Is a Minimum Wage Increase the Best Way to Boost Incomes?

by Reihan Salam

Ask conservatives about how they want to change the U.S. economy and you’ll hear references to reforming the tax code to improve work incentives, the need to curb regulations that stymie business model innovation, and (these days) making our woefully inefficient health and education sectors more productive by making them more competitive. These are all good and important ideas. Yet the inevitable next question is a tougher one to answer: how will these measures impact low- and middle-income families? And there’s an answer to this question. If tax and regulatory reform lead to an increase in work effort and an increase in productivity growth, we will have more growth and higher wages. The trouble is that the increase in work effort and productivity levels won’t be evenly distributed across sectors and firms, and some individuals within firms will capture more of the benefits of growth than others. Workers who are easily replaced by other workers or by machines won’t necessarily see much in the way of compensation gains, even if they work in sectors and firms experiencing big productivity gains; workers who are very hard to replace will generally see much bigger gains in compensation, and these gains will be magnified during an economic expansion. (This is why policymakers on left and right often tout the benefits of tight labor markets, which is to say labor markets in which all workers are hard to replace. As we’ve discussed, however, the U.S. appears to have developed a segmented labor market, part of which is tight and part of which is slack.)

So what can conservatives say to low- and middle-income voters who want to know how a conservative policies will translate into increases in disposable income? They can give the rather unsatisfying, if honest, answer that “it’s complicated.” Liberal Democrats, led by President Obama, have a much more straightforward answer. They want to give Americans a raise by raising the federal minimum wage to $10.10. A number of conservatives have also jumped on the bandwagon. It is worth noting that a minimum wage hike is less an anti-poverty policy than a policy that appears to benefit lower-middle-income households. The following is drawn from the Congressional Budget Office analysis of the president’s minimum wage increase proposal:

The increased earnings for low-wage workers resulting from the higher minimum wage would total $31 billion, by CBO’s estimate. However, those earnings would not go only to low-income families, because many low-wage workers are not members of low-income families. Just 19 percent of the $31 billion would accrue to families with earnings below the poverty threshold, whereas 29 percent would accrue to families earning more than three times the poverty threshold, CBO estimates.

The CBO estimates that the 2016 poverty threshold (in 2013 dollars) will be $18,700 for a family of three and $24,100 for a family of four, so families earning more than three times the poverty threshold would be earning $56,100 for a family of three or $72,300 for a family of four; families earning six times the poverty threshold would be earning $112,200 for a family of three and $144,600 for a family of four.

Moreover, the increased earnings for some workers would be accompanied by reductions in real (inflation-adjusted) income for the people who became jobless because of the minimum-wage increase, for business owners, and for consumers facing higher prices. CBO examined family income overall and for various income groups, reaching the following conclusions:

* Once the increases and decreases in income for all workers are taken into account, overall real income would rise by $2 billion.

* Real income would increase, on net, by $5 billion for families whose income will be below the poverty threshold under current law, boosting their average family income by about 3 percent and moving about 900,000 people, on net, above the poverty threshold (out of the roughly 45 million people who are projected to be below that threshold under current law).

* Families whose income would have been between one and three times the poverty threshold would receive, on net, $12 billion in additional real income. About $2 billion, on net, would go to families whose income would have been between three and six times the poverty threshold.

* Real income would decrease, on net, by $17 billion for families whose income would otherwise have been six times the poverty threshold or more, lowering their average family income by 0.4 percent.

Essentially, the proposed minimum wage increase redistributes income from affluent households (-$17B), who are well-represented in the ranks of business owners and consumers facing higher prices, to households earning between $18,700 ($24,100) and $56,100 ($72,300) (+12B), with another good-sized chunk flowing to households below the poverty-level (+$5B). We can understand the higher prices paid by all households as a kind of tax that finances this transfer. How does the minimum wage increase stack up relative to other forms of tax-financed income redistribution?

