Reviews Minimum Wages and Poverty: An Evaluation of Policy

One of the problems with the economic analysis of social policy is the tendency of researchers to consider policies in isolation from one another. Although Econlit contains over 2000 articles and books on minimum wages, and over 150 on Earned Income Tax Credits (EITCs), only 20 articles or books deal with the two topics together. Although this ‘silo’ approach encourages in-depth analysis of individual policies, it often presents a problem to policy-makers, who need to know which is more cost-effective. Because politicians and bureaucrats must typically decide between alternative policies, studies that focus only on a single policy may not provide enough information to make a careful decision. Faced with two studies of different policies, each purporting to show that the benefit outweighs the cost, how is a decision-maker to go about choosing between them? Minimum Wages and Poverty: An Evaluation of Policy Alternatives, by US economists Formby, Bishop and Kim, deals with this problem directly. The authors compare three popular policies, all with the same societal cost: a $1 per hour increase in the minimum wage, an equiproportional increase in the EITC, and an equiproportional rebate of payroll taxes paid by low-income working families. Each of these policies has been advocated as a means of curtailing the growth in inequality at the bottom of the distribution. Since the 1970s, the earnings of full-time US men in the bottom decile fell from 51 per cent of median earnings in 1976 to 45 per cent of median earnings today. Over the same period, earnings of Australian men in the bottom decile dropped from 73 per cent of median earnings to 60 per cent. Turning to household income inequality, the 10/50 ratio for household incomes has also fallen in both countries over the past 30 years, but the change has not been as substantial. Assessing policies can often depend to a large extent on one’s assumptions, and Formby, Bishop and Kim are refreshingly open about theirs. The initial chapters of the book are devoted to discussing the main factors that affect how their proposed policies will affect the poverty rate: the relationship between low-wage work and low-income households, the elasticity of labour demand with respect to the minimum wage and the elasticity of labour supply with respect to the after-tax wage. The first issue – where low-wage workers fall in the household income distribution – was raised by Nobel laureate George Stigler in a 1946 paper that stated ‘The connection between hourly wages and the standard of living of the family is thus remote and fuzzy’. Formby, Bishop and Kim argue that the link is not as tenuous as Stigler asserted. They find that poor households are indeed more likely to earn near-minimum wages, but estimate that the earnings of low-wage workers accounted for only 10–15 per cent of the disposable income of low-income families. Similar results have been found in the Australian context (Richardson and Harding, 1999; Leigh, 2005). The second factor is the elasticity of labour demand with respect to the minimum wage. Although noting research by Card and Krueger (1995) suggesting that raising the minimum wage has no disemployment effect, Formby, Bishop and Kim present additional evidence from state panel data suggesting that labour demand elasticities differ not only by age, but also by race and sex, ranging between −0.1 and −0.65 for workers aged between 16 and 24 (their largest elasticities are for black teenagers). In their preferred estimates, they simulate the effect of a minimum wage rise, allowing elasticities to differ by age, race and sex. The third parameter affecting the choice of policies is the impact that a negative income tax (or lower payroll tax) will have on labour supply, taking into account both substitution and income effects. As the authors note, the natural experiment literature has tended to find that boosting the EITC has a large positive effect on labour supply among single women, and a small negative effect on labour supply of married women. It is therefore somewhat surprising that the trio choose to model the policy on the assumption that boosting the EITC has no effect on the labour supply of single women, but may reduce the labour supply of married women. Given the evidence, such an approach seems akin to handicapping the EITC horse from the start. Yet this seems to make little difference to the eventual results. Across a suite of simulations, Formby, Bishop and Kim find that the EITC has the highest