Minimum Wages: Employment and Welfare effects, or Why Card and Krueger were wrong

By Des Moore*


*I wish to acknowledge Geoff Hogbin’s extensive and generous contributions to this paper, particularly to the section analysing the claims by Card and Krueger and the evaluations of those claims.

Many qualified analysts are unconvinced by the case advanced by US economists Card and Krueger(C&K) that, within limits, the employment effects of raising the minimum wage will be zero or positive. Indeed, examinations of C&K arguments and studies by such analysts reveal many flaws and generally support the conventional view that minimum wages reduce employment. Using the minimum wage to assist low wage earners is also an inefficient and ineffective welfare measure as higher income groups benefit from it more than others. Eliminating the AIRC’s role in determining the minimum wage and moving to a market-determined wage could be made more politically acceptable if accompanied by some form of additional social security assistance linked to and encouraging work for low wage earners in low-income households, and protecting their living standard. To avoid any additional budgetary cost, such assistance could be financed by reducing the large social welfare benefits currently provided to higher income groups.


In recent years a major controversy has developed in OECD countries, including Australia, over the issues of whether governments or their regulatory institutions should prescribe minimum wages, the levels at which any such minima should be set, and the consequences if they do. Such issues have been part of the broader debate about labour market regulation and the appropriate components of welfare policy.

The debate has developed against a general background in which unemployment has increased and/or employment has struggled to keep pace with the growth in working age populations. The increased difficulty experienced by unskilled labour in obtaining employment has been reflected in the widening proportions of populations reliant on welfare assistance. This situation has produced two different types of response.

In the US employers and employees have continued to be allowed greater freedom than elsewhere to determine wages and conditions and, although national and state minimum wages have been increased at irregular intervals, they have nevertheless been kept at low levels relative to average earnings. That country has also increasingly linked the provision of welfare to preparedness to work, including through the provision of an earned income tax credit (EITC). Especially after the Thatcher-era reforms, the UK also developed a more flexible labour market (with unemployment now down to around US rates) and, although it recently introduced a minimum wage, that was set at a relatively low level. It also put increased emphasis on linking welfare payments to employment, including a "working families" tax credit.

In both countries the lesser regulation of employment conditions has been accompanied by improved rates of employment and unemployment, as well as a reduced reliance on unconditional welfare. At the same time, the widening both have experienced in the dispersion of earnings has led to criticisms that the increased labour market flexibility has put an inappropriate burden of adjustment to changes in economic conditions on wages.

By contrast, Continental European countries have generally maintained far more regulatory labour market regimes, with relatively high minimum or "reservation" wages. While proponents of this approach claim it is to be preferred because the distribution of European earnings is more equal, the generally higher rates of unemployment and/or lower rates of employment than in the US/UK have meant that higher proportions of the working age population have been deprived of the earnings and opportunity of advancement that employment provides. The greater dependency on welfare has also required governments to impose the higher taxes needed to provide higher welfare assistance, but also having adverse implications for employment. The more extensive attempts to improve employment through labour market programs appear to have had only limited success.

The debate about whether the US/UK or Continental European approaches to labour market and welfare policies should be pursued is naturally relevant to Australia. Notwithstanding the US research (discussed below) suggesting that minimum wages do not necessarily have adverse effects on employment and may thus usefully contribute to welfare policy, this paper’s examination of the research and the analyses of it suggest:

For Australia, a freer labour market policy (which should include the elimination of the AIRC’s role in determining minimum wages), combined with welfare assistance linked to work, can be expected to result in higher employment and a better welfare outcome for low-skilled workers.


The Card/Krueger "New Economics of the Minimum Wage"

Conventional economic analysis says that setting a minimum wage above market will reduce employment at the bottom end of the labour market, thereby increasing unemployment rates for unskilled workers. Job losers will receive welfare payments lower than their wages and suffer long-term damage by losing access to the employment ladder.

