The President in his State of the Union address last week proposed increasing the federal minimum wage from $7.25 an hour to $9, and then indexing it by the rate of inflation. The proposal will not commend itself to most economists who study the economic consequences of minimum wages. They make three principal arguments: minimum wage laws reduce employment (and efficient resource allocation) by pricing labor above its market rate; the laws do not reduce poverty, because most beneficiaries of minimum wage laws are not poor; and as a means of reducing economic inequality, such laws are inferior to the Earned Income Tax Credit (i.e., the negative income tax). I will try to assess these arguments.
Although there is some disagreement among economists, the majority of those who actually study the
effects of minimum wage laws agree that they have a modest disemployment effect concentrated on young persons. But the issue is the effect of a 24 percent increase ($1.75 ÷ $7.25) from the current minimum wage; it could be immodest. The effect will vary from state to state, depending on each state’s minimum wage law. A few states set the minimum wage well above $7.25 and one (Washington) has set it above $9, though only slightly ($9.13). In Connecticut and Illinois the state minimum wage is $8.25, in Oregon $8.95, and in Vermont $8.60. But in most states it is at the federal level and in some states it is below it—and some southern states have no minimum wage at all.
The majority of economists also believe that the minimum wage laws have no effect on the poverty level—except perhaps to increase it. A minimum wage law has no effect on poor people who don’t work, unless they belong to a family that has workers whom the law affects. And because the application of the law depends on the individual’s wage rate rather than on family income, a sizable fraction of those whose wages are affected by such a law are not poor, because they are members of families that are not poor, Many of these beneficiaries of minimum wage laws enjoy family incomes that are twice the poverty level (and thus about $40,000). It has been estimated that only 11 percent of workers paid the minimum wage are actually poor people.
As for the Earned Income Tax Credit, because eligibility depends on family income rather than on the wages of individual family members, the payments do not benefit the nonpoor, except that, to avoid a sharp cliff, eligibility extends beyond the poverty level. A married couple with two children and annual income of $7000 is entitled to an Earned Income Tax Credit of $2810, rising to $5036 if the couple earns $15,000 and falling to $2179 if it earns $35,000.
In analyzing the case for and against a hike in the federal minimum wage, one should bear in mind that a minimum wage law is really a form of redistributive taxation. It’s effectively an earmarked tax on employers. Income is redistributed from businesses, and their customers (because a business hit with higher costs, labor or otherwise, will, if its competitors likewise are hit, be able to pass on some of the cost hike to consumers in the form of higher prices), to workers; additional costs are borne by workers who lose their jobs (or can’t find a job) because they are not worth the minimum wage to any employer. With the minimum wage understood as a form of taxation, the objection to a hike in the minimum wage that it will cause a distortion in the labor market falls away; all taxes create distortions. If as some critics of the President’s proposal advocate, the Earned Income Tax Credit is expanded, this will require an increase in federal taxes or borrowing, measures that also distort markets. Furthermore, the Earned Income Tax Credit is limited to families who have minor children living with them, and so provides no redistribution to poor people who are childless, or whose children are grown.
The fact that the minimum wage mainly benefits workers who are not poor, because they are members of nonpoor families, is a less forceful criticism of the President’s proposal than may appear. The reason is that the poverty line is extremely low. It is $11,170 for a single person and only $23,050 for a family of four. At $7.25 an hour, a minimum wage worker makes only $14,500 in a year if he works 2000 hours a year. That is below the poverty line unless he's single, and if he has minor children and no working spouse he is earning way below the poverty line, although his total income in real terms will be higher because of food stamps, Medicaid, and other benefits available to the poor and the near-poor (though not to all of them; Medicaid for example has quite restrictive eligibility criteria). To recall my earlier example, a worker who makes only $14,500 a year and has two minor children will be eligible for about $5,000 in Earned Income Tax Credit, but his total income will still be below the poverty line for a family of four of $23,050.
As I have argued in previous posts, income inequality has become a serious problem in the United States. The median income in the United States--$50,000—though far above the poverty level, is too low to enable optimal investments in the human capital of children in families whose total incomes are at or below that level, even with the various governmental benefits available to them. Increasing the minimum wage is an inefficient response to the problem, but what is the alternative? What the advocates of increasing the minimum wage have going for them is a widespread sense that people who work full time at menial jobs (as most minimum wage jobs are) should be paid a decent wage, and that $7.25 an hour is no longer a reasonable estimate of a minimally decent wage for such work.
Still, a 24 percent increase is a big jump. A prudent compromise might be to increase the federal minimum wage to $8.25 and study the results over a period of a couple of years.
And I don’t think indexing the minimum wage to inflation is a good idea; should inflation surge, which is always a possibility though not (it seems) an imminent one, an equal increase in the minimum wage might contribute to an inflationary spiral.