More on living wages and minimum wages

By Eric Crampton 25/02/2014


Fairfax’s Richard Meadows asked me a few questions about living wages and minimum wages. Some of them made it into his excellent story, here. I agree with everything Matt Nolan said there too.

[Update: Nolan’s extended comments are here. And I’m really pleased to see that Richard’s linked the more extensive commentary from both of us.]

Here are the bits of mine for which he didn’t have room, for those who are interested.

To what extent do childless people subsidise families under the current model?

The tax and benefit system strongly benefits lower-to-middle income individuals with children, with the cost most heavily borne by higher income individuals both with and without children, but also by poorer people without children. In addition, a substantial part of the government’s non-transfer expenditures go towards the health and education of children and young adults, with the burden falling the same way.

Is the subsidisation of families considered a “good” thing for the economy as a whole?

Some subsidisation of lower income families has public good aspects. Ensuring that families have the resources to make at least some investment in their children’s health and education helps reduce the chances that those children will themselves be in poverty later in life. But much of the current Working-for-Families scheme is a straight transfer to middle-income families with children. Chicago economist Aaron Director lent his name to one of the iron laws of transfer policy: Director’s Law holds that transfer programmes mostly work to the benefit of the middle class. Education, 20-hours-free-ECE, WFF, zero-interest student loans: Director would say these are the sorts of policies we should expect where the middle-income median voter has children.

I would question the premise of your question though. If we think that it’s good to give money to low-to-middle-income working people with kids, then WFF is good. If we think that others would benefit more, then it isn’t. I can’t tell you whether it’s better to take money away from childless people, both rich and poor, to give to low-to-middle income people with kids. Economists can tell you a bit about the tradeoffs involved and the likely effects of the policy on different groups of people – both intended and unintended. But once we’ve taken proper account of these tradeoffs, then we start moving into value judgments to decide whether the policy’s worthwhile.

Are there any unintended consequences or distortions caused by the status quo?

Poverty campaigners often criticise WFF for not doing enough for non-working families. I think they miss the point of WFF: it’s intended as a family wage supplement for lower income working families. The distortion then isn’t in that WFF helps encourage the lowest-income families, typically single mothers, to re-enter the workforce: that’s the intended consequence.

The high effective marginal tax rates on middle income families under Working-for-Families strongly penalises second earners, often women, deciding to re-enter the workforce when the children get a bit older. For some, this then can become a trap: over reasonable income ranges, the combination of income taxes and Working-for-Families clawback rates mean that they don’t get to keep much from an extra hour’s work. Higher income families don’t get the WFF transfers, but also don’t face the distortions caused by these high effective marginal tax rates. This could be an unintended consequence of WFF. We should note, though, that while there appeared to be a reduction in female labour force participation rates shortly after the introduction of WFF, as best I know, there has not been a study looking at micro data that can tease out whether this was a causal relationship.

Let’s imagine replacing WFF with an $18.40 minimum wage. What impact might raising the minimum wage to $18.40 have on unemployment?

An $18.40 minimum wage would be extraordinarily destructive. While the family envisioned in your scenario is the kind of family that Living Wage campaigners have used in setting their models, a substantial proportion of those earning below $18.40 are second-earners in higher-earning families or young adults starting out in the labour market. If the goal of the policy is to improve the lot of lower-income working families, this is better done through schemes like WFF than through across-the-board measures like minimum wages. While WFF may have some effect on employment rates by discouraging second-earners from working, and through the higher tax rates required to fund the transfer system, it can encourage some lower income workers into the labour market by making work more attractive than benefits. An $18.40 minimum wage would cause substantial unemployment among some of our most vulnerable cohorts. And while those who did not lose their jobs would be better off, the poor are often the consumers of the goods and services produced by the working poor, and some of the cost of the higher wage rates would be passed along to those customers.

While recent American data suggests little effect of minimum wages on overall employment, American minimum wages tend to be about 40% of the median wage. The current New Zealand minimum wage is more than 60% of the median wage, and an $18.40 minimum wage would be almost 90% of the median wage. The unemployment effects of an immediate shift to an $18.40 minimum wage would be large, rapid, difficult to reverse, and especially destructive to the lifetime work prospects of some of our most vulnerable cohorts.

On balance, is it likely to do more harm than good?

On balance, it is likely to be ridiculously and uselessly destructive. The modelling here really needs to account for the sharp rise in unemployment we’d see with a rise in the minimum wage of such a magnitude.

Would the cost of goods and services simply rise accordingly, and be passed on to consumers?

Whether workers would bear the burden through increased unemployment or reduced on-the-job benefits, customers would bear the burden through increased prices, or shareholders bear the burden through reduced returns, would vary greatly industry-to-industry. In some cases, firms and customers would absorb most of the cost increase, at least in the short term. In the long term, the biggest burden will be borne by those workers who want to work but who cannot provide services worth $18.40 an hour to any employer. They’ll be out of work. And if we take the economics literature on happiness at all seriously, we will do far more harm to this cohort than we would benefit those who stay in work. Being unemployed is far worse than being paid less than one might hope for.

Would there be any positive effect on employment, consumer spending and business growth if taxes were cut universally? [imagining a scenario in which WFF is abolished and a tax-free income threshold is established in its place.]

Scrapping WFF and replacing it with a universal tax-free threshold costing the government as much would have a few effects. Most directly, we would stop providing the substantial transfer from childless families to those with children. We didn’t have this transfer before WFF, so ending it isn’t unimaginable or the stuff of the dark ages. We’d likely see a positive labour supply response from second-earners currently subject to very high effective marginal tax rates. I would expect stronger beneficial effects from ending the very high effective marginal tax rates under WFF affecting middle-income families than from the slight reduction in taxes paid by the poorest cohorts.

While a $10,000 tax free threshold sounds nice, it might not be as beneficial as an equivalent reduction in the tax rates affecting lower and middle-income earners. The tax-free threshold would benefit everybody, but would only reduce the tax burden of working an extra hour for those people earning under $10,000 per year. For an equivalent cost to the government, we could reduce tax rates in the lower-income bands to let workers keep more of the next dollar earned.

Could it be dangerous to remove the targeted support for families and replace it with universal cuts?

A lot of families have come to rely on WFF support. They’ve taken out mortgages, made employment decisions, and maybe even made decisions about family size, with WFF calculations at the back of their minds. There’s a reason that Key’s incoming National government didn’t scrap WFF in 2008 despite having campaigned against it in 2005: it would be politically dangerous. At the same time, the longer WFF stays in place, the harder it would be ever to get rid of it: more families will become locked into choices that depend on the existence of WFF.

Further, one reasonable benefit of Working for Families is that it makes employment pay for some of our lowest income cohorts: single mothers with low skills and low wages. One alternative could be to turn Working for Families into a wage subsidy scheme targeted more directly toward those on lower incomes, whether or not they have children, while enhancing access to childcare facilities.

Could other parental subsidies (paid parental leave, childcare assistance, greater chance of accommodation supplement) provide enough support in the absence of WFF?

I think I’ve covered that off above, but I’ll add one bit on accommodation supplements:

In the current housing market, we shouldn’t really think of the accommodation supplement as something that helps poor families. Where cities make it very hard to get consent to build new housing, generous accommodation supplements mostly serve to help landlords earn more. When cities again make it easier to build new houses, then the accommodation supplement could do the job it’s supposed to be doing. But for now, it’s not helping the group it’s intended to help.