This conventional view was challenged in the early 1990s by two US economists, David Card and Alan B. Krueger (C&K), who claimed that, within limits, setting a legal minimum wage above free market rates has either zero or positive effects on employment and that, consequently, a minimum wage improves the welfare of low-paid workers. The claim derived initially from their 1991telephone survey comparing the employment effects in New Jersey fast-food stores of the increase in the minimum wage there from $4.25 to $5.05 per hour with employment in stores in neighbouring Pennsylvania, where the state minimum had remained at $4.25. That survey showed an expansion in employment in New Jersey relative to Pennsylvania (C&K 1994).

Subsequently, C&K conducted other extensive research claiming similar results and in 1995 published a book in which they stated:  

If a single study found anomalous evidence on the employment effect of the minimum wage it could easily be dismissed. But the broad array of evidence presented in this book is more difficult to dismiss (C&K 1995 p4)

As C&K are well-qualified economists it is not surprising their claims have been widely publicized and influential in policy-making circles. Much less publicized is the C&K caveat that, if the minimum wage is raised "too much" - whatever that means - there would be employment losses (C&K 1998). This is especially relevant for labour market policy in Australia, where the minimum wage of nearly 60 per cent of the median wage is higher than in most countries and much higher than in the US or UK (36 and 42 per cent respectively).

The following summarises a range of research that casts serious doubt on the validity of the CK arguments on minimum wage effects. Although (as with most other controversial issues in economics) it is not possible definitively to disprove the CK claims on employment effects, the analysis of this research and evidence strongly suggests neither employment nor wages policies should be based on them.

Evaluating the theoretical basis for the C&K claim 

The strongest argument against the claim is that it runs counter to a central tenet of economics (and commonsense)—that if the price of something rises people will buy less of it. There is a very wide array of readily observable evidence, much incontrovertible, accumulated over centuries from many spheres of human interaction and consistent with the proposition that there is an inverse relationship between quantity demanded and price. Accordingly, when claims are made that are not in accord with conventional theory (eg that raising a minimum wage does not reduce employment), economists properly insist on adequate explanations for them. C&K and their supporters have come up with two explanations that are at least theoretically defensible, although far from convincing for many economists.  

C&K’s main theoretical argument is that, contrary to the conventional economic belief, many firms are not price-takers (wage-takers) in the market for low-wage labour but, rather, have monopsony power. Where a firm has such power, it can be shown unambiguously that setting a legal minimum wage above the wage it currently pays will, within limits, induce a profit-maximising firm to hire more labour than otherwise. This is in accordance with C&K’s claim.

A monopsonist is a single buyer of a given input. A commonly used textbook case of a monopsony employer is that of a country hospital, the single employer of nurses in a district, that is obliged to raise wages for all its nurses in order to induce more (extra) trained nurses married to farmers to sacrifice their leisure and return to work.

Monopsony contrasts with competitive demand for inputs where all firms can buy any plausible quantity of an input, say labour of a given quality, at the current market wage. Where a firm faces competitive demand for an input the extra cost of extra unit of labour is the wage rate. In contrast, the extra cost of an extra unit of labour (marginal cost) for a monopsony is higher than the market wage because wages must not only be increased to attract the extra worker but also to pay all other workers. A logical consequence of this is that, just as a monopolist can increase profits by reducing sales and raising price (relative to a competitive supply scenario), so a monopsonist can increase profits by reducing the quantity of, say, labour hired (relative to a competive labour demand scenario). But another logical consequence is that a labour monopsonist can be induced to hire more labour by setting a minumum wage above the wage that would be chosen to maximize profits.

In short, the effect of the minimum wage is to increase the profit-maximising quantity of labour the monopsonistic firm will hire. C and K used this analysis as the basis for explaining their finding that employment in fast-food stores increased faster in New Jersey than in Pennsylvania following the 1991 increase in the minimum wage in New Jersey.

However, for this explanation to be generally valid monopsony power would have to be pervasive. For example, it must be the case that firms such as McDonalds in Sydney are not able to hire more labour unless they raise wages for both their additional and existing employees. However, although there is no way of demonstrating a priori that monopsony power is not sufficiently pervasive and not strong enough for a minimum wage to induce an increase in total employment of low-wage workers, such a proposition is doubtful at best. Finally, it is worth reiterating that C&K acknowledge that, instead of increasing the quantity of labour a monopsonist will employ, increases in a minimum wage beyond some point will reduce the monopsonist’s profit-maximising level of employment.  

