Wednesday, June 1, 2011

Minimum Wages and the Earned Income Tax Credit (a first cut)

Mark has written a number of recent blog posts on the minimum wage and living wage laws. The positive and negative consequences minimum wages are well-known to economists: 1) Minimum wages increase wages for those currently employed at minimum wage and 2) Minimum wages have a host of negative unintended consequences. Here is a list of various unintended consequences that have been researched by economists:

Negative Employment Effects (This is well reviewed here) - Because firms compete against each other in the market place they must keep prices low and quality high. When minimum wages increase there are increases in the cost of doing business. Thus, in order to keep prices low in the face of competition certain strategies such as outsourcing, loading more responsibilities onto less people, or substituting technology for labor become desirable. In any case this means that less low-skilled labor will be hired. Luminary and economic Nobel Prize winner Paul Samuelson once wrote in 1973,
"What good does it do a black youth to know that an employer must pay him $2.00 per hour if the fact that he must be paid that amount is what keeps him from getting a job?"
To this point, former colleague and excellent labor economist Dave MacPhearson has a working paper showing that much of the unemployment amongst African Americans can be attributed to the recent increases in the minimum wage. This has especially impacted African American teenagers at 40% (versus 25% for other teens).

One proposal to help improve the employment of low skilled teenagers is a sub-minimum wage "training period". This would allow firms to benefit from the labor of teenagers, screen those teens who show the most promise, and then retain those teenagers at a higher wage after the training period. From the standpoint of teenage benefit they have the opportunity to obtain skills and develop a good track record. In light of the next unintended consequence a "training period" at a lower wage may not be a bad idea.

Altered Opportunity Cost - Because there is greater reward for those working in low-skilled jobs under a higher minimum wage this has been shown to increase the opportunity cost of staying in school. Neumark and Wascher (1995) show increased minimum wages cause more high school drop outs. Some suggest that this unintended consequence only underscores the need for compulsory education laws. I'm not against compulsory education; however, I would ask the question of what kind of education (I believe we overlook the importance of vocational education in the U.S. ---this is a topic for another post).

Overall, no economics research (known to me) show the minimum wage has reduced poverty.

The studies are more numerous than these and are well summarized in this massive literature review (here and also in book form here). Nevertheless, the minimum wage continues to appear desirable because well intentioned people continue to desire a wage that secures a basic level of welfare for all workers. This desire is not unfounded. But, what policy could obtain the goal of helping the poor without all the nasty unintended consequences? The Earned Income Tax Credit.

The EITC is a cousin of the Negative Income Tax (NIT). There is a good summary of the negative income tax on Econ Library. The basic idea is that people receive a "wage subsidy" to supplement their income. The size of that wage subsidy is determined by two components: the initial threshold and the rate of the tax subsidy. The initial threshold determines what someone would earn if they worked zero hours. The downward slope determines the size of the wage subsidy at each unit of income (i.e. the subsidy gets smaller as income gets larger, but, at what rate does the subsidy decrease?). Where the NIT is a strictly decreasing slope the EITC increases, decreases, and is flat over different ranges of income (see below from Tax Policy Center)


Because the EITC targets independents and people earning less than a certain amount of money there are fewer problems with helping the poor. While the minimum wage disproportionately benefits teenagers, teenagers who file taxes as dependent would not qualify for the EITC. Also, while a higher minimum wage (or living wage) might induce a stay at home Mom or Dad into the labor force the EITC may not. This is because if their spouse earns a certain level of income they would not qualify to receive the EITC.

At this point you may be saying, "The EITC sounds like a better policy than an increase in the minimum wage, but, how would you fund such a thing?" That's a really good question, especially with the national debt rising to great heights. But, funding is not problematic when you view the EITC expansion as a replacement of, rather than an addition to, other programs. I came to this idea independently, but, it turns out it is not original. In Greg Mankiw's best-selling economic textbook he reports that 79% of economists agree that the government should restructure the welfare system along the lines of a negative income tax.

The rationale for restructuring the welfare program along these lines stems from at least a few observations. First, there would be lower administrative costs to distributing money via the EITC. Second, the EITC provides an incentive for employment that welfare does not. Third, unlike the so-called backward hustle (talked about in the documentary Waging a Living and written about at the Mises Blog) the EITC does not punish people for promotions.

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