Better together: Pairing smaller minimum wage increases with tax policy to reduce inequality

Arguably, the lowest-earning households are the primary target for efforts to substantially boost minimum wages at the federal, state, and local levels. A worker at today’s $7.25 per hour federal minimum wage grosses $15,080 annually—just over the federal poverty guideline for a single person. The popular proposal of a $15 federal minimum wage would more than double this hourly pay.

However, new research from Minneapolis Fed Monetary Advisor Patrick Kehoe and visiting scholar Elena Pastorino (with Erik Hurst and Thomas Winberry) concludes that low-wage households fare best when a modest minimum wage increase works in conjunction with a progressive tax policy, such as the earned income tax credit (EITC).¹

Specifically, the economists find that increasing the minimum wage to around $9.25 is enough to effectively erode the labor-market power of employers, thus raising pay and increasing jobs, especially for workers earning low wages. Meanwhile, the EITC directly supports the incomes of these workers and makes them even more affordable to firms, further expanding job opportunities.

An increase in the minimum wage to $12 or more, by contrast, appears over time to hurt the workers who need it the most. The economists model a mechanism that they consider essential for understanding the long-run effects of the minimum wage: Firms gradually invest in new capital equipment as it depreciates, shifting to technologies more reliant on higher-paid, more productive workers who are not affected by the minimum wage. As lower-skilled roles are shed over many years, the model “reveals the distributional paradox of too large a minimum wage policy,” they write. By effectively making these roles more expensive, raising the minimum wage “hurts precisely the lowest-earning workers whose income it is supposed to support.”

Evolving capital, different workers

“The Macroeconomic Dynamics of Labor Market Policies” builds upon the authors’ earlier Minneapolis Fed staff report. At a time of flourishing research on the minimum wage, their research shows why rendering a positive or negative verdict on the minimum wage depends on the policy details and the questions we ask. Is the proposed minimum wage increase small or large? Is the focus on its short-term or long-term effects? Which workers do we most want to help?

As the authors point out, most studies of state and local minimum wage increases have measured effects in the short run. That is no surprise, given that the “long run” has not yet arrived for these relatively recent policy changes. The authors cite recent summary research that assessed more than 100 published studies of the minimum wage, finding that 80 percent showed minimal harm to employment within two years after a minimum wage increase.

Such short-run observations are highly limited, the authors contend, insofar as they miss an important, long-run dimension of adjustment: Employers are able to substitute one type of worker for another. This is especially true of workers without a college degree—those most affected by the minimum wage—who vary considerably in pay and skill. Prior research has established that these workers are substitutable for one another, although not right away. This delay is because firms are stuck for some time with the capital—equipment, job training, work processes—best suited to their workforce.²

When workers can be paid below $8 an hour, for example, it might make sense for a fast food restaurant to employ many workers in low-skilled jobs to take, prepare, and deliver orders. The owner has optimally set up work processes, designed the restaurant layout, and selected the equipment to best help these low-wage workers perform their jobs.

When the minimum wage increases, most firms would not immediately toss out this current investment in capital, as long as it is profitable to use. This means that for years, potentially, they still need many staff who are trained and compatible with it.

As the years pass and equipment naturally needs replacing, however, employers will invest in capital that best complements the more productive workers whose initial wages are near or above the new minimum wage. In the fast food example, a restaurant might invest in new technology to assume order-taking, food-preparation, or meal-delivery functions. Correspondingly, more job tasks may now focus on operating and maintaining the high-tech equipment or on problem-solving around complex customer service or management issues. Jobs for the lowest-skilled, lowest-wage workers fade.

Long-run pain—but short-term gain

It’s a slow process, though. When the economists examine the effects of a $15 minimum wage, they find that just 20 percent of the long-run impact on jobs has played out in the first two years. A typical worker who made $7.50 before the change sees income jump at first, but then begin to decline. Income falls below the initial level after 10 years and continues to decline as work dries up. The effect of firms turning over old capital for new is still playing out in the labor market even 20 years after the initial policy change.

Although the long-run outcome looks dire, this slow adjustment process is a consolation for low-wage workers, many of whom continue to benefit from higher wages in the meantime. For current workers making between $9 and $15 an hour, the researchers find that the net effect of raising the minimum wage to $15 an hour is positive. Although many of their jobs will be lost and income will fall in the long run, they benefit from higher wages until that happens.

