The Effectiveness of (Raising) the Minimum Wage

This post will mostly be a response to three recent posts which argue that the minimum wage:

– Would be a net benefit to people it targets (low-wage hourly workers)
– Helps other policies acheive their objective, particularly the Earned Income Tax Credit (EITC)
– Or some combination of the two

The three posts are:

Jared Bernstein’s February 14th, 2013 post titled “Raising the Minimum Wage: The Debate Begins…Again”
Mike Konczal’s February 15th, 2013 post titled “Interview with Dube; EITC and Minimum Wage as Complements”
Paul Krugman’s February 16th, 2013 blog post titled “Minimum Wage Economics”

It will also include some musings about minimum wage and the Keynesian view of the business cycle.

The (Negative) Effects of Minimum Wage

It follows from classical economic theory that the minimum wage is an example of a price floor: the government enforces a minimum hourly wage (price) at which employees (potential suppliers of labor) and employers (potential sellers of labor) make their trade.

It is possible (and probable) that an employee and an employer can agree on a trade for a range of hourly wages. That is, the value of the employee’s labor to the employer, and the minimum price the employee is willing to work for, may not be the same value.

Following this logic, it is entirely possible that a minimum wage has no effect on whether a trade happens or not; even if it is binding at a certain price that two agents would agree on, it may not be binding at a higher price that they both agree on as well. Extending this to the overall market, it is possible that a minimum wage has no effect on the volume of labor services traded whatsoever. However, given the variety of employers and employees, this seems unlikely.

So, what’s the empirical observation? A 2007 economic literature review by UC Irvine’s David Neumark and the Fed’s William Wauscher concludes:

A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries.

So it would seem that the economic literature as a whole agrees with the conclusions of classical economics that we should expect the minimum wage to cause unemployment. However, it is worth noting there are significant exceptions: a literature review published this month by John Schmitt concludes:

The weight of that evidence points to little or no employment response to modest increases in the minimum wage.

The paper makes some other conclusions about how employment responds to the minimum wage besides changing the quantity of employees. I won’t directly deal with those other conclusions in this post.

To me, the conclusions of both of these literature reviews are consistent with the classical model; because it says that the minimum wage might not be binding, and might not affect whether a trade happens even if it is binding to a single price, we should expect it could be possible that it either creates a surplus of labor (unemployment) or has no effect. I am not asserting that the classical model is an excellent one for the study of labor markets as a whole; I think labor in general behaves differently from other goods. However, we don’t seem to have found anything that would refute the classical model’s conclusions about price controls.

The (Normative) Question of Minimum Wage

Conclusion 1: The minimum wage has no empirical effect on the quantity of employment, therefore we should expect it to help poor hourly workers independently.

This is the conclusion that seems most puzzling to me. Only Bernstein makes it; Krugman and Konczal may or may not support it, but do not specify in their posts.

1) It’s very easy to imagine negative effects of a price floor besides surpluses. I can think of two:

– The policy would cost resources to enforce. Even if we already had minimum wage enacted, businesses would use resources adjusting to a change in the price floor, regardless of the effect on employment. We would spend time and resources changing the legal code even if no new enforcers of the law (police, inspectors, IRS agents) were required.

– The policy would lend itself to rigid nominal prices regardless of the quantity of trade. The New Keynesian view of business cycles holds that depressions persist because prices are “sticky.” A minimum wage would reinforce price stickiness, especially if labor costs are a large share of the total cost of production.

2) There are other programs that have proven very empirically effective at helping the working poor.

– The Earned Income Tax Credit (EITC) is one of these. It maintains an incentive to work (you need to be employed to qualify), lowers taxes on the working poor, and is means-tested, meaning it’s very effective at reaching the people it intends to help. Bernstein agrees with this conclusion.

– Education is one of the oldest ideas in the book for increasing the productivity of workers. With higher productivity, employers will value the same person’s labor more highly, potentially increasing wages.

– The Temporary Assistance for Needy Families (TANF) Act, passed by Clinton in 1997, is time-correlated with both a reduction in the number of Americans in poverty and the reduction of the number of Americans qualifying for means-tested assistance.

