The minimum wage, the living wage, and the effective marginal tax rate

Advocates for the living wage tend to ignore that workers that currently receive the minimum wage also receive a lot of other government support, in the form of various rebates and subsidies, that they may not be eligible for if they earned a lot more. That means that increasing the minimum wage to the living wage would not necessarily lead to gains in net earnings that are as high as those advocates expect.

A worked example, based on U.S. data, is provided in this article by Craig Richardson. Here is the key figure:

Increasing the hourly wage from US$7.25 per hour to US$15 per hour would net a full-time worker only US$198.94, after accounting for all of the social benefits they would lose, and the additional taxes they would pay. Richardson writes:

There are some uncomfortable truths about raising the minimum wage from its current level of $7.25 per hour to $15 per hour that are revealed by an online tool created by our Center for the Study of Economic Mobility (CSEM) at Winston-Salem State University, along with our local research partner Forsyth Futures.

The tool, which we call the Social Benefits Calculator, enables anyone to go online and experience for themselves what it is like to be receiving social benefits and experience a monthly wage increase. Designed for Forsyth County, the calculator shows that with more than a 100% rise in the minimum wage, many people who currently receive social benefits will barely experience a change in their standard of living...

Let’s use the calculator and create a hypothetical example: a full-time working parent earning the minimum wage, who is unmarried with two children in subsidized day care. As seen in Table 1, after his or her wages more than double from $7.25 an hour to $15 an hour, earnings rise from $1,160 to $2,400, or a $1,240 change.

Sounds good, right? That’s an enormous bump up of wages by 106%. But after subtracting the decrease in benefits and higher taxes, that $1,240 increase erodes to just a $199 net improvement, or just a 16% change.

Imagine getting a big raise and seeing 84% of it go away. 

The effective marginal tax rate (EMTR) is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements. Taking the example of the table above, increasing the worker's wage from US$7.25 per hour to US$15 per hour increases their monthly before-tax-and-transfers income from $1160 to $2400. In other words, their income increases by $1240. With that higher income, they pay more federal and state taxes. Their monthly tax payments increase from $88.74 to $314.70. In other words, they pay an additional $225.96. The marginal tax rate over that interval is 18.2% (calculated as [225.96 / 1240]). But wait! Their entitlement to social benefits decreases from $3110.10 to $2295 monthly. In other words, they lose $815.10 in entitlements, as well as the additional taxes they pay. So, their effective marginal tax rate over the interval is 84.0% (calculated as [(225.96 + 815.10) / 1240]).

EMTRs are something that policy makers should keep a close eye on. When the EMTR gets too high, it can create some perverse outcomes. In some cases, workers could actually be financially better off by working less (this happens whenever the EMTR exceeds 100%). The problem is that every program has its own eligibility rules and thresholds, and keeping track of how the interaction between all of those works is incredibly difficult. You can try out the Social Benefits Calculator tool mentioned in the article here (it is based on data for Forsyth County, North Carolina). We really need a similar calculator for New Zealand.

[HT: Marginal Revolution]

The living wage may need an urgent look, but it needs to be a balanced one

In a story entitled "NZ living wage needs urgent look, Massey University and AUT researchers say", the New Zealand Herald reported today:

What could a New Zealand living wage look like?

A team of researchers have begun investigating the concept, which they say could help struggling, low-paid workers and tackle mounting challenges regarding poverty and productivity.

Massey University psychologist Professor Stuart Carr, who is co-leading the new three-year study, said living wages usually refer to higher minimum wage rates, derived from calculations of the material cost-of-living needs of a hypothetical household unit.

"However, the broader concept of living wages goes much further," he said...

The research team saw an urgent case to examine the area.

They said working poverty had "soared" due to low pay, insecure work that provided interrupted or insufficient hours of paid employment and rising housing, energy and food costs – all of which disproportionately affected women, younger and older people, and Maori and Pacific people in particular.

Researchers say that while a national minimum wage is a legal floor intended both to provide protection for workers and encourage fair competition among employers, minimum wages were now widely recognised as failing to provide sufficient cost-of-living income.