A second explanation is a variant of the theory of "efficiency wages"—the notion that some firms are willing to pay above-market wages to induce employees to contribute extra effort. Broadly, the argument is that setting a legal minimum wage above the market wage will strengthen incentives to contribute effort (partly because workers may be happier and partly because the penalty of losing a job carrying an efficiency wage is higher than otherwise) and/or that employers will invest in improving the quality of their workers to lift the productivity to the level required to make employing them at the higher minimum wage profitable. This argument is unconvincing for at least three reasons.

However, again there is no way of proving a priori that the efficiency wage explanation is invalid. In summary, although C&K’s theoretical arguments are weak, they cannot be dismissed on purely theoretical grounds.

Evaluating the C&K evidence 

Major criticisms emerged shortly after C&K’s 1995 book when a leading professional journal published reviews by five widely respected US labour economists (Industrial and Labor Relations Review 1995). These reviews included one by renowned labour market expert Professor Daniel Hamermesh who argued, inter alia, "no unbiased reader could conclude from (C&K’s) reworking of earlier studies anything other than that the effect of minimum wage increases is small and negative". While the reviews noted the desirability of continually testing "accepted truths", they made other comments raising serious doubts about the research, including the following:  

An important more recent analysis by Cornell University Professor Burkhauser and others (Burkhauser 2000) compares different outcomes produced by econometric studies that were all based on the same CPS data. One set of studies found increases in federal minimum wages in the US had zero or positive effects on teenage employment, whereas the other found negative effects consistent with the conventional view.

The Burkhauser analysis of these studies suggests that, when appropriate modelling and estimation strategies are used to handle the problem of separating macroeconomic from minimum wage effects:

increases in the minimum wage during the 1990s led to modest but statistically significant declines in teenage employment and that the elasticity of teenage employment with respect to the minimum wage lies in the range of -0.2 to -0.6.

Other studies of minimum wage effects 

The publication of C&K’s book in 1995 led to an outburst of competing analyses of minimum wage effects, as illustrated by the two surveys in the Commonwealth’s submission to the 2001-02 Safety Net Review by the AIRC (DEWR 2002).

Of the submission’s 14 studies on US employment outcomes published in 1996 or later, 11 showed a "significant negative" effect, one (by C&K) showed "little evidence", one no evidence, and another "mixed results". This survey of US studies does not include the Burkhauser analysis just mentioned or some other studies also showing significant negative effects.

The submission’s survey of 25 studies based either on data from other countries or international data showed 17 with a significant negative relationship, with the other eight ranging from "neutral to marginally positive", through to "no clear relationship" and "generally consistent with the view that minimum wages cause employment losses among youth". Again this survey is incomplete.

The 1997 OECD publication on Implementing the OECD Jobs Strategy described the CK claim as "highly controversial and may reflect the fact that the federal minimum wage in the United States is relatively low". It reminded readers of the 1994 Jobs Study conclusion that "excessive" minimum wages (relative to productivity) could have serious adverse employment effects. Although these OECD analyses do not provide a definitive conclusion on the employment effects of minimum wages, their generally unfavourable reaction to CK claims is significant given that many OECD countries have and/or support the use of such wages.

Thus, a high proportion of these various econometric studies support the conventional view that a minimum wage reduces employment - and even C&K agree it will do so if "excessive".

Other implications of minimum wages  

Most of the statistically estimated elasticities showing negative employment effects indicate only relatively small net reductions. However, gross reductions may be larger and the idea that objections to minimum wages can be put aside because there will only be "small employment effects" overlooks the inequity of keeping even one person out of a job. Moreover, elasticities are usually calculated over relatively short time intervals (one or two years) and fail to recognise the likely greater longer run adverse employment effects.

Even if the overall employment reductions are small, the welfare consequences of an increase in a minimum wage are likely to be more adverse for particular groups. Burkhauser and others have also shown (Burkhauser 2000b) that:

minimum wage increases significantly reduce the employment of the most vulnerable groups in the working-age population— young adults without a high school degree (aged 20-24), young black adults and teenagers (aged 16-24) and teenagers (aged 16-19).

