Tax Credits and the Minimum Wage

January 10, 2007

This morning, the Senate Finance Committee held a hearing on whether tax credits should be used to offset the harm done to some businesses as a result of the minimum wage increase. Unfortunately, once again members are attempting to use the tax code to solve one problem, yet could likely end up creating more problems.

Because the economic incidence of the minimum wage hits many differing parties, lawmakers’ attempts to compensate business owners through tax credits as a result of a minimum wage hike will likely not reach their ultimate target.

We know from economic literature that there is some deadweight loss from the minimum wage in that it results in higher unemployment. The magnitude of that deadweight loss is subject to much debate in the literature (see the work of Neumark and Card & Krueger). This deadweight loss leads to a decrease in overall national income, and there is no way to compensate those who are hurt by this deadweight loss without imposing some other harm on someone else.

There is also the transfer component of the minimum wage. That is, the minimum wage redistributes income to those who work minimum wage jobs. (Technically, there is also the argument that overall compensation increases very little and that employers merely shift from non-wage compensation such as working conditions to wage compensation.)

Who pays for this transfer? The answer is, two parties: employers and consumers.

Assume for a moment that all of this redistribution falls on employers, and thereby business owners. Trying to compensate through the tax code those business owners for this hit unfortunately requires directed tax credits, which is the subject of today’s hearing. However, there are two problems with this. First, it is very difficult, if not impossible, to compensate exclusively those hurt by the minimum wage. Second, if tax credits for these businesses are passed, then that means taxes must be raised on everyone else, i.e. all taxpayers. Now we have all taxpayers bearing the redistribution portion of the burden of the minimum wage hike. This obviously leads to the question: why not just redistribute through the Earned Income Tax Credit (EITC)? The resulting incidence of the burden would be exactly the same (all taxpayers paying for it), yet EITC is much more directed at those families who live predominantly off of minimum wage income.

Now assume that all of the redistribution burden falls on consumers. That is, minimum wage hikes are merely passed on to consumers in the form of higher prices. This means that all consumers of minimum wage-produced products would be bearing the burden. That is no different than having a redistributionist spending program (like EITC) financed by a national retail sales tax such as the FairTax. And, because minimum wage-produced products are consumed disproportionately by those in the lower-income groups, under this incidence assumption, the minimum wage is not very redistributionist, and any tax credit to specific businesses would not be even close to a proper compensation of the affected parties.

Obviously, the burden falls somewhere in-between the two extremes. But wherever it lies, Congress should not attempt to use the tax code to compensate specific parties that are harmed by certain regulatory policies like the minimum wage. Giving every American a 50 cent coupon to any fast food restaurant would likely be a better method of compensating those hurt by the minimum wage rather than the tax credits some in Congress are asking for. Unfortunately, given the political realities on the Hill, Congress is likely to do something with tax policy as part of the minimum wage debate. Because of this reality, while we would never like to see improvements in tax policy become exclusively a function of minimum wage hikes, if tax law changes were to be made, they should not be directed at certain parties with credits. They should involve lowering of the overall tax rates on businesses and individuals as a substitute for tax credits.

For more on this topic and how overall tax rate reductions are superior to hand-picked tax credits, read a recent commentary here from Brian Phillips.

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