"This is due not only to the growth of informal work, poor awareness and weak enforcement of wage laws, but mainly to minimum wage rates not matching increasing living costs and the realities of precarious work," said Professor Jim Arrowsmith, of Massey's School of Management.

 Investigating the living wage is important, but it's difficult to see what canvasing four employers ("a city council; a public-sector Maori organisation; a Pacific social enterprise; and a local small or medium-sized enterprise") will tell us. Especially when there is already a wealth of research on the effect of higher minimum wages.

Much of the theoretical background (and some of the evidence) was summarised by Jim Rose (of the Taxpayers' Union) in an interesting report on the living wage earlier this year (full report here; summary here). While much of the report is a rebuttal of points made by the living wage movement (their report is available here), there are some general points that need to receive a bit more air, starting with:

The economics of a unilateral living wage policy by an individual employer is different to that of a minimum wage increase.

This is a point I have made before. The living wage may be good for employers, but not if all employers pay a living wage. That effectively increases the minimum wage, which is probably not a good idea.

The main reason that most people use to support imposing a living wage is to help reduce poverty, or especially child poverty. However, if you hold that view then you need to confront the fact that:

The Treasury (2013) estimated that 79% of households earning pay below the living wage rate have no children; 6% are sole parents; the remaining 15% of households are couples with children (see graphic below). Almost all teenagers and majority of adults in their twenties earn below the living wage; 29% of low income workers live in families whose income exceeds $60,000...

This is a point that Eric Crampton has made before too (see for example here). So, a living wage would not be well targeted, and as Eric has also pointed out, increasing Working for Families would be a better option than increasing minimum wages. The reason is that a lot of the increase in the living wage would be lost to tax. According to Rose:

The living wage increase has a much smaller effect on the take-home pay of employees with families because of a reduced Working for Families tax credit. In its 2015 Minimum Wage Review, the Ministry of Business, Innovation and Employment (2015) calculated that a couple working 60 hours between them on the minimum wage lose over 40% of a living wage increase to reduced Working for Families and to tax...

Ok, so let's leave the higher minimum wage aside, and consider individual employers (rather than all employers) paying a living wage:

Any employer who unilaterally introduces a living wage is simply raising their hiring standards. The workers who previously won the jobs covered by the living wage increase will not be shortlisted because the quality of the recruitment pool will increase. The Council must by law hire on merit so only those who currently earn $18- $20 in other jobs will be shortlisted for living wage vacancies. These recruits are on about the living wage now so they do not benefit from the living wage policy...

Workers who would not have previously applied for council jobs because they can earn more elsewhere will now apply because of the higher pay. These better paid applicants will crowd out the applicants of the minimum wage workers who currently win these jobs. Living wage advocates do not discuss what becomes of these low-paid workers who are no longer shortlisted. They should.

This is a point that we don't see raised nearly enough. A rational employer will employ labour up to the point where an additional hour of wages costs the same as the revenue it generates. So, if you pay a higher wage, then workers need to be more productive (see also this post). Rose's report addresses this point in some detail, providing a range of evidence (including New Zealand evidence) that suggests a living wage raises hiring standards. The key point is that employers want to be sure that the higher wages will be justified by higher worker productivity (as measured by higher revenues to offset the higher wages).

But what about public sector employers, where revenue is (arguably) less of a consideration? Rose writes about an Auckland Council proposal for a living wage:

Mayor Goff said he could pay for the living wage increase by cutting costs elsewhere... If these expenditures such as on better fleet management and group procurement are of low enough value to be reprioritised to fund a living wage policy for no loss of service, ratepayers are entitled to ask why the expenses were incurred in the first place.

Indeed, if there are cost savings that can be made (with no loss of service) in order to afford a living wage, then why are those cost savings not already being made? Was Auckland Council simply wasting ratepayers' money previously? In reality though, most 'cost savings' are mythical so I'm not sure we can really buy the argument that a living wage would be paid from cost savings anyway. Nevertheless, productivity is still a consideration for public sector services, and the New Zealand evidence in the report does seem to demonstrate that hiring standards increased when Wellington City Council became a living wage employer.

