Wage inequality in the U.S. has increased substantially over the past 70 years, but the manner in which policymakers have used two familiar devices to redistribute wealth and narrow the gap — minimum wages and taxes — has changed considerably, according to a new Wharton research paper. Workers, on their part, try to better their lot by upgrading their technical skills, but the wage gap between skilled and unskilled workers widens, worsening inequality, the paper noted.
Under perfect market conditions, the ideal way to reduce income inequality is to use minimum wages and income taxes in a complementary way instead of one substituting the other, according to the paper, titled “Are Minimum Wages and Income Taxes Complements or Substitutes in Addressing Rising Skill Premia?” In such redistribution, taxes collected from higher-skilled and higher-income workers are used to benefit lower-skilled and lower-income workers with higher minimum wages, welfare programs, or direct cash transfers.
The paper’s authors, Wharton finance professor Sergio Salgado and Indian School of Business economics and public policy professor Shiv Dixit, provide a framework to use those redistributive tools optimally, adjusting for changes in skill levels and the government’s ability to audit individual tax filings.
The authors noted that although minimum wage limits and redistributive income taxes have the “shared goal” to reduce income inequality, there is no consistency in how U.S. states use them. Some states treat them as complements or use them together, while others treat them as substitutes, where they pick one in place of the other; the variation also shows up across different time periods.
In addition to empirical facts, the main finding of the paper is the heterogeneity in how states use the two levers differently. The model attempts to explain that heterogeneity, and to explain under which conditions policymakers could combat increasing income inequality using either minimum wages or taxes, and whether they should use them together or separately. The authors chose state taxes (instead of federal taxes) because of the variations in how states use the two tools.
The paper showed that differences in the sensitivity of the auditing technology — that is, the ability of the tax authorities to verify whether individuals are correctly reporting their income — to changes in income can explain variations in minimum wages and income taxes across states and over time.
“The choice of instruments a planner might use depends on how good you are as a country or as a state in auditing your workers to check whether or not they are telling the truth about their income,” said Salgado. “If you have good auditing technology, using taxes is a good idea because you can go and check if workers have enough money, and redistribute accordingly. But if you don’t have a good auditing technology where it is easy for workers to hide their income, maybe it’s better to use minimum income for redistribution.”
“The choice of instruments a planner might use depends on how good you are as a country or as a state in auditing your workers to check whether or not they are telling the truth about their income.”— Sergio Salgado
Investigating what causes those different approaches and the resulting different outcomes guided the authors to the crux of the paper: What determines the optimal mix of wage floors and taxes in the face of rising skill inequality? Using U.S. government data on wage floors and income taxes from 2000 to 2015, they modeled their exercise to understand how public policies respond to changes in workers’ skill levels, termed as skill-biased technical change (SBTC).
Why Audits and Skill Premiums Matter
The study found that designing the optimal policy mix of minimum wages and income taxes depends on the government’s wherewithal to verify that workers disclose their wages and technical skills that impact productivity.
The paper noted that intuitively, the minimum wage serves as an indirect mechanism for extracting firm profits and redistributing them to low-skilled workers, assuming that firm profits are not directly taxed.
When high-skilled workers upgrade their skills and raise their “skill premium,” the resulting increase in high-skilled wages expands the income tax base, leading to higher tax revenues and larger transfers to low-skilled workers. When low-skilled workers receive more generous transfers, the relative importance of their labor earnings diminishes, making job losses or reduced hours less costly in welfare terms, the paper noted.
But without effective audits of workers’ productivity with skill upgrades, the case weakens for using minimum wages and taxes as complementary tools; that relationship can shift from complementarity to substitutability, the paper argued.
The paper identified two main factors that drive tax evasion. One, the IRS typically audits higher-income individuals — about a seventh of the filings by individuals earning in the seven digits are audited, compared to the overall rate of 0.62%.
Two, when public policies reduce disposable income — through lower minimum wages or higher tax rates — evasion is more attractive, leading individuals to underreport more of their income. “As aggregate evasion rises while enforcement capacity remains fixed, detection probabilities decline,” the authors noted.
How Skill Premiums Influence Income Inequality
With skill-biased technical change, the wages of high-skilled workers in the study sample increased faster than those of lower-skilled workers, increasing income inequality between the two. “Changes in technology over time have benefited people who have used or know how to use information technology,” Salgado said. “Low-income workers might not have been able to use such technology because it is not complementary to them. That, in part, explains the increase in inequality.”
Salgado pointed to two sources of technology that influence the skill premium for workers. One source is technology that complements the skill sets that high-skill workers already have, such as knowledge of how to use computers or other technologies. The other is technology that could replace the manual work that low-skilled individuals could do.
“The minimum wage serves a dual purpose — not only does it redistribute income, but it can also discourage high-skilled individuals from pretending to be low-skilled to receive benefits intended for the latter.”— Shiv Dixit
Automation and outsourcing tend to keep the wages of low-income individuals very flat, but computers, the internet, and AI tend to complement workers’ existing skills. “We hope that AI will be complimentary, although in some sense, it’s also replacing some work functions,” Salgado said.
How the Minimum Wage Serves a Dual Purpose
If the government can ascertain through audits what workers declare about their earnings and therefore their skill levels, and new technologies mainly benefit high-skilled workers, then it makes sense to raise both taxes and the minimum wage. “When the government knows exactly how productive each worker is, a rise in the skill premium increases the case for using taxes to redistribute income,” said Dixit.
As high-skilled workers earn more, they pay more in income taxes, which allows the government to provide larger transfers to low-skilled workers, he explained. Higher minimum wages could lead to job cuts or reduced hours for workers — those transfers help offset the resulting income loss, he added.
“When low-income individuals receive higher transfers, the overall welfare loss from job cuts is smaller,” Dixit continued. “As a result, policymakers may be more willing to raise the minimum wage even if it reduces some low-skilled employment, because the affected workers are better protected.”
Higher minimum wages can also help in preventing workers from underreporting their earnings or skill levels, when the government doesn’t have the auditing resources to ascertain their skill levels. “In such cases, the minimum wage serves a dual purpose — not only does it redistribute income, but it can also discourage high-skilled individuals from pretending to be low-skilled to receive benefits intended for the latter,” Dixit said.
By setting the minimum wage high enough, the government can limit the consumption of low-skilled workers, who might be unemployed or underemployed as a result. That would make it unattractive for high-skilled workers to misrepresent themselves as low-skilled to claim benefits, Dixit explained. “In this way, the minimum wage becomes a screening tool to preserve the integrity of redistributive programs.”
Salgado said their paper contributes to the debate on how to decrease income inequality or how to go about redistribution of wealth. “The question is how we should address the issue, especially for those who may not have a living wage or live paycheck to paycheck.”
According to Salgado, their paper is relevant now in light of the current administration’s efforts to cut taxes on rich individuals. “That will increase income inequality for sure,” he said. Reducing the power of the IRS to audit individuals could also indirectly increase income inequality, he added.
