Recently, several economists have recommended a hike in the minimum
wage. It is tempting to say that these economists must have failed
Econ 101, since basic economics textbooks regularly teach the
foolishness of a minimum wage policy. Yet, these economists are
neither inept nor foolish; they include three Nobel Prize winners
and a highly regarded labor economist. These economists must be
basing their recommendation on new theory and evidence that textbooks
Indeed, there is a new economics of the minimum wage. The new
economics suggests that a minimum wage policy should not be rejected
out-of-hand as foolish. However, it also does not by itself support
the economists' recommendation. These economists had to make a
number of value judgments in order to reach their conclusion,
judgments better made in the political arena. To better understand
where their economic analysis ends and personal value judgments
begin, one needs to understand the challenge raised by the new
arguments for a minimum wage hike.
The old argument about minimum wages which is found in textbooks
is quite simple: Government intervention in a competitive labor
market is a mistake. If the minimum wage is set at or below the
prevailing market wage, it will have no effect. If it is set above
the prevailing market wage, the number of workers employed, determined
by the firms' demand, will be lower than without a minimum wage.
This is a foolish policy, because there conceptually are ways
of transferring income to low-paid workers that do not reduce
the number of people working.
A study by David Card and Alan Krueger in 1994 challenged the
old argument. They found that in New Jersey a higher minimum wage
increased employment, rather than decreasing it. Other studies,
mainly conducted by at least one of the above researchers in collaboration
with others, find similar outcomes.These findings led to development
of new theories of minimum wages along two lines. The first, which
I refer to as the monopsony theory, is hard to defend. The second,
which I refer to as the tax-transfer theory, is quite defensible.
The monopsony theory takes the Card-Krueger findings at face
value. It assumes that firms act as monopsonies in hiring low-wage
workers; that is, they do not face strong competition for such
labor and so have discretion in setting wages. According to this
non-competitive theory of the labor market, a higher minimum wage
can increase both efficiency and employment.
I find this argument in support of a higher minimum wage weak
at every turn. First, the Card-Krueger findings are far too tentative
to treat as an observed fact. Their data have been criticized,
and researchers working with better data have shown the Card-Krueger
findings are reversed. Other studies recently published in the
prestigious American Economic Association Papers and Proceedings
are also in conflict with the Card-Krueger findings. Moreover,
even if the Card-Krueger data were correct, one can argue that
their study searched for effects across too few industries and
allowed too little time to elapse. Second, evidence about labor
markets suggests the low-wage market is better characterized as
competitive as opposed to monopsonist. Can Burger King set its
wage for hamburger flippers much lower than those for McDonald's
flippers, local newspaper carriers or grocery carry-out help without
losing them? Finally, even if we accept the monopsony theory,
it does not tell us whether or how much to raise the minimum wage.
It tells us there is an optimal minimum wage, but the current
minimum wage is not zero. Should the optimal wage be higher or
lower than the current minimum wage? Is the 90¢ increase proposed
by the administration too low or too high? Shouldn't it be set
differently in different locations? This theory gives little guidance
on these questions.
The tax-transfer theory does not take the Card-Krueger evidence
at face value. In fact, as Richard Freeman, the highly regarded
labor economist, suggests after reviewing a number of studies
on both sides of the aisle, a rise in the minimum wage may lower
employment but that effect is modest and much smaller than previously
While a higher minimum wage may entail some modest employment
reduction, proponents of a higher minimum wage correctly point
out that is not enough to reject it. Benefits also have to be
examined. Freeman correctly argues that a useful way of thinking
about a minimum wage policy is as a distorting, off-budget tax-transfer.
Let's take a closer look at this way of viewing minimum wage policy.To
see that a minimum wage policy is a tax-transfer, let us suppose
that the government seeks to implement a $5 per hour minimum wage
through the budget rather than through mandate. It assigns a government
agent, Minnie, to collect taxes each month from Scrooge-like employers
and distribute the proceeds to low-wage employees. At each firm
Minnie asks for a record of all employee hours worked at less
than $5 per hour and the wages actually paid. She then computes
the employer's tax bill as the sum of hours worked which were
paid at less than $5 per hour times the difference between $5
and the wages actually paid. That is, if the employer had 100
hours of work paid at $3 per hour and 250 hours of work paid at
$4 per hour, its tax bill would be computed as: 100*(5 - 3) +
250*(5 - 4) = $450.
