Minimum Wage Hikes vs. Tax Rebates - What's More Effective?

There's been much talk in the blogosphere lately about what happens to unemployment levels when the minimum wage is increased (the consensus is that there is no consensus), but what happens to the people who see their wages go up?

Nobel-winning theory from Milton Friedman says that when a person knows his income will increase, he'll spread out those gains over the rest of his life and not spend it all at once. In the case of a $1 minimum wage hike, annual spending should increase by about $400.

But that grossly understates what actually goes on, write economists Daniel Aaronson, Sumit Agarwal, and Eric French in a new Federal Reserve Bank of Chicago working paper.

The trio examined what happened to the consumption and debt levels of households that experienced either a federal or state minimum wage hike.

First, they found that spending didn't increase when the legislation was passed, but when it went into effect. This goes against Friedman's theory, which assumes that a person will change spending as soon as he learns of his future income stream.

Second, spending increased by a whopping $800- to $1,000-per-quarter compared with a $250 increase in pay as a result of a minimum wage hike. This means that debt levels also rose.

"If households were spreading the income gain over their entire lifespan, the spending increases should be far smaller than what we observe in the data," the researchers write.

So, where does the money go? The researchers found evidence that the bulk of it is spent on big-ticket items like cars and trucks. All this implies that a pay bump allows minimum wage earners to make down payments on expensive items that they wouldn't have been able to otherwise. To me, this spending behavior seems remarkably similar to what we wanted from the $120 billion stimulus plan. So, could a minimum wage hike be more effective?

Right now, the national minimum wage is set at $5.85/hr and will get a bump in late July to $6.55/hr followed by another boost to $7.25/hr next July. The Economic Policy Institute says that 5.6 million workers will be affected by this change. Aaronson, Agarwal, and French estimate that a $1 minimum wage increase translates into a $2,000 boost in annual spending.

A back-of-the-envelope calculation (assuming that 5.6 million minimum wage earners experience a $1 gain in pay) would put new spending at $11.2 billion. The cost to businesses would be $2.8 billion in increased wages.

On the other hand, past research has shown that consumers spent about two-thirds of their stimulus checks back in 2001. This time around, that would translate into an additional $80 billion in spending. So, what's better, spending $120 billion to stimulate $80 billion in consumption, or $2.8 billion to stimulate $11.2 billion?

Obviously, it's much more complicated than this simplistic scenario. Getting $80 billion in additional spending from minimum wage increases would mean boosting pay way more than $1, which could cause all sorts of unexpected side effects not limited to higher unemployment in the economy. But given the evidence here that workers are quick to spend their income gains perhaps -- assuming it's not very costly for businesses to implement -- even a temporary minimum wage hike could be more cost-effective than a tax rebate.

Comments

[John Pseudonym]

Increasing the minimum wage increases wages across the board and that is the last thing we need right now.

If you manage a minimum wage crew (The crew makes at $5.85) and you make $10 an hour as the manager, all is well.

Now, 2 years later, your idiot crew is making $7.25 while you're making $10.50...you're not going to be happy.

Artificial wage inflation which will drive up all wages, which drives up prices which negates the artificial rise in wages which puts us right back to where we started.

If setting wages artificially really works, then why not set the minimum at $20 an hour?

Wouldn't that be the end of poverty?

[bearfund]

It's also unreasonable to assume that burst of borrowing will occur in the future. Credit is harder to come by and more expensive than over the past decade, especially for people who don't have much (or good) history. Plus, many of these minimum wage earners are already up to their eyeballs in debt thanks to soaring prices. The wage increases in the pipeline will mostly be saved or used to pay down debt - exactly the uses we should all be hoping they're put to. The challenge to the US economy is not to stimulate growth in debt-fueled consumption (haven't we learned anything?!) but first and foremost to avoid collapse, then to clean up our individual and collective balance sheets and rediscover save-and-invest economics.

It would be a sign of health if real GDP were to remain unchanged for the next 10 years if in that time its composition also moved away from consumption and toward investment, especially if funds for that investment came domestically from savers and new shareholders. This kind of deleveraging would make the US economy leaner, more competitive, and more resistant to credit shocks. It would also strengthen the dollar and remove price pressures. Americans, including minimum wage earners, would consume less but would have much greater wealth, especially as their investments generate income and appreciate in value.

This argues for neither wage hikes nor cash giveaways (financed by borrowing abroad) but for tighter credit for all individuals and a cultural shift toward saving. Taken together, this means higher interest rates.

[Malkiel]

I had to laugh when I read your recitation of Friedman's comment and the description of how people actually behave, which is what popped into my head before I had gotten to that paragraph. Economists must be the only "science" that doesn't require actual analysis of data to confirm a theory, just the backing of a political party that likes what it hears.

I have a theory that an enterprise that can't afford to pay minimum wage is a marginal enterprise that's probably parasitically drawing money away from healthy enterprises, and if increasing the minimum wage drives some of them out of business that's better for the overall economy because the money flows instead to the good businesses paying higher (over the table) wages and taxes. I don't have direct evidence for this theory, but if Friedman doesn't need evidence why should I?...

[VintonCounty]

Minimum wage, like all price controls, is harmful. It makes unemployable those not worth the minimum wage, and those worth more don't benefit. That's all anyone needs to know about that subject. Studying subsequent spending patterns is pointless, and it tells you that those studying it are bad economists.