If our objective is to help the working poor, I don’t think price controls are a very effective way of doing it. In particular, because we have a limited amount of political capital for enacting such reforms, we can’t always “come back for seconds” if our initial methods don’t work – we should focus on what’s effective in the first place.

Conclusion 2: The minimum wage has no empirical effect on the quantity of employment, and therefore it will help other programs such as the Earned Income Tax Credit (EITC) achieve it’s goals.

Krugman, Konczal, and Bernstein all come to this conclusion.

This conclusion doesn’t seem to hold water to me because of the economic logic behind minimum wage “helping” the Earned Income Tax Credit achieve it’s goals. Konczal points to a paper by Jesse Rothstein of Princeton University that concludes:

With my preferred parameters the [Earned Income Tax Credit] increases after-tax incomes by $0.73 per dollar spent, while the [Negative Income Tax] yields $1.39.

Konczal doesn’t focus on the conclusions about the effectiveness of a negative income tax, but he claims that:

Jesse Rothstein did an estimate finding that for every dollar of EITC, a worker’s wage only goes up 73 cents. That’s a big capture by employers.

He correctly mentions that we should only expect the EITC to grant 100% of it’s benefits to employees if we assume the demand for wages in low-income markets is perfectly elastic. He then suggests that minimum wage is an effective law at getting more of the EITC to go to worker’s wages. Bernstein comes to the same conclusion.

Since when is it commonplace for economists to advocate legal codes against economic truths such as elasticity? I don’t understand why we would think a legal requirement would increase the elasticity of demand for low-wage workers.

Konczal provides a citation of a paper by David Lee and Emmanuel Saez that concludes that a binding price floor prevents the lowering of wages as a result of government transfers like the EITC; but from classical logic, we would expect this to increase the unemployment associated with a binding price floor!

This seems like a terrible conclusion on the part of these two economists, especially considering the EITC and other programs have proven very effective on their own.

Minimum Wage and (Effective) Keynesian Policy

An idea I touched on earlier is that minimum wage might help exacerbate depressions because it contributes to nominal wage “stickiness” or inflexibility, increasing the time it takes prices to adjust in response to phenomena that happen extremely quickly (like banking crises).

However, if we consider the idea that lower-income workers have a higher marginal propensity to consume, then we can talk about some possible counter-cyclical effects of an increase in the minimum wage, or the enactment of a new minimum wage policy, given that we make two assumptions:

1) Minimum wage laws are effective at increasing the discretionary (after-tax) income of poor-income workers.

2) Minimum wage laws have no overall net effect on the quantity of employment.

The first assumption is incredibly dubious; minimum wage laws contribute to phenomena like inflation, and may have other effects on the income of workers besides increasing their hourly wage rate. However, let’s assume it’s valid for now.

Given the empirical tests, the second assumption seems like it might be reasonable in some cases, such as when we increase minimum wage only a small amount.

If we consider the idea that minimum wage laws increase the discretionary income of poor workers without decreasing overall quantity of employment, we come to the conclusion that it might be significantly expansionary, because the income gained from an increase will be used to purchase goods and services and thus create higher expectations of inflation.

However, I would expect this policy to be extremely ineffective as a counter-cyclical policy for a few reasons:

1) An increase in income would work similarly to a tax cut; even for low-income workers, part of that money might be saved or used to pay down debt. We would expect the multiplier (the increase in the velocity of money) to therefore be lower than if the government simply spend the money itself on things like infrastructure projects.

2) The magnitude of the policy matters. Adam Ozimek agrees that minimum wage is ineffective compared to the EITC.

3) An increase in minimum wage that significantly increased discretionary low-incomes would probably be extremely disruptive and affect much of the hourly labor market.

Conclusion

The minimum wage might have no negative effects on the quantity of employment, but it seems economically unreasonable to assume it has no negative effects whatsoever.

For the objective of increasing the incomes of poor families, the minimum wage is ineffective.

The minimum wage would be very ineffective as Keynesian policy even given extremely questionable assumptions.

– Thomas C.

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