The minimum wage has long been a controversial subject, especially with concerns that employers could exploit workers by paying them less than a fair wage. The prevailing federal minimum wage of $7.25 an hour has been unchanged since 2009, but many states, cities, and counties are poised to raise that to varying levels this year. Democrats have pushed for raising it to $15 an hour, and Sen. Bernie Sanders recently floated a plan to raise it to $17 an hour.
But raising the minimum wage does not automatically guarantee workers higher income, employment, and welfare in the long run, according to a new paper by experts at Wharton and elsewhere, titled “The Macroeconomic Dynamics of Labor Market Policies.”
“A key question in evaluating the effects of a minimum wage will be: How easy or how hard is it for an employer to replace or substitute away from that worker?” said Wharton finance professor Thomas Winberry on the main driver of the paper. He co-authored the paper with Chicago Booth economics professor Erik Hurst, Stanford University economics professor Patrick Kehoe, and Stanford research scholar Elena Pastorino.
If an increase in the minimum wage requires a firm to, say, double the wages it pays to a worker, it may decide “to just not hire that worker anymore and instead do their production with another worker,” Winberry continued. However, it will take time for firms to reorganize their production practices in a way that no longer requires such workers, he added.
The authors suggested a more effective way to improve the long-run lot of low-income workers than large increases in the minimum wage. Combining existing transfer programs, such as the earned-income tax credit (EITC) or a progressive tax system, with a modest increase in the minimum wage provides even larger welfare gains for those workers, they stated.
A Framework to Study the Impact of the Minimum Wage
The authors developed a framework to study the impact of the minimum wage in the short run (three to five years) and the long run (beyond 10 years), including the ability it offers employers to substitute workers across different groups. They found that in the short run, both small and large increases in the minimum wage have small impacts on employment, while they increase incomes for workers who were earning less than the new minimum.
In the long run, the effects of the minimum wage differed depending on the size of its increase. With small to moderate increases in the minimum wage, “the wages of initially low-wage workers immediately increase and over time their employment increases as well,” the paper stated. “As firms progressively adjust their input use towards low-wage workers, these minimum wage increases have even more beneficial effects on these workers in the long run than in the short run.”
“A key question in evaluating the effects of a minimum wage will be: How easy or how hard is it for an employer to replace or substitute away from that worker?”— Thomas Winberry
But with large increases in the minimum wage, “firms have an incentive to substitute away from these workers, if the new minimum raises their wages well above the efficient level,” the paper stated. “Hence, large minimum wage increases have potentially substantial negative effects on the employment, labor income, and welfare of low-wage workers in the long run.”
The study looked closely at how firms can respond to changes in input costs such as a higher minimum wage. They could resort to “labor-labor substitution,” or replace workers, among those that have similar education profiles but vary in productivity; or they could do such substitution among workers across different education groups; or they could substitute between labor and capital.
The study included the capital component within labor substitutability, assuming that the types of capital investments determine the production processes a firm may use. Firms have limited flexibility in the short run to reorganize production, such as a bank replacing a teller with an ATM machine, but they would have more of those options in the long run, Winberry said.
Winberry pictured a setting for firms that pay their workers $8 an hour but now have to pay $15 an hour. “In the short run, firms aren’t going to get rid of all of these $8-an-hour workers right away, but instead pay the $15-an-hour minimum wage and keep them on,” he said. “So in the short run, the $15 minimum wage is actually quite good for these workers because their wage jumps right up, and firms can’t fire them right away because they’re stuck with the production processes that they have in place. Over time, as firms adjust their production processes, the number of workers they employ starts to fall.”
The size of the increase in the minimum wage has a lot to do with whether workers are better off in the long run. In the short run, a small increase from, say, $7.25 an hour to $8.50 (a 17% jump) raises the wages of workers in the lowest rungs, and it has a negligible effect on their employment, the paper stated. In the long run, the employment of those workers increases; small wage increases don’t hurt a firm’s profits too much.
Undesirable Long-run Effects for Some
A large increase in the minimum wage where it more than doubles to say, $15, no doubt benefits low-wage workers in the short run. But that ultimately hurts them in the long run. The paper pointed to “the potential paradox” of a large minimum wage policy: “In the long run without any countervailing force such as inflation, productivity growth, or other corrective policy, [a large minimum wage] hurts precisely the lowest-earning workers whose income it is supposed to support.”
The study showed that in the long run, a big jump in the minimum wage to $15 an hour lowers employment rates of approximately 60% of non-college workers who initially earned less. The earning losses are concentrated among a fifth of the workers who earned less than $10 an hour before the wage increase.
Specifically, in the long run, a $15 minimum wage reduces the employment of workers without a college degree by about 12%, the study found. Employment gains are concentrated among workers whose initial wage was already close to $15, or those who earned between $11 and $15.
According to the paper, a “key drawback of the minimum wage is that it is too blunt a redistributive instrument to support the labor income of workers earning the lowest wages in the long run.” The authors offered alternatives: “Other policies within the U.S. tax and transfer system, which are better targeted to the population of interest, may be more effective at redirected resources to a larger group of workers, including those at the low end of the wage distribution, who are the intended beneficiaries of these policies.”
Winberry noted that the EITC, along with other labor market policies that are targeted at lower-income workers, are “redistributive” — it benefits people in the low- and middle-income brackets, but does not extend that benefit to higher-income workers. It also allows workers to claim a refund even if they did not have federal taxes withheld.
All considered, “a moderate minimum wage increase can play a valuable role in supporting transfer programs like the EITC,” the paper concluded.