Some implications for wage setting in Australia 

The critiques of C&K have particular relevance to Australia where the minimum wage is high relative to other wages in an economy. As the Commonwealth Government’s submission to the Safety Net Review (DEWR, 2002, 47-50) shows, the ratio of minimum wages to the median wage (0.58) in Australia is high - and high relative to most other countries (Netherlands 0.47; New Zealand 0.46; Canada 0.43; UK 0.42; US 0.36) the exception being France (0.61). In this situation, the effects of increases in minimum wages on low-paid workers in Australia can be expected to be stronger than suggested by estimates from other countries where the "bite" is weaker. Australian elasticity estimates are also more likely to understate the "bite" because they are derived from experience in a more regulated labour market.

The evidence of negative effects of a minimum wage on employment from other countries is broadly consistent with the limited Australian studies of minimum wage effects. The analysis published by the Productivity Commission of the effect of junior rates (which are a form of minimum wage) on youth employment (Productivity Commission 1998) is of particular interest because it focussed on industries employing a high proportion of youth. Its conclusion suggesting strong negative employment effects - that a 1 per cent increase in youth wages would decrease youth employment by between 2 and 5 per cent – contributed to the bipartisan agreement to the 1999 Commonwealth legislation permanently exempting junior rates from laws outlawing discrimination on the basis of age.

The case for focussing on the effects of minimum wages on those who will be actually affected by that wage was further emphasised in a paper by James, Wooden and Dawkins (JW&D 2001). This paper points out that it is not surprising that most studies using the employment-to-population ratio for all teenagers find that rises in minimum wages only have a small impact on total teenage employment

as most teenagers earn substantially more than the minimum wage and do not see their wages rise as a result of an increase in that wage (p60).


The paper also notes that it is unsurprising that OECD analyses (OECD 1998) showed no significant impact on adult employment from minimum wages as they were similarly derived by using the employment-to-population ratio for all adults. In short, low elasticity of demand estimates derived from aggregate data are not necessarily a good guide to the real elasticity.

These two papers also reflect an earlier analysis by Lewis (DHLS 1997). He noted that, although a minimum wage has only a small impact on both total average wages and aggregate employment and unemployment, the imposition of such a wage has the potential to cause a large fall in employment of workers who could otherwise have earned below the minimum. Lewis also suggested that monopsony has "little relevance to any practical problem except that of a company town" (p206).

At the more aggregate level, Dawkins and Freebairn (D&F 1997) reviewed various elasticity estimates and the evidence on changes in the minimum wages and then presented alternative ‘hypothetical simulations’ of the results of holding money minimum wages constant for four years, with the objective or reducing real minimum wages. These alternative simulations all result in a reduction in unemployment, including one that would reduce the rate to 5.5 per cent from 9 per cent.   

The proposal by the five economists for a wage freeze on minimum awards (discussed further in the next section) also includes econometric estimates suggesting that a freeze on minimum wages would, if sustained, increase employment - "particularly amongst those who rely on wages safety net adjustments for wage increases" – by 2 percentage points over two years and 4 percentage points over ten years.

The evidence summarised above shows the need for much greater attention to be given to the likely adverse effects of minimum wages on employment and unemployment, particularly at the bottom end of the labour market.


The Minimum Wage As A Welfare Instrument

Since the C&K minimum wage claim the argument amongst economists has centred on the employment effects. There has been an implicit assumption behind this argument that, if those effects can be shown to be favourable or at least neutral, that will justify strong support for a minimum wage (within limits) because of the favourable welfare effects, viz that it would provide significant protection of the living standards of those able to earn only low wages. But the evidence suggests that the minimum wage is both largely ineffective in helping such people and also a very inefficient welfare instrument more generally, especially in Australia.

A general appreciation of its ineffectiveness can be obtained from data on income distribution (ABS 1999-00). For households in the lowest quintile this shows that in 1999-00 wages and salaries provided only 8.3 per cent of gross income while nearly 70 per cent came from Government pensions and allowances. Those in the lowest quintile include asset "rich" but income "poor" pensioners who would experience no direct income effects from changes in minimum wages. Moreover, account needs to be taken of the fact that some of those households who start in the lowest quintile will move, over time, to higher quintiles.

