My wife was following a debate recently on social media regarding the minimum wage and asked me to write an analysis on this topic. As a good husband, I have complied with this request and hopefully present this complex topic in a somewhat interesting and easy to follow manner.
History:
The minimum wage in the United States began its history as part of Franklin D. Roosevelt’s New Deal. In 1933, Roosevelt said “In my Inaugural I laid down the simple proposition that nobody is going to starve in this country. It seems to me to be equally plain that no business which depends for existence on paying less than living wages to its workers has any right to continue in this country. By “business” I mean the whole of commerce as well as the whole of industry; by workers I mean all workers, the white collar class as well as the men in overalls; and by living wages I mean more than a bare subsistence level-I mean the wages of decent living”. Ultimately, the Fair Labor Standards Act of 1938 was passed years later and set the minimum wage at 25 cents.
Ever since, the minimum wage has been a hot button topic in the United States. The arguments both for and against minimum wage increases appear to be a perpetual fight with predictable talking points on both sides of the political spectrum. Generally speaking, my mantra is when a politician (regardless of political affiliation) condenses something as complex as the minimum wage into simplistic talking points, you should take everything said with a grain of salt.
In this article, I aim to present eight common myths around the minimum wage and address it with a fact-based analysis. My points are primarily focused on the United States, but can have applicability to other nations as well.
Myths:
- Myth 1: The minimum wage serves as a floor where all workers will make AT LEAST that hourly wage. False. The minimum wage does not apply to certain workers, such as small farm employees, and there are certain exceptions for other classification of workers based on factors such as age and disability. I recently examined a meme discussing the price of a Big Mac in the US, Australia, and France where they tried to show that higher minimum wage didn’t correspond to a price increase in the Big Mac. This is only partially true. In Australia’s case, the minimum wage is currently $17.29 (before tax), but this doesn’t apply to workers under 21 years of age. Actually, in many cases, a younger worker in Australia may earn less than the counterpart in the US due to this loophole.
- Myth 2: The minimum wage causes unemployment. Partially False. This is not necessarily the case, but this is highly dependent on the level of the statutory minimum wage. There have been many studies to debunk this myth, some are included here, here, and here. However, what can occur is something called the “substitution effect” whereby the employer will substitute labor with other labor. I can see a relatively high minimum wage for an entry level position causing employers to select higher-skilled over lower-skilled workers, in addition to creating more worker demand for those entry level positions. To truly understand the effects of the minimum wage on employment, the labor market as a whole should not be examined, but rather segments of the labor market. Furthermore, in a study published in February 2014, the CBO estimated that a $10.10 US minimum wage would reduce employment by 500,000 workers (or 0.3%). This is a relatively small number, but the negative effect needs to be taken into account.
- Myth 3: We should raise the minimum wage, as all developed nations have a government mandated minimum wage. False. The Nordic countries (Denmark, Iceland, Finland, Norway, and Sweden) do not have a legislative minimum wage. What effectively occurs in these countries is that negotiations between unions, of which a majority of workers are members, and employers set the wage for various occupations. That, plus a generous benefit system subsidized by very high taxes, makes a statutory minimum wage unnecessary to protect the lowest paid workers.
- Myth 4: Minimum wage raises prices of goods/services. True. A study byPurdue University published in July 2015 indicated that raising labor costs to $15/hr would lead to an estimated 4.3% increase in prices at those limited service restaurants. That is not a large increase in price. However, when you increase the minimum wage to $22/hr, this would result in a 25% increase in prices. So, it appears there is an inflection point where wages can be raised and not have a material impact on the underlying pricing model. From a fast food standpoint, if the wages went up considerably, then a corresponding portion size reduction would likely occur to offset the direct financial impact to the consumer.
- Myth 5: Raising the minimum wage can have a stimulating effect on the economy. Partially True. This only applies in economies with high levels of consumption and lower corresponding levels of savings and the stimulating effect is short term in nature. In 2013, Federal Reserve Bank of Chicagoeconomists published a study which found that a pay hike of $1.75/hr would augment spending by at least $48 billion in the first year following implementation, but would not have a long term GDP effect. However, the number of workers earning minimum wage is relatively small compared to the overall workforce, so this lessens the overall stimulating effect. According to the BLS 3.9% of all hourly paid workers earn at or below the minimum wage. This does not take into account the “ripple effect”, however.
