Minimum Wage Hype

Richard Epstein

The White House wants sharp increases, but that—on top of Obamacare—will kill jobs.

The White House Council of Economic Advisors recently published a post on its website optimistically declaring, “Congressional Budget Office Report Finds Minimum Wage Lifts Wages for 16.5 Million Workers.” The piece describes a CBO report on a current proposal, which has gained much momentum in recent weeks, to increase the minimum wage in three stages from its current level of $7.25 per hour to $10.10 by 2016, after which it would be permanently indexed for inflation—at least until further legislation is enacted. The White House should temper its optimism, however: Upon closer review, the CBO report raises several serious theoretical and practical issues that the CEA’s optimistic headline conceals.

The Minimum Wage and the Market

Neither the Council of Economic Advisors nor the CBO spend sufficient time dealing with the common objections that market-oriented economists raise against minimum wage laws. Under the standard analysis, the demand curve for labor slopes downward, for the simple reason that employers are willing to offer fewer jobs as wage levels increase. By the same token, the supply curve slopes upward, because as wages increase more individuals bid for labor. In a market in which wages are unregulated, the market wage is determined by the intersection of the supply and the demand curves. At that price, the market clears so there is neither a shortage of jobs nor a glut of workers. Let the wages drop too low, and there is a shortage of workers; let them rise too high, and there is a surplus.

This simple paradigm is distorted by minimum wage laws, which place a constraint on the operation of the market. It is extremely difficult to estimate empirically what the effects of any such law will be. If the minimum wage is below the market wage, then market behavior won’t change in the short run. Nonetheless, even in that setting, implementing a minimum-wage scheme is an arduous affair. Everyone thinks that they know what counts as an hour of work, because firms and workers in an unregulated market can choose any definition that pleases them. But under the Fair Labor Standards Act of 1938, the phrase “hours worked” is a statutory term of art, which categorically excludes (for example) “any time spent in changing clothes or washing at the beginning or end of each workday which was excluded from measured working time during the week involved by the express terms of or by custom or practice under a bona fide collective-bargaining agreement.”

So complex is this issue, in fact, that the FLSA sets up a Wage and Hour Division within the Department of Labor to churn out pages of regulations just to define the statutory hour. The front-end costs involved with setting up the system are therefore a lot higher than the simple economics describe.

Worse still, the minimum wage constraint can spring to life whenever the equilibrium point of the economically ideal wage falls below the statutory minimum. Yet the extent of these distortions is uncertain: The unadorned supply and demand curves for labor do not account for other terms of the wage contract. Thus, the employer and employee may agree to make other changes in the employment contract, dealing perhaps in meals or split-shifts, that could offset the effect of smallish increases in the minimum wage. But sooner or later, the unemployment effects have to kick in, as liberal legislators implicitly acknowledge. Otherwise, why stop at a paltry $10.10 per hour? Why not $100? Moreover, that crossover point may take place at different levels in different parts of the nation, since the equilibrium wage will of course vary by city and region.

No one should be confident that they can predict the minimum wage statute’s effect without detailed knowledge of these individuated wage profiles. And no one can predict with confidence the effects of each dime or dollar increase on the overall picture.

None of these basics are offset by the arguments that the White House advances to push its case. Thus it is neither here nor there that the real value of the minimum wage peaked in 1968 and has declined since that time. If the minimum wage law is a structural mistake, then 1968 represents the low point in the cycle, not the high point. Indeed, it is worth noting that the most rapid decline in the real value of the minimum wage took place during the Reagan years, when labor markets continued to gain strength. The relevant baseline is not historic demands of the minimum wage law; it is what workers earn. We have very low labor market participation today. If an increased minimum wage will make it harder for low-skills persons, minorities, and teenagers to gain a toehold in the labor market, why support it?

Nor is the case for a higher minimum wage advanced by insisting, as the White House does, that “paying workers more can also improve motivation, morale, focus, and health, all of which can make workers more productive.” Indeed, these considerations cut exactly the opposite way. If increased wages alone increased productivity, there would be no need for federal intervention: Employers would have all the incentive they need to raise wages voluntarily. That is how markets work.

