Ottawa’s recent announcement that it will effectively lower Employment Insurance (EI) premium rates featured an important wrinkle: the lower rate applies only to business premiums " not workers’ premiums " and only to the smallest businesses in Canada.

For the reasons listed below, this decision was problematic. But this blog post argues that its potential to do great good or inflict great harm on the Canadian labour market is over-blown. To keep things in perspective, this is a relatively modest move with an estimated average price tag of $275 million annually. This represents only 1 percent of total EI revenues and is essentially equivalent to a rounding error in the context of the $2 trillion Canadian economy.

Here are five concerns that have been raised in response to this policy:

1. Narrow tax targeting: This move continues the well-worn and ill-advised approach of narrowly targeted “boutique” tax preferences.

2. Other feasible options would have been better: As others have pointed out, EI benefits could have been enhanced and/or premiums could have been lowered across the board for all businesses and workers " the latter option is implied by the Chief Actuary’s report (quietly released the day after the EI announcement).

3. Over-sold job creation effects: The beneficial job-creating effect of this policy that appeared in media coverage is implausibly large. Specifically, the Canadian Federation of Independent Business (CFIB) estimated that this policy will ”œcreate 25,000 person years of employment over the next two or three years”. This impact seems too large by at least an order of magnitude, given Finance Canada’s estimated cost of the measure.

(Incidentally, CFIB’s methodology uses sensitivities of the impacts of changing CPP not EI premiums. The former is typically viewed as deferred compensation by workers; the latter much less so.)

4. The misleading label of ”œjob” credit: The ”œSmall Business Job Credit” will undoubtedly target small business, but it isn’t based on a business’s employment level; it depends on the total EI premiums owing in the tax year.

5. Perverse incentives: Commentaries such as those by Stephen Gordon and Mike Moffatt describe the perverse incentive that kicks in at the threshold where the tax credit is withdrawn (at the 15,001st dollar of EI premiums payable in 2015 or 2016). For a firm on the razor’s edge of $15k, the next dollar in EI premiums means they forego up to about $2,600 in a worst-case scenario. The figure below is a stylized example that glosses over some complexities.

EI_Sept_2014_announcement_fig_FINAL

This “kinky policy” clearly has an undesirable design feature that could lead to some gaming of the system. Stephen Gordon writes that ”œfirms may choose to actually reduce employment in order to be eligible for the tax credit”. Mike Moffatt agrees with the potential for job losses and adds another possibility: that affected firms might reduce wages to get the tax credit.

In theory both the adverse employment and wage effects are possible, but I think these concerns are also over-sold.

This argument assumes a fair bit of effort by the small business for a few thousand dollars. The firm must be aware of the new policy, understand exactly how it works, know their total EI payables in real-time, and be able to reduce their wage bill in a fairly surgical way to optimize the tax credit.

These conditions may all apply for a small number of firms, but probably not many. And when these conditions apply, the firm has easier options than reducing employment or wages.

Consider firing: it’s difficult; it requires hard choices and awkward conversations; it can kill morale in the workplace; it can involve costly severance packages; it might also mean that you need to hire additional people later " which itself is a time-consuming and costly process.

In sum, the direct and indirect cost of adjusting the number of workers is not zero, as is implicitly assumed in these policy critiques. (Recall the theory of “labour hoarding”.) Labour adjustment costs are significant and would soon dwarf the potential tax benefit of, say, $2,500.

What about wages? Again, you need to choose the person and have that tough conversation. Moreover, this argument overlooks ample evidence (in the literature on downward nominal wage rigidity, such as: this) that suggests workers are quite averse to wage cuts.

For those firms close to the credit threshold, there are easier ways to qualify for the credit than reducing employment or wages, which would have far milder macroeconomic effects.

Perhaps the simplest would be to just mis-report your taxes by reallocating a few expenses. (This is, of course, unethical, and I’m not advocating it…but if you’re considering firing someone solely for a tax credit, then you’re already walking down a troubling road). Or you could keep workers and wages unchanged and marginally reduce hours to qualify.

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The recent EI announcement was not optimal policy design in action, and it’s unlikely to have the positive employment impact advertised by some proponents. At the same time, I take some solace in the fact that it probably won’t be as bad for Canada’s labour market as some critics fear.