There's a lot of interesting points made in Rose's report, based on a range of theory and research in labour economics. If you're not familiar with the literature, it's well worth a read for that alone.

Coming back to the future research by Carr et al. that led this post, I'll be interested to see what they find. However, I'm not holding my breath that it will be a particularly balanced view, given how it has been reported so far.

Read more:

• Want a living wage for everyone? Raise productivity first
• The living wage is good for employers; unless lots of employers pay a living wage

Want a living wage for everyone? Raise productivity first

Jim Rose (economic adviser to the Auckland Ratepayers' Alliance) wrote in the New Zealand Herald back in June:

The Auckland Council's new living wage policy will lift the pay of its minimum waged employees by 30 per cent. Of course, no minimum wage worker will be shortlisted for these jobs in the future because these jobs will be paying $20.20 per hour. Minimum wage workers will be crowded out by better quality applicants who already earn a similar pay.

Rose's point is that increases in wages need to be underpinned by increases in productivity. To see why, consider our simple model of labour demand, as shown in the diagram below. The VMPL curve is the value of the marginal product of labour (also called the marginal revenue product of labour) - it's the extra value that one additional hour of work provides to the employer, in terms of additional revenue. Essentially it is the productivity of the marginal worker (the amount they would produce in that additional hour), multiplied by the value of that output. A profit maximising employer will be willing to hire a worker for an hour provided that the VMPL is at least as great as the wage. If the wage is higher than the VMPL, then hiring a worker for that hour would reduce profits. So, if the wage is equal to W0, then the quantity of labour employed will be where VMPL is exactly equal to W0, which in the diagram below is Q0.

Now, consider what happens if you implement a living wage that is higher than W0 (say, at W1). Let's assume that the value of output is the same regardless of which worker produces it (which seems reasonable). When the wage goes up to W1, relatively low-productivity work hours (previously producing VMPL between W0 and W1) will no longer be profitable for the employer, so it will cut back on labour hours (from Q0 to Q1). Fewer people will be employed, or those who are employed will be employed for fewer hours.

Advocates for the living wage argue that it will increase productivity, as Rose notes:

Living wage activists prefer to talk about the costs supposedly being offset by labour productivity gains - higher staff morale, fewer absences and reduced staff turnover. These are supposed to make everything right and low risk.

This is essentially an efficiency wage argument, which I have discussed before. As I noted then, it only works provided not all employers are paying the living wage, since it relies on alternative jobs for employees paying much less. However, if only a limited number of employers are using the living wage, then it could increase productivity for those living-wage-paying employers, by ensuring that the most productive employees go to work for them (and not for other employers). However, other employers would be left with less-productive workers (and would pay lower average wages as a result). So wages on average across the economy remain unchanged, because the overall productivity of the economy remains unchanged.

Rose's overall point is that we can't simply legislate higher wages, through proposals like the living wage:

Living wage activists and unions are right to point out that we live in a low-wage economy compared to Australia. The solution is not to vote ourselves a pay rise.

Increasing productivity, innovation and entrepreneurship is the only way to catch up.

If we want higher wages across the economy as a whole, we have to be more productive first.

Read more:

• The living wage is good for employers; unless lots of employers pay a living wage

The living wage is good for employers; unless lots of employers pay a living wage

The living wage is back in the news this week, with The Warehouse Group being held up as an example for other (especially retail) employers in terms of looking after the wellbeing of their workers. From this Bernard Hickey piece in the New Zealand Herald:

The Warehouse is one of a growing number of companies paying a "Living Wage". From August 1, it started paying 4100 of its workers a "Career Retailer Wage" of at least $18.50 an hour. To qualify, they must have full training and 5000 hours' experience. It represents a pay increase of 10-20 per cent.

Warehouse CEO Mark Powell estimated it would cost almost $6 million in extra wages, but it was an investment worth making...

This week, union researchers Eileen Blair, Annabel Newman and Sophia Blair delivered a paper to the Population Health Congress in Auckland on the experience of employers and workers who have adopted the Living Wage, currently $18.80 an hour - 32 per cent above the $14.25 minimum wage.

They interviewed four employers and found a variety of reasons for adopting the Living Wage, including that it was the right thing to do.