Elsewhere in the report, the CBO makes the following observation:

To achieve any given increase in the resources of lower-income families would require a greater shift of resources in the economy if done by increasing the minimum wage than if done by increasing the EITC. The reason is that a minimum-wage increase would add to the resources of most families of low-wage workers regardless of those families’ income; for example, one third of low-wage workers would be in families whose income was more than three times the federal poverty threshold in 2016, and many of those workers would see their earnings rise if the minimum wage rose. By contrast, an increase in the EITC would go almost entirely to lower-income families.

But again, this isn’t a problem if we aim not just to increase the disposable income of poor families, but also middle-income families.

The trouble is that the “tax” that finances these income gains isn’t just paid in the form of higher prices for consumers. It is also paid by workers who are locked out of the labor market. Minimum wage advocates often accuse low-wage employers of exploiting low-wage workers. Note, however, that firms that employ less-skilled workers often make significant human capital investments in these workers. Entry-level jobs often entail imparting noncognitive skills that aren’t specific to the specific job. A young person or an ex-offender or an older person who has been out of the workforce for a long period of time might learn how to interact with customers, or to work effectively as part of a team. The low-wage employer who imparts these skills will retain some of her entry-level employees, who might remain in place, or who will rise through the ranks of the firm; in most cases, however, entry-level employees will find work at other firms, which will benefit from the training offered by that first employer. One can imagine a world in which employers who take the trouble to educate raw recruits in the ways of the workforce capture a share of the income of these employees as they leave to take other, more lucrative jobs. That is not the world we live in. It is thus not unreasonable to assume that firms underinvest in this kind of training, as it can be difficult, expensive, and the employers who undertake it don’t capture the lion’s share of the benefits. This is an important part of the case for wage subsidies: the benefits of entry-level employment, and the training that is an essential part of it, don’t fly exclusively to employers or even employees; there are spillover benefits as well. There is a real danger that we are underestimating the cost of policies that lock out workers from the low end of the formal labor market.

In an ideal world, our efforts to raise the disposable incomes of middle-income families wouldn’t start with a win-lose policy like a minimum wage increase. Rather, we’d start with win-win policies, like better monetary policy and, most intriguingly, corporate tax reform. In 2012, Aparna Mathur of AEI summarized research she conducted with her AEI colleague Kevin Hassett:

When capital flows out of a high tax country, such as the United States, it leads to lower domestic investment, as firms decide against adding a new machine or building a factory. The lower levels of investment affect the productivity of the American worker, because they may not have the best machines or enough machines to work with. This leads to lower wages, as there is a tight link between workers’ productivity and their pay. It could also lead to less demand for workers, since the firms have decided to carry out investment activities elsewhere.

Our paper was one of the first to explore the adverse effect of corporate taxes on worker wages. Using data on more than 100 countries, we found that higher corporate taxes lead to lower wages. In fact, workers shoulder a much larger share of the corporate tax burden (more than 100 percent) than had previously been assumed. The reason the incidence can be higher than 100 percent is neatly explained in a 2006 paper by the famous economist Arnold Harberger. Simply put, when taxes are imposed on a corporation, wages are lowered not only for the workers in that firm, but for all workers in the economy since otherwise competition would drive workers away from the low-wage firms. As a result, a $1 corporate income tax on a firm could lead to a $1 loss in wages for workers in that firm, but could also lead to more than a $1 loss overall when we look at the lower wages across all workers.

Mathur’s policy prescription offers, in theory, a win-win approach to boosting wages, and it does so without excluding workers from the formal labor market. But reading Ashley Parker’s New York Times report on the new Democratic strategy for 2014 brings to mind a political vulnerability:

Democrats say the strategy of spotlighting the Koch brothers’ activities is politically shrewd. The majority leader was particularly struck by a presentation during a recent Senate Democratic retreat, which emphasized that one of the best ways to draw an effective contrast is to pick a villain, one of his aides said. And by scolding the Koch brothers, Mr. Reid is trying to draw them out, both to raise their public profile, and also to help rally the Democratic base.

Minimum wage advocates have a villain — low-wage employers, who have been portrayed as exploiters of low-wage workers rather than as investors in the human capital of workers on the first rungs of the economic ladder. Those who favor the EITC as an alternative to labor market regulation, and corporate tax reform as a way to achieve higher productivity and higher wages, don’t have a readymade villain.