The deduction for employee compensation is among the most longstanding and least controversial deductions in the Tax Code. Unlike many deductions, which move the tax law away from a comprehensive tax base, the compensation deduction helps measure net income accurately. Perhaps for this reason, the treatment of employee wages has undergone few significant changes since the early years of the income tax. In a forthcoming article, Prof. Daniel Schaffa proposes a radical departure from the conventional approach. He reimagines the compensation deduction as an economic incentive for hiring and a subsidy for employee wages.

Specifically, Schaffa proposes reforms to replace the dollar-for-dollar compensation deduction with a more progressive structure. The reformed law would provide a substantial “bonus” deduction for low-wage workers, provided that the employee’s wages are above a minimum dollar threshold. Schaffa offers the following example: “each business receive[s] a bonus deduction of $60,000 for each worker it paid at least $30,000 annually.”  The proposed deduction would have two objectives: (1) to nudge employers to hire more low-wage workers and (2) to induce them to raise wage rates for low-wage workers.

Schaffa predicts that “[i]f businesses received a larger deduction for dollars paid to low-wage workers, they would hire more low-wage workers.” In the current economy, national unemployment levels are low, but Schaffa argues that hiring rates are still inefficiently low in some markets. He points to places where a handful of employers dominate the labor market. When local workers have few employment options, employers can depress wages. In these markets employers may choose to “maximize their profit with lower wages, less hiring, and lower output” instead of “raising wages to attract new workers” (emphasis added).

Accordingly, the second goal of Schaffa’s bonus deduction proposal is to encourage employers to increase the wage rates paid to their low-wage workers. He argues that if the bonus deduction is high enough, and set at the right threshold, then “low-wage work could be eliminated in the U.S.”  In the example above, “for any worker earning above $15,000 and below $30,000, employers would save by raising the worker’s compensation to $30,000.” In other words, the proposed bonus deduction would be so large that employers would literally profit from raising some employees’ wages.

Of course, a bonus deduction of that size would be very expensive. Schaffa presents several possibilities for how to pay for his proposal. Some rely on assumptions about economic growth: if economic output increases, both the corporate income tax base and individual income tax base may increase, generating additional tax revenue. Other possibilities include revenue-raising changes to the tax system. For example, the compensation deduction for high-wage workers could be converted to a partial deduction. The exclusion for employer-provided health insurance could be repealed. The Earned Income Tax Credit—an employee-side tax credit that also aims to increase workforce participation and subsidize wages—could be scaled back or repealed.

And here is where I start to get worried: if a bonus deduction is paid for by a repeal of the EITC, then outcomes would be highly dependent on the incidence of the benefit. Employers would need to respond to the incentive by increasing pre-tax compensation for virtually all the low-wage taxpayers who currently depend on the EITC for social welfare. Anything less may harm the very taxpayers the proposal seeks to benefit.

That said, Schaffa’s proposal is creative and provocative, and I would support a small-scale implementation of some version of his idea in a few test cities. I am not sure if employers would significantly expand their workforce in response to the bonus deduction. Hiring incentives are nothing new, particularly at the state and local level, and only a handful of studies have found statistically significant (let alone large) increases in employment rates. However, I agree that it’s possible employers would raise wages for at least some of their existing workers if the bonus is big enough—and I am unaware of any hiring incentive as large as Schaffa proposes.

However, even if the bonus is large, other factors may affect the strength of the incentive. Employers would have to be confident they can get full value from the deduction. Schaffa suggests making the deduction refundable for companies that don’t have enough taxable income to absorb it. But refundable business tax credits are rare (and refundable deductions don’t even exist under current law!). In addition, employers would need to be confident that the law won’t change in ways that decrease the deduction’s value. For example, lower corporate tax rates would decrease the value of the deduction. And cost-saving reductions to the size of the bonus—or an outright repeal—could be financially disastrous to employers that increase compensation levels in reliance on the subsidy.

For these reasons, I think it would be important to collect more empirical data on this proposal before attempting to implement it nationally—but if trial programs yielded promising outcomes, then this proposal would be worth considering as a supplement or alternative to current policies. Schaffa is clearly correct to observe that existing policies have failed to solve the problem of stagnant wages, which exacerbates the harmful impact of high housing costs and inflation.

Overall, this article is a fascinating thought experiment that pushes back on conventional wisdom and asks important questions about the structure of tax law, equity/efficiency trade-offs, and the potential for an old incentive to perform new functions and promote important policy objectives. I recommend this article to anyone interested in business taxation, economic incentives, and anti-poverty tax programs.