Can Higher Wages Actually Hurt the Economy?
The Congressional Budget Office recently released a report with an estimate of the economic effects of raising the minimum wage from $7.25 to $10.10 an hour.
The results have been generally viewed as a mixed blessing.
On the one hand, CBO claims that overall income would increase for most households at the low end of the income scale. But the increased income comes at a cost: half a million workers would lose their jobs.
These results are accurate only if CBO analyzed the minimum wage and its effects on the economy in a sensible manner. In my opinion, it does not appear that CBO met this threshold.
The key number in the CBO analysis is the “elasticity of demand for labor.” Economists use this term to measure the sensitivity of demand to a change in price. Thus, if the price of tomatoes increased by 20%, the demand would decrease by some percentage.
If an elasticity is between zero and minus one, then the buyer will spend more for the product as the price increases. This obviously cannot hold forever, because buyers run out of money. CBO measures the elasticity of demand for labor at a paltry -0.1. The net result is that for any wage increase, CBO would find workers making more money, and very few workers losing their jobs.
With this assumption, it is not surprising that CBO finds that tens of millions of people would be better off if the minimum wage were raised by 39%, to $10.10 an hour. Employers in CBO’s world would hire 96% of workers formerly making $7.25 an hour, even when their new wage rose to $10.10. Consumers would face higher prices, but they would not adjust spending down in a substantial manner.
CBO concludes that real income in the economy would rise by $2 billion if the minimum wage were raised to $10.10 an hour. The report states that “raising the minimum wage would increase demand for goods and service because, taken together, the second, third, and fourth direct effects would shift income from business owners and consumers (as a whole) to low-wage workers.”
The report continues, “Low-wage workers generally spend a larger share of each dollar they receive than the average business owner or consumer does; thus, when a dollar from business owners or consumers is shifted to low-wage workers, overall spending increases.”
But spending by upper-income consumers helps to employ low-wage workers. The Labor Department’s consumer expenditure data for 2012 show that the highest fifth of income earners was responsible for 52% of spending on personal household services, and 56% of spending on fees and admission to entertainment. These are all local businesses that employ low-wage workers. Reducing the incomes of the top fifth will result in less spending on these categories, and less domestic employment.
In contrast, the lowest fifth of income earners spend a higher than average percent of their income on apparel, footwear, and nondurables, which are more likely to be imported. A substantial percentage of goods sold at superstores — where low-income individuals tend to shop — are made overseas.
CBO states that “The agency’s estimation approach was similar to the one that it used to assess the effects of the American Recovery and Reinvestment Act of 2009 (ARRA).” But I don’t believe that estimation resulted in an accurate prediction of the state of the economy.
After passage of the stimulus bill, in a March 2009 letter to Iowa Senator Chuck Grassley, CBO predicted that the unemployment rate in the last quarter of 2009 would rise to 9% without the stimulus package, from its then-current level of 8.2%. With the stimulus, CBO said, the unemployment rate would range from 7.8% to 8.5%. The actual rate in December, 11 months after enactment of the stimulus, was 9.9%, far higher than CBO said it would be absent the stimulus.
CBO predicted that in the fourth quarter of 2010 the unemployment rate would be 8.7% without the stimulus, and between 6.8% and 8.1% with the stimulus package. But the unemployment rate in the fourth quarter of 2010 was 9.6%. So much for CBO’s estimation approach for ARRA.
Transfers of income from one group to another do not succeed in creating economic growth. If they did, why stop at $10.10? Why not go to $15 an hour, as Fast Food Forward and New York Communities for Change are demanding? Or $24, the average wage in the economy? The CBO model shows that all wage increases benefit labor, and the wage elasticity as invariant to the wage.
There is substantial evidence to suggest that the employment disincentives of higher wages are greater than CBO admits. Different states have different minimum wages. Over the past year, the highest employment growth has been in states with minimum wages at the federal level, rather than higher.
The Washington D.C.’s City Council recently voted to raise the wage for incoming Walmart WMT -0.71% stores to $12.50 an hour. Mayor Vincent Gray vetoed the bill as a certain job loser. Had the mayor followed CBO’s advice, Walmart would not have opened its stores in the District of Columbia, and 1,800 fewer people, now working for Walmart, would be employed.
Washington D.C. and two Maryland counties, Montgomery and Prince George’s, will raise their minimum wage in four stages to $11.50 an hour by 2017 (2016 in Washington DC), beginning this summer. The biggest beneficiary will be the neighboring Commonwealth of Virginia.
Most Americans know that we compete in a global marketplace for practically everything, from manufactured goods to services of all kinds. China and other countries compete against America partly with lower wages. Raising wages in the United States will make America less competitive in the global marketplace.
The CBO analysis never mentions the relationship between wages and marginal productivity, the contribution of the worker to the creation of a product. Conventional economic analysis holds that wages will not exceed the economic contribution of workers to the product.
CBO’s conclusion that approximately 96% of workers will keep their jobs, even with substantial increases in their wages, suggests that these workers have been underpaid. The only way this could be the case is if labor markets in the United States were profoundly out of balance. CBO presents no evidence that this is the case. Indeed, CBO does not address the millions of unemployed Americans who seek work, especially teens and low-skill workers. This is evidence that entry-level wages are too high, not too low.
CBO does not address the biggest losers of increasing the minimum wage: low-skill teenage workers who will be denied the right to work in the United States. They may be willing and able to provide a prospective employer with services that are worth $5 an hour, or $7 an hour. If the hourly minimum wage rises to $10.10, they will miss the first rung on the career ladder to success. Sitting idly unemployed, they may take solace in knowing that CBO calculated that they would be better off.
Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, directs Economics21 at the Manhattan Institute. You can follow her on Twitter here.