- Myth 6: A minimum wage increase would primarily benefit the poor and decrease poverty. False. There have been several studies which indicate that a significant portion of minimum wage earners are not from the lowest income brackets when taking overall household income into account. In fact, the Economic Policy Institute has noted that approximately 68% of minimum wage earners are in a household with income of at least $60,000 annually. While the minimum wage can technically reduce poverty, the impact is limited because poor families may not have any working members and many of those who receive the minimum wage are in higher income households. A more targeted method, like the Earned Income Tax Credit (EITC), directly helps the poor. The other aspect is to consider the main drivers for poverty which are changing trends in an economy, lack of education, high divorce rates, overpopulation, and lack of employment rather than being employed for the minimum wage.
- Myth 7: The true value of the minimum wage has not kept up with inflation and eroded over time. True. In terms of purchasing power, the minimum wage peaked in 1968 at an adjusted rate of $8.54 (in 2014 dollars). The argument that the minimum wage has not kept up with inflation is a valid argument and multiple data sources support this assertion.
- Myth 8: The minimum wage was never intended to be a “living income” and was designed for younger people entering the workforce. False. It was clear from Roosevelt’s quote, presented at the start of the article, that the minimum wage was intended to be “more than a bare subsistence level”. Whether the government should mandate such a rate is another argument, but the quotes issued around the time of the minimum wage inception are clear on this issue.
Conclusions:
While the minimum wage may have marginal short term effects on unemployment across the labor market, there are magnified impacts upon particular segments within the workforce. The substitution effect is very prevalent and an above market minimum wage corresponds to a negative effect on lower-skilled workers in favor of those with a higher compliment of skills. This will impact younger workers (ages 16-19) who are trying to establish themselves at the entry levels in the workforce as well as workers from disadvantaged backgrounds.
There is a statutory minimum wage threshold whereby once it is set beyond an acceptable market level, a broader negative effect on employment occurs. The question becomes what is that invisible level? To fully understand the implications of a higher minimum wage, it is not productive to view the wage against the entire labor market. Rather, I suggest taking the minimum wage and comparing it against specific industries (e.g. restaurant/hospitality and low skilled workers), age of workers, and those with disabilities. If set too low, the minimum wage loses its usefulness. If set too high, it will lead to a substitution effect (or reductions in employment) and negatively impact those workers it was intended to protect.
Another aspect of the minimum wage that is not often considered is called the “ripple effect”. The ripple effect occurs when an increase to the minimum wage spills into higher wage brackets. For example, let’s say the minimum wage is increased from $8 to $12/hr. Then, not only are the lowest paid workers brought up to the new wage, but certain workers making over the minimum would also see a corresponding pay increase. The ripple effect is a double edged sword. On one hand, the employer’s labor costs could go up drastically depending on the composition of their employees. On the other hand, a broader amount of workers would have more income which can lead to higher demand of goods/services in a consumption based economy.
In certain industries, an above market minimum wage will likely create a demand for more capital intensive production, which will ultimately shift the demand curve from low-skilled workers in these industries. This would not occur immediately, but could influence a demand for automation over time. The paradox is that even if the minimum wage laws are reversed, the capital presence in the industry will remain due to the initial outlay and payback period of the investment.
For a minimum wage to be effective, we have to be realistic as to what it can and cannot do. Research tells us that it is not an efficient means of reducing poverty. Additionally, there are other potential pitfalls to the lowest paid workers, such as poverty traps based on government provided benefits. If a government is to enact a statutory minimum wage increase, it has to be taken in conjunction with a broader policy mix around specific benefits provided to the lowest paid workers and labor market considerations to nullify the negative effects and magnify the positive effects.
There is much debate among economists as to whether a higher minimum wage helps or hurts an economy. Based on the discussion and facts presented in this article, what do you think?