In short, the wages "system" is relatively unimportant as a provider of income support for low-income households because they receive most, in many cases all, of their income through the tax and social security systems. Although this is not a socially desirable situation, the fact is that those systems also appear to have been providing effective support, as shown by the slight increase in the percentage share of income going to the lowest quintile for households between 1994-95 and 1999-00. Indeed, although there has been a widening in the distribution of earnings, the effect on overall household incomes has been offset through those systems so that there has been "no significant change in the level of inequality in the period since 1994-95" (ABS 1999-00 p6).

It is somewhat ironic that, despite the wider dispersion of earnings, and despite the decline in real minimum wages since the mid-1970s (Moore 1998), the Australian Industrial Relations Commission (AIRC) has continued to be portrayed as the principal protector of low wage earners. The Commission presumably seeks to reinforce that image through its strange decisions in Safety Net cases determining minima for awards that cover employees receiving wages at rates well above the lowest minimum.

The inefficiency of using the minimum wage as a welfare instrument is revealed by the fact that more than half of low wage earners are located in the top fifty per cent of ‘equivalent’ family disposable incomes (Harding & Richardson 1998a). This mainly reflects the fairly even spread across the range of household incomes of married women and young people who are employed at low wages (defined as adults earning less than $10 an hour and juniors earning less than $6 per hour in 1994-95). The welfare of most in this group would not be dependent on the minimum wage: rather their wages would be used to supplement family income and/or for discretionary spending.

An implication of this income dissection is that raising the minimum wage is likely to increase the inequality of incomes as between households. It also implies a policy of providing large amounts of "welfare" to those living in households with above average incomes. Neither approach is suggestive of a social welfare policy intended to target assistance to those in need.

Analysis by Harding and Richardson (H&R 1998a) shows in Figure 1 that, in addition to providing the above-mentioned dissection of the location of low wage earners into decile groups of "equivalent disposable income" (similar to household groups), a high proportion of the unemployed are in the lowest deciles of the income distribution. As a single adult unemployed receives $9,500 a year and minimum wage earners about $21,000 a year, this raises the possibility of improving income distribution by allowing minimum wages to be set lower in the market place, thereby increasing the employment of the unemployed and raising their income.

Partly reflecting their perceived uncertainty over the employment effects of minimum wages, H&R expressed the judgment that the impact of lower wages on income equality was "unclear" because a lower minimum wage would make all low-wage workers worse off and would benefit only some unemployed. However, a lower minimum wage would not reduce the wages of all existing low wage earners: those with satisfactory productivity would retain their existing wage. Moreover, those who were unemployed and started on a lower minimum would obtain the work experience that would, over time, provide increased opportunities to improve work skills and move up the wages ladder.

Also relevant here is the composition of the unemployed and employed. Although it is difficult to obtain a satisfactory break down of relative skills from ABS data, the following table suggests that the unskilled and inexperienced appear to make up about 60 per cent of the unemployed. By contrast, they appear to comprise only about 20 per cent of the employed. This highlights the considerable potential for reducing the extent of unemployment benefits and improving labour market performance by employing more of the unskilled and inexperienced. As suggested already, that would be considerably assisted if employers were allowed to offer wages at lower than the prescribed minimum.


Table: Employed, Unemployed and Wages by Broad Skill Categories

*Managers and Administrators, Professionals, Tradespersons and Advanced Clerical and Service Workers.

# Intermediate Clerical, Sales and Service Workers, and Intermediate Production and Transport Workers.

+ Elementary Clerical, Sales and Service Workers, and Labourers and Related Workers.

~ Looking for first job, Looking for full time work and former workers.

NOTE: Average wages are calculated by using average wages for each major occupational group in May 2000, employment for each major occupational group in August 2001 and re-calculating average wages for the above groups. ABS publications on the Labour Force and Employee Earnings were used for this purpose.

H&R have also expressed doubts about the desirability of using increases in the minimum wage to improve income distribution and agreed on the inefficiency of that instrument, viz:

We agree that an increase in the level of low and even minimum wages is not a very efficient instrument for equalizing the distribution of equivalent family income. Although it is somewhat equalizing, means tested support for children in low income working families or an earned income tax credit would be more efficient instruments, if no account is taken of the costs of raising the revenue which they require (H &R 1998b).

