How effective is the minimum wage at supporting the poor?

By Paul Walker 08/01/2015


This is an important question since one good reason for supporting having a minimum wage would be if it is an effective antipoverty policy measure. Such a belief would rely on two assumptions: first, raising the minimum wage will increase the incomes of poor families; and second, the minimum wage imposes little or no public or social costs.

The policy debate over the minimum wage principally revolves around its effectiveness as an antipoverty program. A popular image used by both sides of the debate consists of families with breadwinners who earn low wages to support their children. Policies that raise the wages of these workers increase their earnings and contribute to their escaping poverty. As a counterbalance to this impact, opponent of the minimum wage argue that wage regulation causes some low-wage workers to lose their jobs and they will suffer income drops. The issue, then, becomes a tradeoff; some low-income breadwinners will gain and others will lose. Promoters of the minimum wage retort that employment losses are quite small and, consequently, the workers who gain far exceed those who lose.

In addition to potential adverse employment effects, opponents of minimum wages further counter the belief that the minimum wage assists poor families by documenting that many minimum-wage workers are not breadwinners of low-income families. They are, instead, often teenagers, single heads of household with no children, or not even members of low-income families. Promoters of the minimum wage admit that some of these groups may also benefit from the wage increase, but since few workers lose jobs, they contend that the minimum wage still benefits low-income families with children.

The notion that the minimum wage can be increased with little or no economic cost underlies many advocates’ assessments of the effectiveness of the minimum wage in its antipoverty role. Most economists agree that imposing wage controls on labor will not raise total income in an economy; indeed, elementary economics dictates that such market distortions lead to reduced total income implying fewer overall benefits than costs. If, however, one presumes that employment losses do not occur and total income does not fall, then the minimum wage debate becomes a disagreement over how it redistributes income. The efficacy of a minimum wage hike as an antipoverty program depends on who benefits from the increase in earnings and who pays for these higher earnings. Whereas a number of studies have documented who benefits, who pays is far less obvious. But someone must pay for the higher earnings received by the low-wage workers.

At the most simplistic level, the employer pays for the increase. However, businesses don’t actually pay, for they are merely conduits for transactions among individuals. Businesses have three possible responses to the higher labor costs imposed by the minimum wage. First, they can reduce employment or adjust other aspects of the employment relationship (e.g., less fringes or training opportunities), in which case some low-wage workers pay themselves through loss of their jobs or by receiving less non-salary benefits; second, firms can lose profits, in which case owners pay; and, third, employers can increase prices,wherein consumers pay.

Of these three sources, entertaining that low-wage workers bear any cost of the minimum wage has been largely dismissed by proponents in recent years based on several (albeit much disputed) studies that found little or no job loss following historical increases in federal and state minimum wages. While the extra resources needed to cover higher labor costs could theoretically come out of profits, several factors suggest that this source is the least likely to bear costs. Capital and entrepreneurship are highly mobile and ill eventually leave any industry that does not yield a return comparable to that earned elsewhere. This means that capital and entrepreneurship, and hence profits, will not bear any significant portion of a “tax” imposed on a particular factor of production. Stated differently, employers in low-wage industries are typically in highly competitive industries such as restaurants and retail stores, and the only option for these low profit margin industries becomes lowering exposure to low-wage labor or raising prices. With jobs presumed to be unaffected, this leaves higher prices as the most likely candidate for covering minimum wage costs. In fact, supporters of minimum and living wage initiatives often admit that slight price increases pay for higher labor costs following minimum wage hikes.

The above comes from a new paper, How Effective Is the Minimum Wage at Supporting the Poor? by Thomas MaCurdy of the Department of Economics in Stanford University.

MaCurdy sets out to evaluate the redistributive effects of the minimum wage adopting the view implicitly held by its advocates, that is, the study examines the antipoverty effectiveness of this policy presuming that firms raise prices to cover the full amount of their higher labor costs induced by the rise in wages.

In particular, the analysis simulates the economy taking into account both who benefits and who pays for a minimum wage increase assuming that its costs are all passed on solely in the form of higher consumer prices. The families bearing the costs of these higher prices are those consumers who purchase the goods and services produced with minimum-wage labor. In actuality, most economists expect some of these consumers would respond to the higher prices by purchasing less, but such behaviors directly contradict the assertion of no employment effects since lower purchases mean that fewer workers would be needed to satisfy demand. Consequently, to keep faith with the view held by proponents, the simulations carried out in this study assume that consumers do not alter their purchases of the products and services produced by low-wage labor and they bear the full cost of the minimum wage rise. This approach, then, maintains the assumption of a steady level of employment, the “best-case” scenario asserted by minimum-wage proponents. Although highly stylized and probably unrealistic, the following analysis demonstrates that the minimum wage can have unintended and unattractive distributional effects, even in the absence of the employment losses predicted by economic theory.

To evaluate the distributional impacts of an increase in the minimum wage MaCurdy investigates the circumstances applicable in the 1990s in the U.S.A. when the federal minimum wage increased from US$4.25 in 1996 to US$5.15 in 1997. (In 2014 dollars, this increase corresponds to a change from US$6.40 to US$7.76.)

To identify families supported by low-wage workers and to measure effects on their earnings and income, this analysis uses data from waves 1-3 of the 1996 Survey of Income and Program Participation (SIPP). To translate the higher earnings paid to low-wage workers into the costs of the goods and services produced by them, this study relies on national input-output tables constructed by the Minnesota Impact Analysis for Planning (IMPLAN) Group, matched to a time period comparable with SIPP’s. To ascertain which families purchase the goods and services produced by low-wage workers and how much more they pay when prices rise to pay for minimum wage increases, this study uses data from the Consumer Expenditure Survey (CES), again matched to the same time period as SIPP’s. The contribution of this study is not to estimate the distribution of benefits of the minimum wage, nor is it to estimate the effect on prices; both of these impacts have already been done in the literature. Instead the goal of this paper is to put the benefits and cost sides together to infer the net distributional impacts of the minimum wage on different categories of families and to translate this impact into a format readily accessible to economists and policymakers.

