February 5, 2019 2:40PM

The Rationale for Minimum Wage Increases

This morning I gave oral testimony to the Vermont Senate Economic Committee on their proposal to raise the state minimum wage to $15 an hour by 2024. As part of my written evidence, I explored in detail the rationale for minimum wage hikes from the “Fight for $15” campaigners and other think-tanks. Below is a slightly edited version of that section of my testimony, which has wider applicability.

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Theoretically, a minimum wage hike can improve the functioning of a labor market when employers are “monopsonistic.” When firms have significant labor market power over employees, raising a wage floor can increase both pay for workers and employment levels. Some economists have argued that most firms do have a slight degree of monopsony power over their employees. This suggests a modest minimum wage can, in some cases, actually improve economic efficiency, ending so-called “exploitative” low wage rates without reducing employment.

But those advocating minimum wage hikes across America today do not use this economic line of argument. Bureau of Labor Statistics data shows 84 percent of employees paid at or below the federal minimum wage work for businesses in retail, leisure and hospitality, and education and health services. These industries do not tend to be characterized by powerful companies which dominate local labor markets. The theoretical economic case for minimum wage hikes to solve “market failures” is therefore weak.

Instead, proponents of higher minimum wages assert that legislation should deliver some target level for minimum hourly wages to fulfill other objectives. Their rationale is really about giving minimum wage earners more money. And they use a host of metrics to show that, currently, minimum wage earners are just not being paid enough.

But what should determine where the minimum wage level is set? Ideas seemingly differ across $15 wage proponents. Some implicitly argue that minimum wages should be set to cover certain essential living costs. Democratic presidential primary candidate Elizabeth Warren, for example, suggested this when she claimed:

When I was a kid, a minimum wage job in America would support a family of three. It would pay a mortgage, keep the utilities on and put food on the table. Today, a minimum-wage job in America will not keep a mama and a baby out of poverty.

Others prefer different metrics. In testimony to this committee, David Cooper of the Economic Policy Institute documented extensively how current minimum wage rates had not “kept up” with average wages or economy-wide productivity levels, and did not provide incomes for full-time workers to cross certain poverty thresholds.

None of these claims are disputable as facts. But I want to suggest that those metrics are not appropriate for judging what the Vermont minimum wage should be. Devoid of broader context, they are misleading and might lead to damaging policy conclusions.

Cost of living: It’s important to remember that employers pay employees for the perceived value of the work undertaken, not to compensate workers for their rent, food, energy, transport, clothes or child-care bills (which will differ hugely by family and are beyond employers’ control).

High living costs are a very under-discussed cause of economic hardship. My own research has found typical poor American households face higher prices on essential goods and services due to misguided interventions and regulations that cost them between $800 and $3,500 in total per year.

Rather than tackle the causes of these high prices, minimum wage hike campaigners want businesses to bear the cost of compensating workers for their living expenses. This is not economically sensible. Putting the full burden of the cost of living on shareholders and customers of low wage employers, divorcing pay rates from the work employees undertake, market conditions, and firms’ ability to pay, could risk a significant diminution in low wage job opportunities.

Productivity: Economy-wide labor productivity has risen faster than minimum wage rates over the last fifty years. Given productivity changes should affect worker total compensation levels, $15 wage campaigners imply that minimum wage workers are being paid below what their productivity commands.

But comparing productivity gains of all workers to speculate what hourly wage rates should be for minimum wage workers alone is misguided. After all, different industries experience different productivity growth rates over time.

Sadly, a productivity growth series solely for minimum wage workers is not available. But long-term data for the food services industry might be a reasonable proxy. Bureau of Labor Statistics data show that from 1987 to 2017, labor productivity in the food service sector rose by an average of just 0.4 percent per year (with unit labor costs increasing by 3.2 percent per year). If the minimum wage had been pegged to this productivity measure, it would have increased by 13 percent in real terms – from $7.16 in 1987 (2017 dollars) to $8.06 in 2017.

The actual 2017 federal minimum was, of course, $7.25 in 2017 and the Vermont minimum wage was $10. Using this productivity series and start date then, the Vermont minimum wage is now higher than justified by food service productivity improvements since 1987.

This does not prove that Vermont minimum wage rate increases have exceeded the productivity growth of all minimum wage employees, nor does it tell us what the minimum wage level should be according to this measure (given the necessary arbitrary start date). But it does show the danger of making spurious comparisons between economy-wide productivity and minimum wage rates. Pegging minimum wage rates to aggregate productivity trends might lead us to deliver much higher wage floors than justified by the productivity of workers in certain sectors, causing significant job losses or other adjustments.

Poverty: A stated ambition of $15 minimum wage advocates is to lift households above poverty thresholds. Minimum wage hikes can achieve this by raising incomes for minimum wage earners. Yet poverty is measured at the household level. The very reason why minimum wages were not used as a primary tool to reduce poverty for households in recent decades is that they were not considered particularly well targeted or effective.

First, people who earn around the minimum wage are often not from poor households. In 2014, the economist Joseph Sabia estimated just 13 percent of workers on hourly rates between $7.25 and $10.10 lived in households below the poverty line. Many people earning around the current minimum wage rate are second earners (particularly part-time) or young people who live in households with parents not in poverty. Second, minimum wage hikes could have adverse consequences on employment prospects by raising business costs.

That’s why economists have long concluded that in-work income transfers to families with children through programs such as the earned income tax credit (EITC) are better targeted at reducing poverty. Many believe they are preferable to minimum wages as a poverty reduction policy, because they encourage work while boosting incomes of poor households, rather than discouraging employers from hiring (though they come with other problems).

Yet poverty thresholds themselves ignore the EITC and other transfers that have expanded in recent decades. Comparing the income for a full-time minimum wage earner to poverty thresholds is therefore very misleading on the living standards many households actually enjoy.

In short, the metrics that $15 minimum wage advocates use to make the case for substantial hikes are not economically sensible benchmarks. For all the noise and economics-y language of their arguments, economists generally oppose manipulating prices to obtain social policy objectives.

Your focus in considering this policy proposal should center instead on traditional labor market economics.

Changing the legislated minimum wage affects both:

1)   the incomes of minimum wage workers who maintain their jobs and hours

2)   the number of jobs and hours of work employers demand, and broader working conditions, due to the change in business costs.

Standard economics tells us that, in most cases, raising the minimum wage will boost 1) and reduce 2). What becomes crucial then is considering the potential size of these two effects and judging their importance to achieving your objectives. The first requires drawing on economic evidence. The latter is more a question of philosophy.