The issue of possible alternative forms of assistance to low income groups is considered further below.

Notwithstanding the considerably less extensive provision of social security benefits in the US, recent analysis has pointed out that the use of wages as a welfare instrument is also ineffective in that country. In 1999 Professor Burkhauser, who has made submissions to the US Congress and the UK Low Pay Commission arguing the welfare ineffectiveness of the minimum wage, presented to the Commission a paper that assessed the effect of the minimum wage on the income of a family of four on the poverty line of about $US16,000 in 1996. This showed that wages would have provided only about 5 per cent of the income of families on such a line (Burkhauser 1999).

In that paper Burkhauser also pointed out that most workers who received the 1996 increase in minimum wages (from $US 4.25 to $US5.15 per hour) lived in families whose income was far above the poverty line. As in Australia, "most minimum wage workers are not the heads of poor families struggling to earn a living wage [but] are single persons or second or third earners in non-poor families". He concluded that:

advocates of further minimum wage hikes must recognize that such increases were never very target-efficient and are even less so today. Moreover, the role of government and the number of policy options available to reduce poverty have changed considerably since the late nineteenth and early twentieth centuries when minimum wage policies were first debated. Today, the appropriate question to ask is: Are there better alternatives to minimum wage hikes available to help insure a living wage for the working poor? The answer to this question is unequivocally yes. The Earned Income Tax Credit (EITC) is a far better mechanism for rewarding low wage workers who live in poor families (ibid).


A Possible Alternative to Using the Minimum Wage For Welfare

From an Australian perspective this reference to the EITC is relevant to the proposal by the five economists to increase employment and reduce unemployment through a wage freeze on minimum awards accompanied by a tax credit designed to protect the living standards of low wage earners while providing an increased incentive to work. The tax credit would be provided to wage earners only and would increase progressively up to a maximum of $30 per week (after three years), but with a cut off at an income of $31,150 pa. It would tend to reduce the inequality of incomes because, unlike a minimum wage increase, the benefit would not go to those living in higher income families.

This proposal has been supported by the Business Council of Australia (BCA) which in December 2000 published an update (BCA 2000) of the initial presentation of the proposal at a special conference held in April/May 1999 for that purpose. The update now includes, first, the modelling of two alternative wage freeze scenarios by Professor Peter Dixon using his MONASH model and, second, an analysis by NATSEM of the budgetary and income distribution effects of introducing a tax credit. The results of such modelling depend, of course, on the assumptions made about, inter alia, the response to the reduction in real wages from the freeze.

The first scenario assumes the reduction, covering 25 per cent of employees, is permanent and estimates an increase in employment of 2 percentage points over two years and 4 percentage points over ten years. An important basis of the assumption is that the tax credit is accepted as an appropriate compensation policy and there is "thus no need for any catch-up adjustments after the three year period of the freeze". This scenario produces considerably higher GDP and employment, "particularly amongst those who rely on wages safety net adjustments for wage increases". The only "losers" are said to be those who do not receive the income tested tax credit because they are in "relatively high income families". The second scenario assumes the wage freeze is not permanent, so that the gains to employment are only short term. However, it is argued that, in practice, the provision of the tax credit is likely to mean that there will be some permanent employment effects from even a short-lasting wage freeze.

The estimated gross cost of the tax credit was put at about $4.4 billion per annum (after three years) but the increased employment and output under scenario 1 would generate sufficient revenue to more than pay for the tax credit. Under scenario 2, however, tax would eventually have to increase to pay for that.

One problem with this BCA endorsed proposal is that it "does not address the feasibility of implementing such a policy with our current institutional structures" and it acknowledges that a permanent reduction in real wages "may be difficult to engineer in Australia’s current setting". What is implied (but without saying so explicitly) is that, unless the powers given the AIRC were to be reduced or eliminated, that institution would almost certainly assume a role for itself in determining and/or varying the minimum wage. Given the track record of that body, it is unlikely that it would agree voluntarily to a wage freeze except in an economic emergency. The likelihood is that there would also be problems in sustaining a wage freeze covering a significant proportion of employees. These and other issues are further considered in a submission to the Business Council’s special conference (Moore 1999b) but they suggest that overcoming the minimum wage problem requires the elimination of any role for the AIRC in that area.