To provide an economic setting for evaluating the distributional measures presented here, this study develops a general equilibrium (GE) framework incorporating minimum wages. [Details of the GE model are given in the Appendix to the paper] This model consists of a two-sector economy with the two goods produced by three factors of production: low-wage labor, high-wage labor, and capital. A particular specification of this GE model justifies the computations performed in the analysis, and entertaining alterations in its behavioral elements permits an assessment of how results might change with alternative economic assumptions. The model proposed here goes well beyond what is currently available in the literature, which essentially relies on a Heckscher-Ohlin approach with fixed endowments (supplies) of labor and capital inputs. In contrast, the GE model formulated in this study admits flexible elasticities for both input supplies and for consumer demand, as well as a wide range of other economic factors.

As to results. Remember the exercise described in this paper simulates the distributional impacts of the rise in the federal minimum wage from US$4.25 to US$5.15 implemented in 1996-97.

Following the assumptions maintained by advocates, the simulation presumes (i) that low-wage worker earned this higher wage with no change in their employment or any reduction in other forms of compensation, (ii) that these higher labor costs were fully passed on to consumers through higher prices, and (iii) that consumers simply paid the extra amount for the goods produced by low-wage labor with no change in their quantities purchased. The cost of this increase is about 15 billion dollars, which was nearly half the amount spent by the federal government on such antipoverty programs as the federal EITC, AFDC/TANF, or Food Stamp program. The analysis assesses the extent to which various categories of families benefit from higher earnings, and the amounts that these groups pay more as consumers through higher prices. Combining these two sides yields a picture of who gains and who pays for minimum wage increases, including the net effects for families.

On the benefit distribution side, as other research has shown, the picture portrayed by this analysis sharply contradicts the view held by proponents of the minimum wage. Low-wage families are typically not low-income families. The increased earnings received by the poorest families is only marginally higher than by the wealthiest. One in four families in the top fifth of the income distribution has a low-wage worker, which is the same share as in the bottom fifth. Virtually as much money goes to the highest-income families as to the lowest. While advocates compare the wage levels to the poverty threshold for a family to make the case for raising the minimum wage, less than $1 in $5 of the additional earnings goes to families with children that rely on low-wage earnings as their primary source of income. Moreover, as a pretax increase, 22% of the incremental earnings are taxed away as Social Security contributions and state and federal income taxes. The message of these findings is clear: raising wages wastefully targets the poor contrary to conventional wisdom.

Turning to who pays the costs of an increase in the federal minimum wage through higher prices, the analysis reveals that the richest fifth of families do pay a much larger share (three times more) than those in the poorest fifth. This outcome reflects the fact that the wealthier families simply consume much more. However, when viewed as a percentage of expenditures, the picture looks far less appealing. Expressed as a percentage of families’ total nondurable consumption, the extra costs from higher prices are slightly above 0.5% for families at large. The picture worsen further when one considers costs as a percentage of the types of consumption normally included in the calculation of state sales taxes, which excludes a number of necessities such as food and health care. Here, the implied costs approximately double as a percentage of expenditure. More important, the minimum-wage costs as a share of “taxable” annual expenditures monotonically falls with families’ income. In other words, the costs imposed by the minimum wage are paid in a way that is more regressive than a sales tax.

On net, the minimum wage does redistribute income slightly in favor of lower income families, with higher-income families paying more in increased prices than they benefit from the rise in their earnings. However, adverse impacts occur within income groups. Whereas less than one in four low-income families benefit from a minimum wage increase of the sort adopted in 1996, all low-income families pay for this increase through higher prices rendering three in four low-income families as net losers. Meanwhile, many higher income families are net winners.

Political support for the minimum wage largely depends on the apparent clarity of who benefits and the inability to trace who pays for the wage increase, irrespective of whether costs are paid through higher prices, or lower profits, or cutbacks in jobs or employee benefits. As shown in this study, the benefits created by the minimum wage goes families essentially evenly distributed across the income distribution; and, when minimum wage increases are paid through higher prices, the induced rise in consumption expenditures mimics the imposition of a sales tax with a higher tax rate enacted on the goods and services purchased disproportionately by low-income families. Consequently, a minimum-wage increase effectively emulates imposition of a “national tax” that is more regressive than a typical sales tax with its proceeds allocated to families unrelated to their income. This characterizes the income transfer properties of the minimum wage, which many might not view as an antipoverty program.

The highlighted sections are some of the more important takeaway bits from the study.

In summary, MaCurdy adopts a “best-case” scenario taken from minimum-wage advocates. His study projects the consequences of the increase in the national minimum wage instituted in 1996 on the redistribution of resources among rich and poor families. Under this scenario, the minimum wage increase acts like a regressive sales tax in its effect on consumer prices and is in fact even more regressive than a typical state sales tax. With the proceeds of this national sales tax collected to fund benefits, the 1996 increase in the minimum wage distributed the bulk of these benefits to one in four families nearly evenly across the income distribution. Far more poor families suffered reductions in resources than those who gained. As many rich families gained as poor families. These income transfer properties of the minimum wage document its considerable inefficiency as an antipoverty policy.

(HT: thanks to Tim Worstall for pointing out the study.)