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Why A Raise In The Minimum Wage Won't Create Jobs

This article is more than 9 years old.

There's much talk out there about how a raise in the minimum wage will create more jobs, not fewer as the conventional analysis would have it. This new, and surprising, take on it relies on an effect which is undoubtedly there, the marginal propensity to spend, but that's often true in economics. There's an effect: Great, now we need to decide two further things. Firstly, whether it's going to be an important effect and secondly, are there any other effects that are going to offset it? And the joint answers there are, at least I think they are, no not very important and yes, there's another effect that more than offsets it.

The argument being offered, and I must stress that this basic argument is in fact correct in that the effect does exist, is that poor people are more likely to spend all of their incomes into the economy than richer people are. This then means that moving money from richer people to poorer acts as an increase in aggregate demand and we get the usual Keynesian multipliers at work, the economy grows therefore and everything is then peachy in our society: or at least more peachy than it was before.

It's undoubtedly correct that this is true: this will happen to some extent. The normal (very rough) rule of thumb is that richer people save some 15% or so of their income: The poor save nothing. So, if we move $100 in income from rich people to poor people then that aggregate demand will increase by $15. This will undoubtedly be an increase in demand, the usual multipliers will kick on and the economy will grow: from this effect alone there will be more jobs. Please note again: This is obviously true but we still want to know the answers to the two further questions.

As to whether this is important I would argue not. For the effect is only that 15% of the extra income gained by those poorer people and I don't think that's going to be enough to offset the impact of the new, higher, price for labour on hiring intentions. But that is an opinion and not one I'd want to have to prove empirically. We can leave that as being arguable.

However, it has occurred to me that that there is also another effect that is going to come into play here.  For we can model a minimum wage rise as being an increase in taxes upon either the returns to capital or those getting higher wages. It isn't, of course, a tax in itself, as the money is not going off to government and then being redistributed or spent. But the effect on those returns to capital and higher wages are very similar: We're using legislation to change the distribution of income and thus we can usefully use the models we already have about the effects of taxes to illuminate, if not to precisely describe.

And the one thing we know about all taxes is that the very fact that we are raising revenue in this manner reduces economic activity. This is known as "deadweight costs." A useful (and again, very rough) rule of thumb here is that raising $100 in revenue destroys $20 of economic activity. A further estimate is that now, when we're already raising 30-50% of GDP in taxation, the marginal deadweight costs rise to perhaps one third: Every $100 in revenue raised destroys $33 of economic activity which would have taken place in the absence of our having tried to raise that revenue.

Note that these are all rough numbers: And yes, a minimum wage rise is not exactly like a tax but it's close enough that the comparison does illuminate.

At which point it should become obvious that our countervailing effect is going to be larger than the effects of the marginal propensity to spend. Sure, we get the extra $15 of demand being pumped into the economy as a result of the poor having more, more that they spend while the original owners of that income, the better off, would have just saved it (not that there's anything wrong with savings, obviously). But, in that process of moving that $100 from pocket to pocket we've destroyed as much as $33 worth of economic activity. And we can all see that $33 is more than $15. Thus, sadly, the end of the idea that an increase in the minimum wage will increase aggregate demand and thus the number of jobs.

And the thing is, while the precise details above can be argued over, exactly what is the effect of the multiplier, what is that marginal propensity to save, exactly what are the deadweight costs, the basic logical argument there is correct. So also is the fact that those deadweight costs are going to be higher than the increase in aggregate demand from the minimum wage rise. So while this might not be exactly right it is generally right: A minimum wage raise is not going to increase the number of jobs in the economy.

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