Yet even within this group of low-wage workers, there are winners and losers. Higher-earning workers in this group benefit more, at the expense of those who earn the least. Current lower-skilled workers benefit at the expense of future lower-skilled workers, for whom jobs will be harder to find when they enter the labor market.

A tailored role for targeting “monopsony”

By contrast, the economists find gains for all workers with a small increase in the minimum wage—for example, from the current $7.25 federal minimum to $8.50.

The broad-based benefit arises from how increasing the minimum wage reduces the market-power of employers. In a market that is not fully competitive, firms can set wages below what workers would otherwise earn. For some workers, this lower wage makes them decide not to work at all. The economists cite the results of prior Minneapolis Fed research that found this “monopsony” power distorts the labor market in the U.S., costing workers across the earnings spectrum 15 to 35 percent of their potential wages.

Up to a point, a higher minimum wage can check employer market power by inducing employers to post more jobs, attract more potential workers to participate in the labor market, and raise wages. The economists find this effect is meaningful for workers and results in a more efficient economy. However, it starts to dissipate with larger increases in the minimum wage, as the effect on jobs turns from positive to negative.

This result complements other recent work by Minneapolis Fed economists who find relatively small gains to workers from eliminating employers’ labor-market power through minimum wages.

Another approach: The earned income tax credit

Although there are some gains from eroding monopsony power, a minimum wage increase of a dollar or two would likely fall short of the goals that motivate wide support for a $15 “living wage.” Unfortunately, the economists write, “a major drawback of the minimum wage is that it is too blunt a redistributive instrument to support the labor income of all workers earning low wages in the long run.”

The researchers explore another tool to lift up the lowest-earning workers without the same adverse long-term side effects. The current EITC in the U.S. provides an average tax credit of $2,000 to around 31 million taxpayers. Essentially a negative income tax, the EITC redirects resources from high-tax-bracket households to the country’s lowest-earning workers. The tax credit phases in and out at different income levels in a manner intended to provide crucial income support without discouraging work.

In their model, the economists simulate a hypothetical EITC that is expanded to match the budgetary and intended redistributive impact of a $15 per hour minimum wage. They find that this EITC “is much more effective than the minimum wage at stimulating the employment and labor income of initially low-wage non-college workers in the long run.”

The lowest-earning workers experience the biggest increase in income with the expanded tax credit. Also in contrast to the high minimum wage, the benefits of the EITC increase over the long run through the gradual substitution of labor and capital by firms.

In this case, “by subsidizing the employment of workers earning low incomes, the EITC induces firms to substitute towards such workers rather than away from them, as the minimum wage does.” As their capital depreciates, firms also adjust their mix of capital to use more of the low-wage workers’ labor services than they otherwise would. In their model, the economists find that these effects of the expanded EITC lead to a 6 percent increase in non-college employment.

Better together: EITC and minimum wage

The economists’ model generates the best outcomes for low-wage workers when the EITC or other progressive tax policy does the heavy lifting on redistribution, combined with a minimum wage targeting employers’ monopsony power that depresses wages and employment below their competitive levels.

If society’s goal is to redistribute income and reduce inequality, “a moderate minimum wage increase can play a valuable role in supporting transfer programs like the EITC,” they write. With a minimum wage of $9.25, the lowest-wage workers in their model experience a 50 percent increase in wages and a 45 percent increase in employment. Workers who were previously making $9.25 experience increases in wages and jobs of around 20 percent. “This policy combination leads to a much larger increase in long-run wages and employment for non-college low-wage workers than the EITC alone.”

However, when the minimum wage is increased to $12, even when coupled with the EITC, the lowest-wage workers face long-term job losses of around 40 percent.

For a policy whose horizon of impact empirical researchers can still only measure in years—the $15-plus minimum wage—the structural model of Kehoe, Hurst, Pastorino, and Winberry provides a perspective measured in decades. Although policymakers might naturally prefer a simple answer, their research suggests that in the long run, two policies—calibrated carefully—could be better than one.

Endnotes

1 Hurst is an advisor to the Opportunity & Inclusive Growth Institute; Winberry is a former visiting scholar with the Minneapolis Fed. Academic affiliations: Kehoe and Pastorino, Stanford University; Hurst, University of Chicago Booth School of Business; Winberry, Wharton School of the University of Pennsylvania.

2 Formally, the economists apply the economic notion of “putty-clay frictions” to describe this capital adjustment process that is rigid at first but more malleable over time.