Most importantly, however, the proposal would retain the existing legislative/institutional arrangements that impose a high degree of regulation of employment conditions. Indeed, because the AIRC would undoubtedly "supervise" any wage freeze, its role and responsibilities would likely increase. Experience suggests that, while Government sponsored "trade-off" strategies may produce short-term benefits, they tend to have adverse side effects which either distort other areas of the economy or which delay needed structural reforms.

For all the foregoing reasons the wage freeze approach is strongly opposed. Ideally, wages should be determined in the market, with unemployment benefits being relied upon to provide the welfare safety net for those unable to obtain employment. However, there is no doubt that, put forward on its own, a market-determined wages policy would be strongly opposed both politically and by many academics. The adoption of such a policy would be made easier politically, therefore, if it were accompanied by some kind of protective social security measure linked to work for those experiencing a reduction in wages. Such a measure could be limited to those living in relatively low-income households, along similar lines to Austudy. It would have the important advantage of providing an increased incentive to work.

One possible measure would be an earned income tax credit as provided in the US, where such credits go to one sixth of the workforce and extend up to incomes of about $US30, 000. However, given that Australia already provides social security/health/education assistance that is more extensive than in the US, it may be more appropriate to adapt an existing benefit rather than introduce an earned income tax credit that is as "generous" as in the US.

Workplace Relations Minister Abbott acknowledged in an article in the Sydney Morning Herald of 9 February 2001 that a "social wage" (that is, the benefits provided through the tax-social security system) is a ‘much more effective’ way of helping low-income earners, that the benefits to low income earners of an increase in the federal minimum award wage are ‘comparatively minor’, and that it does not make sense in these circumstances to increase employers’ costs. Of course, even a social wage measure that was means/asset tested would likely involve significant net costs to the Budget ie even after allowing for the reduction in unemployment benefits and the increase in income tax from higher employment. The implications for fiscal policy would thus pose potentially significant problems.

One way of avoiding any additional budgetary cost would be to "trade off" a reduction in some of the existing social welfare benefits that are provided to higher income groups against provision of additional assistance to low-wage earners in low-income families. Analysis of the Household Expenditure Survey for 1998-99 shows that the two higher income groups received over $30 billion in benefits of various types in that year, including about $10 billion in health benefits (Moore 2001). Moreover, analysis by the Treasury’s Retirement Income Modelling Unit –RIM- suggests that, unless existing eligibility for health benefits is reduced, the ageing of the population will require a very large increase in the proportion of GDP allocated for that purpose and, in consequence, a significant increase in taxation or government borrowing. Accordingly, some of the savings from the modification of social welfare policy that will inevitably be required could be used to provide assistance to low wage earners in low- income families and, at the same time, help fund an increase in employment.



It is not possible definitively to disprove the C&K claim that, within limits, the employment effects of raising the minimum wage will be zero or positive. However, assessments of this claim need to take account of the following:

Accordingly, particularly for Australia where the minimum award wage is already high by international standards, the 1946 plea by Nobel Laureate Stigler – for economists to be "outspoken, and singulary agreed" that increases in the minimum wage reduce employment - should be the basis for wages and employment policy. Indeed, employment is best encouraged by allowing wages to be determined by the market and the idea of trying to increase it by freezing minimum wages is strongly opposed. Wage freezes would be difficult to sustain in practice and, most importantly, would risk entrenching the existing regulatory arrangements, possibly even enhancing the role of the AIRC instead of eliminating that institution’s responsibility for determining the minimum wage.

The case for moving to a market-determined wages policy is enhanced by the fact that, contrary to widely held perceptions, the minimum wage is both ineffective and inefficient as a welfare measure to assist low wage earners:

A decision to allow wages to be determined by the market could be made more acceptable at a political level if it included some form of additional social security assistance linked to and encouraging work for low wage earners in low-income households, and protecting their living standard. The availability of such additional income supplements would help secure community acceptance of the lower wages needed to enable employers to profitably increase employment of lower skilled workers. Given that Australia already provides social security assistance that is more extensive than in the US, the most appropriate course might be to adapt an existing benefit rather than introduce an earned income tax credit that is as "generous" as in the US.

