Capitalization of Wages & the Payroll Tax
 

May 1998

What is an asset worth? This is a central issue in the study of finance. The most common response to this question is that the present value of an asset is equal to the discounted stream of future net cash returns/benefits that can be generated by the asset. Thus, if the net cash return to an asset in the present is denoted by R₀, the return next year is denoted by R₁, the return two years from now is denoted by R₂, and so on until the return in the last relevant year at which the asset can generate a benefit is denoted as R_N, then the present value of an asset discounted by the rate, r, can be described by the mathematical expression:
 
 

(1)

When taxes are imposed on assets the result is to alter the present value of such assets. The technique for determining the impact of taxes upon the present value of assets, including the present value of labor power as an owned asset (except in slavery labor power is the sole possession of the laborer), is the same as that described above. This technique of capitalization of future cash benefits (turning a claim to future cash returns into a present asset value) by means of discounting those future cash returns by a relevant discount rate can be easily applied to the case of taxing assets, including factors of production.

Let's take the example of a payroll tax applied solely to earnings generated from the sale of labor power. If we can denote the present value of labor power (in this example we are using the term present value of labor power to denote the total monetary value of laboring potential, rather than the usual Marxian procedure of denoting the value of labor power in terms of a socially determined wage rate that must be paid in order to entice workers to sell individual time-units of their labor power) as a function of the discounted future wages (W) that this labor power can generate (where W takes the place of R in the more general mathematical expression above), then this present value of labor power may be described by the mathematical expression:
 
 

(2)

What is the impact of payroll taxes upon the present value of labor power? For any given magnitude of labor power sold, there is a corresponding wage paid (W) and tax applied (T). Thus, for any given time period (n), the laborer can anticipate a wage (Wn) and a corresponding tax (Tn) and the present value of her/his labor power (PV_lp) is given by:
 
 

(3)

Now obviously in a society where slavery is illegal, it is not possible to observe a market-determined valuation of the present value of actual human laboring potential in this sense. Labor (-potential) markets are restricted to rental contracts: individual economic agents can sell only their own laboring potential and can sell this potential in time increments but not in toto. Similarly, the buyers of laboring potential are always buying only temporary use rights to certain laboring potentials and not to laboring potential in general or laboring potential in toto. Buyers may not legally own the person. As in the case of rented land, we cannot assume that the person who rents would use the rented property in the same manner as they might use owned property. The use is limited in both time and in acceptable use. Thus, it cannot be assumed that we might obtain an accurate measure of the market value of laboring potential from existing rental rates qua wage rates.

Nevertheless, each economic agent owns her/his laboring potential and gains a return from the rental of that laboring potential, even if her/his ability to completely alienate this laboring potential is legally restricted under capitalism. It is possible to apply the logic of the capitalization process to this case. The economic agent can be assumed to value her/his laboring potential and, to the extent an economic agent can anticipate some cash benefits from other family members, she/he may similarly value a portion of the future wage (rental) income of those family members, as well. The present value (or, as is always the case, the approximation to this present value based on expectations of the future variable values---wages, discount rates, tax rates, and any other factors that might shape the magnitude of net wages received) becomes one factor determining economic decisions about acquiring and improving assets, including laboring potential.

Under this assumption, it seems reasonable to assume that a tax on laboring potential, such as a payroll tax, that is not also applied to other assets, would lower the present value of laboring potential. This might be expected to reduce investment in laboring potential. How would this be manifest in society? Perhaps economic agents would be less likely to invest in education (which is an improvement in the asset---laboring potential), either for themselves or other family members. If this were the case, the reduction in investment in education (and thus in laboring potential) could negatively impact long-term economic growth, particularly in societies where skilled labor is in short supply. On the other hand, since the reduced value of laboring potential changes the relative values of assets, it is also possible that it might result in a shift of investment from laboring potential to capital assets or land. If this is the case, then it is possible that the impact could be positive or ambiguous upon long term economic growth and development. For instance, in a society with relatively abundant labor resources, including skilled labor, and scarce capital (India springs to mind) then a tax that shifts investment from laboring potential (or human resources) to capital assets might serve the economic development and growth process better than a tax on capital assets.

Of course, the choice does not have to be between taxing one asset category versus another. It is possible to tax all asset categories relatively equally via some form of income tax (a tax on all asset returns, including that from laboring potential). It is also possible (and perhaps desirable) to avoid taxing assets altogether and to tax consumption instead. This has been strongly advocated by some social activists and politicians in the United States. Taxing consumption could result in more savings and more savings could lead to greater investment in all asset categories. A tax system that results in an increase in investment in all asset categories might be the best one from the standpoint of development and growth. 

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Copyright © 1998, Satya Gabriel, Economics Department, Mount Holyoke College.