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Two Reasons Not to Raise the Minimum Wage

By Evan Soltas
January 03, 2013 11:43 AM EST

Should the federal minimum wage go up by more than $2?

U.S. Senator Tom Harkin, an Iowa Democrat, has proposed that it climb to $9.80 over the next two years, having stood at $7.25 an hour since 2009. Harkin's proposal would give a minimum-wage worker the greatest purchasing power he or she has seen since the late 1960s. Harkin intends to submit legislation in the next Congress.

He is not the only Democrat who has expressed support for a minimum-wage increase. It was part of the Democratic Party platform in 2008 and 2012. A higher minimum wage, Democrats argue, would support low-wage workers by reducing income inequality and stimulating the economy.

The evidence for their first claim is reasonably strong. An increase in the minimum wage would reduce inequality by pushing up the incomes of the poor, a report from the Organization for Economic Co-operation and Development found this year. A 2008 paper by economists Robert J. Gordon and Ian Dew-Becker also found that minimum wages have significant empirical impacts on income inequality.

It is less clear, though, that a higher minimum wage would do anything to boost economic activity. A study by the Federal Reserve Bank of Chicago did find that it would increase consumption: For every $1 increase in the minimum wage, households with minimum-wage workers increased spending by $800 per year. Almost all of these gains, however, come from the interaction of income redistribution with savings rates. Since high-income households save more of their income than low-income households, income redistribution tends to shift savings into consumption. That has ambiguous effects on economic growth.

Republicans, to their discredit, have done a poor job rebutting Democratic arguments. Their main counterargument is that increasing the minimum wage would increase unemployment. A higher binding price floor on labor, Republicans reason from the economic basics, will increase the amount of labor that goes unused.

The problem with this argument is that it proceeds in almost complete ignorance of empirical analyses that find small, if any, impacts of the minimum wage on employment. The most important work on this topic comes from two pairs of economists: David Card with Alan Krueger, and David Neumark with William Wascher. Card and Krueger find no employment impacts, whereas Neumark and Wascher find significant but limited effects.

How can that be? It's because labor is a complex market. It doesn't neatly behave according to the supply-and-demand models you'd find in an introductory economics textbook. There is not a single market for labor, nor is "labor" a single, undifferentiated commodity. Most employers have significant market power for the goods or services they produce, and so they mostly pass on the increased labor costs in the prices of their products instead of cutting production and jobs. All of this means that the "labor market" does not quite respond to the minimum wage in the way Republicans have argued it does.

So that means we should sign on to Harkin's proposal, right?

No. Liberal arguments for increasing the minimum wage have a fundamental flaw: They restrict the set of policy choices to either a minimum wage increase or doing nothing. That means they overlook the single most important federal policy for the poor: the Earned Income Tax Credit.

The EITC is a measure in the federal tax code to support the living standards of the poor without creating a "welfare trap" by diminishing the incentive to work. Economists widely consider the credit a success for reducing poverty while increasing employment. Created in 1975, the credit has been successively expanded in five times since. It is now the nation's largest anti-poverty transfer program.

In its latest iteration, for families with two or more children, the credit is 40 percent of the first $10,750 of earned income. After earned income exceeds $15,040, the credit is phased out at a rate of 21.06 cents per marginal dollar, and it goes away fully at the point when earned income reaches $35,458. (The EITC code is similar for smaller families, childless married couples and singles.)

Democrats who want to address income inequality would be much better served by increasing the EITC rather than the minimum wage. Alternatively, if Republicans shifted strategy and suggested an increase in the EITC as a counteroffer to Democratic minimum-wage proposals, they would have the clearly stronger argument on merits. They have the opportunity to do so now, with the "fiscal cliff" deal only temporarily extending the 2001 and 2009 expansions of the credit.

Republicans could correctly argue that compared to the EITC, the minimum wage is a flawed and frankly out-of-date policy tool. First, the minimum wage is inefficient: The same income support could be provided at a quarter of the cost with the EITC, according to Forbes's Adam Ozimek. Second, its benefits are poorly targeted, with little going to the neediest families, according to Employment Policies Institute fellow Michael Saltsman. This is in part because, as Bureau of Labor Statistics data show, many minimum-wage workers are actually teenagers entering the workforce who come from middle-class families.

Although supporting the EITC in opposition to the minimum wage may seem like a change of argument for the Republicans, it would actually be a return to the case that conservatives and free-marketers once argued. George J. Stigler, the Nobel laureate and torchbearer of the Chicago school of economics, once made the outlines of this argument by recommending a negative income tax. Milton Friedman also endorsed the idea as the best way to provide for the social welfare of the poor.

Stigler wrote in 1946, Friedman in 1962. As it comes time again to debate the minimum wage, Republicans would be well served by dusting off Stigler's and Friedman’s insights. They would there find a forceful intellectual case against increasing the minimum wage.

(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)

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