After collecting the tax from all employers, Minnie then visits
all employees who earned less than $5 per hour. She pays them
the difference between $5 and their actual wage times the number
of hours they worked in the month.
This hypothetical tax-transfer scheme is identical in effect
to a minimum wage policy. The major difference is that the minimum
wage mandate removes the government middle-man and moves the policy
from on-budget to off-budget for the government.
The tax-transfer scheme which I describe causes distortions.
That is, there is an incentive for employers to avoid the tax,
and an incentive for individuals to enter the work force to capture
the subsidy. These effects are confirmed in recent studies. Employers
avoid the tax by substituting machines or higher-skilled workers
for their low-wage workers or by changing the composition of the
compensation package they offer workers. That is, they raise wages
to comply with the mandate but reduce training and keep the total
compensation unchanged. Similarly, but on the other side of the
labor market, high school students have an incentive to drop out
of school to receive the minimum wage subsidy.
While the tax-transfer theory suggests that a minimum wage hike
distorts, proponents of a hike would argue that so do all government
tax-transfer schemes-contrary to what economic textbooks assume.
Based on recent evidence, such as that of Card-Krueger, proponents
argue that distortions caused by the minimum wage are no worse
than those caused by other tax-transfer programs. They complete
their argument that now is a propitious time to raise the minimum
wage by making the following observations:
The minimum wage has fallen in inflation-adjusted terms significantly
since it was last set, so that distortions from a small increase
now should be minimal.
Real wages of low-skilled workers have been declining, so
the social benefit of transferring income to this group of workers
With cuts planned in on-budget tax-transfer programs, such
as the Earned Income Tax Credit (EITC), it becomes more desirable
to do the tax-transfers off-budget.
Let me comment on these observations in turn. I do not quarrel
with the first point, but I would add that while the distortions
should be small, so should the benefits. The administration's
proposed 90¢ increase over two years would bring the minimum wage
up to just $5.15. It's hard to believe many workers would be earning
less than this two years from now.
The next two observations, which are crucial to the argument
for why an increase is needed now, are based purely on personal
value judgments. The judgments may or may not be reasonable. My
point is that they do not come from economic analysis.
It is true that real wages of low-skilled workers have fallen
relative to those of high-skilled workers. However, one cannot
just consider the benefit of giving low-skilled workers more money.
One also has to consider who loses in the process. The losers
include the owners and customers of the firms that must pay the
tax. The losers include the few people who will not be able to
get a job at a higher minimum wage, or those who keep their jobs
but consequently receive less compensation in other forms, such
as training or other benefits. The losers also include the public
at large. There is a general consensus that the change noted in
relative wages of skilled and unskilled workers is a worldwide
phenomenon and is caused primarily by new technologies, such as
computers, which simultaneously increase the demand for high-skilled
workers and decrease the demand for low-skilled workers. The change
in relative wages is the market's way of signaling that more high-skilled
workers are needed and fewer lower-skilled workers are required.
A higher minimum wage muffles this signal, resulting in the wrong
mix of workers and causing a loss of goods and services potentially
available to the general public. So yes, the benefits to those
that receive higher wages may increase. But a lot of people will
lose. It takes a value judgment to say the benefits to the winners
outweigh the costs to the losers.
Meanwhile, the suggestion that it is a virtue to have the minimum
wage off-budget is a value judgment. These economists are saying
they know better what is good for society than elected officials
do. It is generally agreed that the EITC dominates the minimum
wage as a means of directing income to those who need it. The
EITC directs money to low-income families. The minimum wage directs
money to low-wage earners. The problem with the minimum wage transfer
is that many low-wage earners happen to be teenagers or other
secondary workers of middle- and upper-income families. If elected
officials determine that there should be reductions in the EITC
transfers to low-income families, how can it be consistent with
their values to raise the minimum wage?
A decision to raise the minimum wage cannot be made on the basis
of economic analysis alone, it also requires the value judgments
of elected officials. My recommendation is that the minimum wage
be put on budget. This is what Congress decided to do with the
mandated employer health care contributions under the proposed
Clinton health care policy. If the minimum wage were put on-budget,
policymakers could weigh in a consistent manner the desirability
of a minimum wage change relative to changes in other tax and