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August 23, 2003

Why Minimum Wage Beats EITC

Matthew Yglesias thinks the minimum wage is only the second best alternative to the Earned Income Tax Credit and other transfers to the working poor:

I think the conservative/libertarian critique of the minimum wage has a reasonable amount going for it, and I would greatly prefer to see more transfer payments to working people and less efforts to achieve the same goal through regulatory fiat.
But transfer payments means that the rest of us are subsizing sweatshop employers, who artificially dump their operating costs on the public. This is bad not just because it's hard on us as taxpayers, but it distorts the labor market and encourages less productive and less efficient production methods. The labor market is an odd beast and poorly modeled in most of economics, but there's little question that pure transfer payments, especially ones that increase wages proportionally as the EITC does, often drive down wages, since the employee can therefore survive on a job where otherwise he or she would look elsewhere.

An Example of EITC Problems: To understand why this can distort the labor market and production, imagine two companies producing Widgets. One employer uses moderately skilled workers and therefore has to pay $10 per hour to attract the needed employees, but he produces 10 widgets per worker per hour.

Employer 2 uses less skilled workers. In the absence of the EITC and other transfer payments, imagine no one would take the job except for $7.50 per hour. But his less sophisticated system only produces 5 widgets per hour per worker, half the productivity of employer number one.

The result will be that employer one will have to pay one dollar in wages for every widget produced ($10 per hour/ 10 widgets produced per hour), while employer two will have to pay $1.50 in wages for every widget produced ($7.50 per hour / 5 widgets produced per hour).

So employer number two will probably be driven out of business by employer number one, who is more productive despite paying higher wages.

Then imagine introducing the EITC and other transfer payments that add roughly 50 cents for every dollar earned paid for by the government. Theoretically, employer number two could bargain his less skilled workers down to just $5 per hour in wages paid, since they will receive an additional $2.50 per hour from the government. So the workers at employer two will still be coming out the same at $7.50 per hour in money taken home so they will take the job.

But now the costs to employer two are lower, and he can produce a widget for a dollar in labor costs ($5 per hour / 5 widgets per hour), making him now competitive with employer number one.

And raise transfer payments a bit more and employer number two may be able to drive employer number one out of business. So the result of these subsidies is that the high-wage jobs get destroyed because low-wage ones are being subsidized by the government.

How Wage Subsidies Distort the Labor Market: Now, the above is a simplification and no doubt in the workings of the labor market, employers cannot drive down wages dollar for dollar compared to subsidies received by employees. But it unquestionably does lead to downward pressure on wages as some people accept jobs at levels they would not have without those wage subsidies. And this inevitably gives those low-wage employers an advantage compared to higher-wage employers whose employess are unsubsidized by the government.

This is bad not just because it hurts those higher wage employees and employers, but is bad because it systematically encourages production systems with lower productivity and less skilled workers. In a global economy where we need to upgrade the skill and productivity levels of our economy to remain competitive, wage subsidies push the economy in the exact opposite direction.

See this article by policy analyst J.W. Mason for more on the problems of the EITC.

History of Wage Subsidies: The most extreme version of how wage subsidies disort labor markets and beggar workers collectively was the disasterous Speenhamland system introduced in England 1795, which created transfer payments such that every worker would have their income raised to a guaranteed subsistence level. WIth no minimum wage, employers sent wages into freefall downward. See here for details on the web or read Karl Polanyi's account in his classic The Great Transformation.

The EITC is designed better than Speenhamland but, in the absence of a strong minimum wage, it does force high-wage employers and workers to subsidize low-wage employers. We should not be creating an economy where the most productive companies subsidize McDonalds and garment sweatshops. That's is a road to economic self-destruction.

That's not to say the EITC should be abolished. When combined with a high minimum wage, it does benefit workers and its distorting effects on the labor market are contained. But the policy decision should not be EITC or minimum wage; the decision should be to implement increases in both in tandem.

See this policy piece on how minimum wage and EITC programs reinforce each other.

What About the Unemployed?- With a high minimum wage, many conservatives argue that this will decrease employment for the poor who are unemployed. The data to support that contention is actually pretty weak. A number of studies, notably by economists Alan Krueger and David Card in their book Myth and Measurement have shown that wage hikes in the past have led to INCREASED employment for the poor because it encourages higher productivity and creates more spending in the poor communities themselves. At best, the evidence is that minimum wage increases are largely a wash.

And if you want to help the unemployed poor, first give them the income to survive until a wage paying more than welfare is offered. Then invest in education and training for some of the better jobs. And create new jobs appropriate for the least skilled workers, instead of just subsidizing lower wages in existing jobs. Sort of A-B-C-- help them immediately, train them for the future, create new jobs.

Update: Max Sawicky has more on the whole debate-- worth reading since Max lives and breathes the tax bizarrities of the EITC. Although by his logic that the opacity of the EITC helps prevent subsidies to employers, then passing Max's reforms to the EITC might dangerously clarify these tax issues and help employers bargain down wages. Although this all just adds to the basic point that unlike Matt's original contention, the EITC like the minimum wage has a complicated relationship to the labor market. I'll have more a bit later.

Posted by Nathan at August 23, 2003 01:09 PM