax break, this proposal would do little to boost demand. But that's only the beginning of the problems.
Another problem is that it raises the question of how to treat new companies. Would they get the credit, and how would it be calculated since all their jobs are new? If they get the credit, what's to stop someone from liquidating their existing company and starting a new company that is different in name only? Perhaps more alarming is the fact that a lot of companies will create more jobs anyway, so a lot of the revenue would be a reward to firms for doing something they would have done even without the tax break.
A proposal that has been recently promoted by the Economic Policy Institute argues that even if one takes these problems into account, a well-designed tax credit can create jobs in a cost-effective way. Even if only a fraction of the jobs created are the result of the credit, the authors figure that five million jobs could be created over two years, at a total cost of about $5,400 per full-time job (or full-time job equivalent) created as a result of the credit.
Given the many questionable assumptions needed to come to this conclusion, we think a much surer bet for job creation would be plain old government spending. Thankfully, direct spending by the government was also included in the proposals the President discussed.
For example, he mentioned extending aid to unemployed and low-income people as well aid to states. This type of government spending would result in increased consumption (and therefore increased demand for goods and services) almost immediately.
As a recent report from the Center on Budget and Policy Priorities explains, aid to states is particularly important right now, because state governments are already planning their budgets for fiscal year 2011, when most of the aid they received in the recovery act is supposed to end. There's usually a lag between an economic recovery and state governments' recovery of their revenue streams, so a lot of states will be cutting services and staff even if the economy is expected to improve in 2011.
Federal aid to state and local governments that allows them to save jobs that they are about the eliminate provides an immediate and clear benefit. It maintains the income that the otherwise eliminated state and local government employees will spend, which boosts demand for goods and services above where it would be if the federal government did not provide this aid.
The President is right that Congress cannot improve our economy by focusing single-mindedly on the budget deficit. The federal government needs to provide the conditions for job creation. Let's hope that this effort doesn't get diverted into a tax-cutting spree that makes good sound bites without addressing our underlying economic problems.