A wage subsidy has the potential to both increase the earnings of low-skilled workers and expand the job opportunities available to them, helping to reduce poverty, increase labor-force participation, and boost economic growth. The ongoing economic crisis in Puerto Rico offers an ideal testing ground for the policy, and the policy offers an ideal tool for addressing the island’s woes.
“Puerto Rico is not eligible for the EITC today, so it can choose between the wage subsidy and EITC approaches. Of the two, the wage subsidy has significant advantage...”
At the root of Puerto Rico’s crisis lies a dysfunctional labor market. Only 40 percent of adults are employed or looking for work, thanks largely to a federal minimum wage misaligned with the island’s local market conditions. The federal minimum of $7.25 per hour has a relatively small effect on the mainland, where the median hourly wage is more than $17.40 and only 3% of workers earn less than $8.50. In Puerto Rico, by contrast, the median hourly wage is $9.61 and 28% of workers earn less than $8.50.
Both the 2014 report of the Federal Reserve Bank of New York and the 2015 report of the Working Group for the Fiscal and Economic Recovery of Puerto Rico lead with this emphasis on labor market conditions and the challenges created by application of the federal minimum wage. But the problem yields no obvious solutions. Simply reducing the minimum wage might create more job openings, but it could reduce the earnings of those who are working. And it would compound a second challenge highlighted by the Working Group, which is that the generosity of mainland-dictated welfare benefits tends to make low-wage opportunities appear relatively unattractive—by one account the Working Group cites, a household of three with no earner might receive $1,743 in monthly welfare benefits while take-home pay for a month of minimum-wage work would be only $1,159.
These conditions are tailor-made for a wage subsidy. The policy would work as follows: The government would establish a “target” wage equal of $10, approximately equal to the island’s median hourly wage. It would then reduce the minimum wage to the often-used benchmark of half the median, or $5 per hour. (When taking higher state and local minimums into account, the ratio of minimum to median in the United States is 47%.) Workers would receive a subsidy in each paycheck equal to half the gap between their market wage and the target wage.
Thus, someone earning $5 per hour would also receive a $2.50 per hour subsidy for total pay of $7.50 per hour. Someone earning $8 per hour would also receive a $1 per hour subsidy for total pay of $9 per hour. Anyone earning $10 per hour or more would receive no subsidy. The system would be administered just as payroll taxes are today—the government already requires employers to calculate tax liability and withhold a portion of every paycheck; putting money back into some paychecks is a similar process.
From the perspective of a worker, taking a job would become more attractive. Even though the minimum wage would fall from $7.25 to $5, the lowest possible post-subsidy wage would increase slightly to $7.50—this perfect offset is unique to the particular distortions of Puerto Rico’s labor market and makes the reform especially appealing. Those earning $7.25 today could see a raise to about $8.60. From the perspective of employers, meanwhile, the discouraging burden that the minimum wage imposes on offering entry-level jobs would be replaced by a subsidy actively encouraging their creation.
In some respects, the policy is similar to the Earned Income Tax Credit (EITC), a program with bipartisan support from which eligible low-income households can receive an annual boost of several thousand dollars on top of their earnings. But Puerto Rico is not eligible for the EITC today, so it can choose between the wage subsidy and EITC approaches. Of the two, the wage subsidy has significant advantages.
While the EITC is paid as a lump-sum at tax season, the wage subsidy pays the worker in every paycheck—greatly strengthening the incentive to work and also helping the household to manage its finances. And while the EITC payment to a household declines if that household works more hours and thus earns more money, a wage subsidy declines only when a worker gets a raise. If a worker takes a second minimum-wage job, or another household member takes a job as well—the types of behaviors critical to lifting a family out of poverty and, in Puerto Rico’s case, jumpstarting an economy—all can earn the full subsidy on every hour worked.
Of course, a wage subsidy would not come free. But several factors mitigate the cost. First, a high minimum wage costs money too. The cost may not appear in any government budget, but employers still have to pay the full amount of the paycheck. If public policy calls for helping workers to earn more than they can command in market wages, that responsibility is better placed on government than on the employers who offer the jobs.
Second, the subsidy could be funded by shifting money out of existing welfare payments. As workers move off government support and into the labor market, some of those funds become available anyway. And scaling back benefits to levels appropriate for the island’s economy and labor market would help to make working relatively more attractive than relying on the safety net.
Third, Puerto Rico is plagued by an enormous “grey market” of economic activity held off the books to avoid both the minimum wage and numerous other regulatory burdens. But the wage subsidy, obviously, would be available only to employers operating above board. Bringing more activity into the formal economy should significantly increase tax collections.
All of the United States is headed toward many of the challenges that Puerto Rico now feels most acutely. Political pressure is rising to raise the minimum wage far beyond what the labor market can bear. Safety-net benefits are becoming ever-more generous, overtaking in many cases what a worker is capable of earning. Labor-force participation, especially among less-skilled workers, is in decline. Now is the perfect opportunity to convert the island from a dismaying preview to a model for effective reform.
This piece originally appeared on The Hill
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Oren Cass is a senior fellow at the Manhattan Institute. Follow him on Twitter here.
This piece originally appeared in The Hill