The Minimum Wage and the Evolving Welfare State

November 18, 1999

Every few years the U.S. Congress and the President haggle over a key piece of federal welfare policy––an increase in the minimum wage. Much to the chagrin of the business community, 1999 was one of those years. It is not clear at the time of this writing whether a minimum wage hike will be signed into law by the President this year. What is clear is that if it falls short this year, supporters will certainly succeed in the election year of 2000.

The minimum wage today stands at $5.15 an hour, and H.R. 3081 would raise it to $6.15 over three years. That’s more than a 6.5 percent-a-year hike when inflation as measured by the consumer price index is running at a little over 2 percent per annum.

It amazes that with such a consistently strong economy and such tight labor markets, there are still many people in the workforce earning less than $6.15 an hour year after year. Unkind as it may sound, the only explanation is that these workers have very few marketable skills. What will happen to these people and their employers, then, when the minimum wage is increased?

Some businesses, unable to afford the new higher wage will lay off workers. Economists’ projections of how many people will be laid off are hotly disputed, of course, but there can be no doubt that some number of low-skilled workers will be given pink slips when the minimum wage goes up. That’s terrible public policy.

The silver lining in this cloud is that the nation’s poorest workers who still have jobs will receive more cash wages. This is obviously a good thing, and all the predictions of dire consequences notwithstanding, this is what will make the Congress eventually agree to it.

In recent years the Congress has taken to providing some tax relief to small businesses to blunt the economic effects of the minimum wage hike. H.R. 3081 includes a number of them, including provisions to reduce the top estate tax rate, shift the unified estate tax credit to a true exemption, accelerate by two years the time when the self-employed may claim a full deduction for health insurance purchases, and allow small businesses to deduct up to $30,000 annually in capital purchases.

These tax provisions are good and reasonable one and all. But few of them would blunt the effects of the minimum wage hike. For example, estate tax relief has little effect on the current cash flow of a small business. Likewise, few self-employed people pay themselves a minimum wage, so allowing them a full deduction for health insurance premiums, while a sound policy, really has nothing to do with the minimum wage. Of the five main tax provisions, only the increase in the amount of asset purchases that can be immediately deducted is the least bit relevant to the minimum wage increase.

Using tax relief to ease the effects of the minimum wage is not a terrible idea per se. The problem is a failure to recognize the inherent nature of the policy at issue. An increase in the minimum wage is fundamentally a social policy with economic consequences. It is a way to increase the income of low-wage workers by government fiat without directly putting additional strains on the Federal fisc. In short, it is an expansion of welfare paid for entirely by an effective surtax on those businesses that hire minimum wage workers.

Back in the mid-1980s Congress recognized the real nature of the minimum wage. Republicans advanced the idea of using refundable tax credits as a substitute for a minimum wage hike. In fact, this was the genesis of the Earned Income Credit (EIC). The advantage of the EIC is that it requires the entire country to bear the costs of this social policy by creating a claim on Federal revenues, rather than dumping the whole cost on small businesses. The disadvantage is that low-income workers who find themselves in the EIC phase-out range are facing very high marginal tax rates.

Further expansions of the EIC are unlikely, so the Congress has returned to a straight minimum wage hike. Thus, it is correct to use the tax code to provide tax relief for minimum wage-paying businesses. In doing so, the cost of the policy is shifted from the small businesses to the public at large. If the Congress is going to enact a social policy, its costs should be spread fairly.

That doesn’t mean Congress should just reach into a grab bag of tax provisions. To mitigate the damage of a minimum wage hike, Congress must enact tax provisions that reduce the current tax liabilities of the affected companies. The easiest way is to give small business a rate cut. To be more focused and a bit more clever, one could devise a refundable tax credit equal to some percentage of the total wage bill paid at the minimum wage.

Having gotten this far, however, let us return to the basic, underlying issue. Raising the minimum wage to increase the income of low-wage workers is welfare–a government transfer of income. The tax provision dimension of H.R. 3081 simply determines who pays for the policy. If the Congress wants to increase welfare payments to workers, it should do so directly, not by sneaking it through the back door in the form of either an Earned Income Credit expansion or a minimum wage hike.

Further, once we recognize the minimum wage for what it is––an off-the-books welfare program, it is reasonable to ask whether this is the best policy for raising the wages of low-income workers. It would be better for the workers involved and certainly better for the economy if the Congress were to direct the money spent on this back-door welfare program toward effective programs that raise the marketable skills of these workers. A hand up is and will always be better than a hand out.


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