In fact, if the incentive is as the White House says, then federal intervention could upset the delicate internal balance of any firm, lowering morale by prompting employers to respond with cuts in hours and changes in shifts and working conditions. The best that can be hoped for is that a hike in the minimum wage will not be too harmful. It is highly unlikely that it can be a source for good.

The Practical Consequences

This gloomy prediction is borne out by a closer look at the details of this particular proposal. President Obama likes to say that the minimum wage increase will give some 16.5 million workers a raise, and that perhaps another 8 million workers will get a bump up in wages from the ripple effects. The downside is that some 500,000 people would lose their jobs. The key question is how to net out these two effects.

On this score, the initial insight is that the negative impact of the next wage increase will hit hardest those people who are at the bottom of the current wage scale. It is much more likely that an employer will fire a worker who earns $7.25 per hour if he is forced to give that worker a 40% increase in wages over the next three years than he will fire a worker who earns $10 per hour, since he only has to provide a 10 cent per hour increase to that person.

The obvious point here is that the losses to individual losers will on average be far greater than the gains to the winners, especially among current workers now earning below the minimum wage. Indeed, it is instructive that the CBO report concludes that “once the increases and decreases in income for all workers are taken into account, overall real income would rise by $2 billion.” That sum works out to about $121 per worker on an annual basis, which is at best a trivial aggregate increase in an economy whose gross domestic product is over $16 trillion.

Furthermore, even these supposed gains are strongly overstated because they do not include the income losses suffered by the employers who pay these wage increases, which of course translate into smaller profits, lower dividends, and weaker capital gains. The figures also ignore the public administrative costs and the private compliance costs, both of which always spike with major transitions in the law.

Finally, by upsetting the relative wage differentials across job categories, the higher minimum wage compresses wage gaps between different job classifications, and thus distorts the incentives that higher wage has on job performance. Taken as a whole, it looks as though a more accurate estimation is that the net overall effect of the law is probably negative, even if we ignore the added dimension of uncertainty that pushes the final estimates lower still.

The White House cites a comprehensive review of minimum wage research since 2000, which states that “evidence points to little or no employment response to modest increases in the minimum wage.” But the conclusion points the other way. We should expect only a “little” response to a “moderate” minimum wage increase. But this proposed three-year increase is far from modest. The sluggish labor market at the bottom end is consistent with the view that real wages are currently falling, which will only magnify with the negative effects of the minimum wage increase, and could easily splash cold water on the overly-optimistic CBO predictions. In this regard, it is worth noting that right now over 20% of the workforce is in jobs that fall below the projected $10.10 minimum wage, a fraction that could increase if labor market conditions remain uncertain.

The proposed minimum wage increase will not take place in a vacuum. It will go into effect at the same time as Obamacare’s employer mandate. It seems clear that the threat of having to pay a $2,000 fine for each uncovered full-time worker will have the effect of increasing the number of employees who will be asked to work less than thirty hours. Putting the sharp minimum wage increase on top of the employer mandate is likely to have unfortunate synergistic effects. As the CBO acknowledges, one effect of the minimum wage law is to induce firms to substitute capital equipment for labor, which is already happening in the restaurant and retail industries, for example. Speaking more generally, the earlier minimum wage studies took place in labor markets that were less regulated than the labor market will be going forward. It is idle to assess the effects of the law in isolation from all the other changes going on.

One of the essential tenets of the system of laissez-faire is that all proposed legislation should be presumed unwise until it is shown otherwise. There are two grounds for this assumption. First, legislation costs money to implement. Second, all too often it interferes with the operation of competitive markets, which generally offer the best long-term path to prosperity.

By this standard, all minimum wage laws should be regarded as mistakes. The point is especially urgent when labor markets are themselves under stress. The White House and the CBO fall into deadly error when they ignore the complications that work against all comprehensive systems of legislation. There is no good reason to believe that even the intended consequences of the minimum wage increase will come to pass. But when the unintended consequences are taken into account, the new legislative program will only slow down a weak economic recovery that already has left far too many people behind.