But there were more practical reasons, including wanting employees paid enough to buy their products, reducing staff turnover and having staff motivated to produce a great product or service.

You can read the research paper by Brown, Newman and Blair here (pdf), and read more about the living wage campaign in New Zealand here.

I thought a blog post on the living wage was timely given that my ECON110 class has just covered the economics of social security, poverty and inequality, and related policy, so this research provides an interesting kick-off point. As Bernard Hickey points out in his article, Henry Ford introduced a $5-a-day wage at Ford factories in 1914 (although Hickey makes the mistake of buying into the story that this was done so that Ford's workers could afford to buy cars - Tim Worstall and others have already thoroughly debunked that story). The $5-a-day wage might not seem like much, but it was about double the ‘normal’ factory wage at the time. Ford had a huge number of job applications (not surprising - they were the highest paying employer around at the time). Staff turnover fell, absenteeism fell, and productivity rose so much that Ford’s production costs decreased even though they were paying much higher wages.

What Ford had introduced was what we term an efficiency wage, a wage that is voluntarily offered by an employer and is above the equilibrium wage in the labour market. Employers offer these efficiency wages because they know they have positive effects - they attract and retain higher quality employees who work harder for the firm, higher productivity, lower absenteeism and lower staff turnover. Why do all these good effects happen? In the simplest sense, having lots of job applicants and being the first-choice employer for most available workers means you get to choose the best (most productive) workers.

But the good effects go beyond the selection of job applicants, because of the incentives that the efficiency wage creates. If an employee is working for you for a wage that is well above equilibrium, then they have a strong incentive not to shirk, not to take too many dodgy sick days, and generally to work hard for you. Why? Because if they don't and they lose their job, then the best possible outcome for them is that they go back to working somewhere else for a much lower wage. Alternatively, maybe the employees just work harder for their employer because they feel good feelings for the employer who is paying them very well. There is plenty of support for the idea of efficiency wages, including research by myself and Steven Lim and others in Thailand, and there are some good quotes from employers in the Blair et al. research report, like this one:

When you spend a lot of money training someone up you don’t want them to just leave three months later, or six months later; you kind of want them to stick around for a year or two. If they feel like they can earn more money and save up more and then go travel for longer, they’ll stick around a lot longer and the productivity will go up...

Now, the living wage is a good example of an efficiency wage. If you pay your semi-skilled (say, retail) employees $18.80 per hour, you are paying above the minimum wage and well above the equilibrium wage. So I'm not surprised that The Warehouse, and the four employers that Blair et al. interviewed for their study, have seen positive gains from paying a living wage. The alternative for their employees is to work somewhere else for (probably much) less, so working hard for more pay might be an attractive option to them.

What's good for a few employers (and their employees) must be great if all employers follow suit, right? If every employer paid a living wage much higher than the mandated minimum wage, won't everyone be better off? Not so fast. The gains from paying an efficiency wage arise because the alternative jobs for employees pay much less. If every other employer is also paying a high wage, then the employees don't need to work so hard because if they lose their job they can go somewhere else that is also paying a high wage. Same goes for absenteeism, staff turnover, etc. The benefits of the efficiency wage evaporate if lots of employers pay efficiency wages.

So, it's likely that the observed gains for employers from paying a living wage of $18.80 (rather than the minimum wage $14.25) are only sustainable so long as the living wage isn't mandatory for all employers. As Bob Jones rightly points out, forcing employers to pay much higher wages is just going to force those with slender margins (including a lot of small-scale retailers) out of business. This would reduce the number of available jobs for semi-skilled workers. According to the Treasury (quoting an MBIE estimate), raising the minimum wage to the living wage would cost 25,000 jobs. Most of these lost jobs would be in accommodation and food services, and retail trade.

Overall, the living wage might have some positive effects for those employers who offer it. But the idea that it should be rolled out by all employers is clearly being oversold if the gains to employers are essentially those that arise from paying an efficiency wage.

[HT: Tracey from my ECON110(NET) class, for pointing me to the Tim Worstall piece on the Ford $5 workday]

[Update: Fixed broken link]