To avoid any additional budgetary cost, such assistance could be financed by reducing social welfare benefits currently provided to higher income groups. Although that would be strongly opposed by some, it would have the offsetting attraction of offering increased employment and reduced unemployment, and the potential for further favourable employment effects from additional labour market deregulation.

Source: Harding and Richardson (1998a)

I The US approach has been widely characterised as creating a class of "working poor". However, care needs to be taken in interpreting the period when real US earnings are shown as having fallen at the bottom end. The data on US earnings exclude large non-cash benefits received by labour and is not a comprehensive measure of total compensation or the trend thereof (for further analysis, see Moore 1999a).

II A few European countries have not had a minimum wage but have used the minimum social welfare safety-net payment as a reservation wage below which nobody would readily accept a job.

III The OECD’s Employment Outlook for 2002 (OECD 2002) shows that in European Union countries the average unemployment rate of 7.4 per cent in 2001 was slightly lower than the 8.3 percent rate in 1990 and that some EU countries even had lower rates in 2001 than the then US and UK rates of 4.8 per cent. However, where EU countries have a lower rate, this appears at least partly to have involved a shifting of unemployed on to some form of social security (apart from unemployment benefits) rather than into employment. The employment population ratios in the US and the UK were over 73 percent and 71 per cent respectively in 2001 compared with 64 percent in the EU. Assessments of labour market performance thus need to include analysis of both employment and unemployment.

IV As Nobel Laureate George Stigler wrote in his classic textbook, The Theory of Price: "Perhaps as persuasive a proof as is readily summarised is this: if an economist were to demonstrate its [the law of demand] failure in a particular market at a particular time, he would be assured of immortality, professionally speaking, and rapid promotion".

V For example, where there is a legal minimum wage of say $4.00 per hour, the cost of an extra hour of labour will be $4.00. However, if a firm with monopsony power is paying, say $4.00 per hour, and wants to hire more labour it will be obliged to pay a higher wage not only to the extra worker, but also to all its current employees. This makes the extra cost of an extra hour of labour substantially higher than the $4.00 wage, which in turn reduces the quantity of labour that can be employed profitably relative to the quantity that would be hired at the constant legal minimum wage. For example, consider a firm that is currently buying 4000 hours of labour at $4.00 per hour for a total cost of $16,000 per week. Now suppose that in order to hire, say, an extra 1000 hours of labour per week, the firm must raise the wage offered from $4.00 to $4.25. Because the firm will have to now pay $4.25 for all 5000 hours of labour the extra cost will not be 4000 x $4.25 = $4250 but rather $4250 + 4000 x $0.25 cents = $5,250 or $5.25 per extra hour of labour. Thus, where a firm has monopsony power the number of employees it hires determines the wage it pays.

VI It should be noted that the ABS has indicated that its 1998-99 estimates understate the welfare income in the two lowest income quintiles (Australian Bureau of Statistics 1999-00 p 7). This suggests that wages may be even less important than indicated as an income source for lowest quintiles.

VII However, in more recent years the AIRC minimum wage award has increased faster than inflation (except in the GST affected 2000-01 when increased budgetary assistance was provided) and faster than average wage costs.

VIII These awards extend to those earning over $900 per week. Further, although only about a quarter of the work force is subject to award wages, when awards are increased there is normally some flow through to those in the "informal" sector where there is no formal wage agreement (covering about 40 per cent of employees).

IX The current lowest minimum wage of about $11 per hour would yield an annual income of about $21,000 for a full time employee compared with the unemployment benefit of $9,500 for a single person ($8,500 each per couple), tapering down to zero at an income of $15,750.

X RIM’s analysis (summarised in Moore 2001) suggests that the proportion of GDP allocated to health could increase from about 8.5 per cent to 13-16 per cent by 2031 and that, under existing policies, this would require an increase in taxation of 25 per cent. See also the Intergenerational Report 2002-03, Budget Paper No. 5, Commonwealth of Australia.



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