Building prosperity from the bottom up. Thomas Palley.

Abstract: National and political attention has been directed once more to the issue of the minimum wage. The nationwide debate developing over the matter of minimum wages could furnish a chance for the nation to develop a new economic strategy predicated upon building prosperity from the bottom up and thereby enhance wage equality and wealth distribution. It is argued that modest minimum wage increases do not necessarily have a negative effect on employment and unemployment.

Full Text: COPYRIGHT 1998 M.E. Sharpe, Inc.

The new economics of the minimum wage, argues this economist, cannot be understood without taking into account bargaining power.

The minimum wage is once again the focus of attention, with President Clinton recently declaring in his January State of the Union address his intention to seek a further increase. The national debate shaping up over this matter is potentially more than just a debate over the level of the minimum wage. Rather, it could provide an opportunity for shaping a new economic strategy predicated upon "building prosperity from the bottom up." Such a strategy would break with the existing "top-down" policy that has resulted in an erosion of incomes at the bottom of the income distribution.

Since the early 1980s, the United States has pursued a policy of trickle-down economics. The hallmarks of this policy have been an enormous increase in the inequality of wealth and income distribution, combined with an outright decline in low-end wages. The latest round of the minimum wage debate offers an opportunity for a decisive break that replaces the existing paradigm of building prosperity from the top down with a new paradigm that builds prosperity from the bottom up.

The impetus for this new paradigm comes from academic research (discussed below) into the economic effects of the minimum wage that fundamentally challenges understandings of the way in which labor markets work. The old view is that a rise in the minimum wage lowers the demand for labor and causes unemployment. The new view challenges this and maintains that modest increases in the minimum wage need have no perceptible effect on employment. Instead, the minimum wage serves as a "sharing" device to ensure that those at the bottom of the wage distribution receive some of the economy's productivity gains. The exact same logic applies to unions, which also ensure that workers get a share of productivity growth.

The new research on the minimum wage provides the intellectual ammunition for breaking with the conventional view of the effects of the minimum wage, and the debate over the minimum wage provides the stage.

As a sharing device, the minimum wage is good for both the working poor and middle-class families. It is good for the working poor because it establishes a wage floor that inhibits excessive wage competition. It is good for middle-class families because many such families have two workers, one of whom is often a minimum-wage worker. By helping middle-class families, a minimum-wage increase can therefore serve as a surrogate middle-class tax cut and deliver far more than can any affordable tax cut.

Over and above these economic arguments, there is also a moral dimension to the argument for a higher minimum wage. Welfare reform has reduced the extent of welfare benefits. Reform must therefore be accompanied by policies ensuring that former welfare recipients, who rise to the challenge, have access to jobs that pay a living wage. To cut welfare without such provision would constitute a breach of faith.

Debunking the Old Economics of the Minimum Wage

The past eighteen months have seen a two-stage increase in the minimum wage that pushed it first from $4.25 per hour to $4.75, and then to $5.15. These increases were heavily contested, and critics claimed that they would lower employment, particularly at the bottom end of the wage scale, where unskilled and young entry-level workers are concentrated. The critics' argument was based on traditional demand-and-supply analysis. According to such analysis, buyers and sellers come together in markets, and, absent government interventions, market prices adjust so that all who want to trade at the market price can do so.

The demand-and-supply model has market wages adjusting to a level at which the demand for labor equals the supply of labor. All sellers of labor therefore find buyers so that there is full employment. Introduction of a minimum wage prevents the market wage from falling to the appropriate level, thereby reducing labor demand and causing unemployment.

The demand-and-supply model has long dominated the teaching of economics, and a generation of students has been exposed to its message. Its policy implication is clear: Minimum wages reduce employment and cause unemployment. Exposure to this model has undoubtedly contributed to shaping policy-makers' thinking about the minimum wage, which explains why many have been content to see a steady erosion in the real value of the minimum wage over the past twenty years. However, the intellectual tide is now turning in a profound way because of the detailed empirical work of economists David Card and Alan Krueger, who have shown that a rise in the minimum wage does not automatically reduce employment among low-wage unskilled workers.

Card and Krueger's findings were highly influential in the 1996 debate over whether to raise the minimum wage. Even more important is the challenge posed by their findings to the demand-and-supply model's analysis of the minimum wage. In the past, opponents of the minimum wage could simply assert that minimum wages reduce employment and increase unemployment. Now, this is no longer possible. Although the rhetorical simplicity of the demand-and-supply model of labor markets means that it is unlikely to fade away, proponents must now acknowledge that its predictions sit uneasily with the evidence.

These findings derive from a study involving the effect of an increase in the minimum wage on employment in the fast-food industry. In 1992 New Jersey raised its minimum wage, while the minimum wage in Pennsylvania was unchanged. Yet Card and Krueger found that subsequent employment growth at fast-food stores in New Jersey was no different from that in Pennsylvania. Another recent study by Jared Bernstein and John Schmitt of the Economic Policy Institute, which examined the impact on employment of the 1996 increase in the minimum wage, showed that it too had no significant effect on the employment of teens or young adults. Their findings cast further doubt on the demand-and-supply model's analysis of the minimum wage.

Yet another piece of evidence challenging the demand-and-supply paradigm comes from the relationship between the federal minimum wage and the national unemployment rate. The solid line in Figure 1 shows the national unemployment rate, while the broken line shows the ratio of the minimum wage to the average wage. The greater the ratio, the greater the relative cost of minimum wage labor. According to conventional arguments, this should lead to higher unemployment. However, the figure reveals a different picture. Between 1955 and 1973 the unemployment rate averaged 5 percent, and the minimum wage was 50 percent of the average wage. From 1974 to 1997 the unemployment rate averaged 6.8 percent and the minimum wage was 41 percent of the average wage.

The New Economics of the Minimum Wage

The evidence shows that modest increases in the minimum wage have no negative effect on employment and do not increase unemployment. Whereas the demand-and-supply model represents the low-wage labor market as having a "single" market-clearing wage, the reality is that there is a spread of wages that depends on bargaining power and specific conditions within firms. Within such a context, firms and workers bargain over division of the surplus, and wage levels can vary modestly without any effect on employment. Increases in the minimum wage merely compel firms to pay low-wage workers more, and employers absorb the higher cost of the minimum wage by lowering profits rather than laying off workers.

The last minimum-wage battle was fought over the demand-and-supply model's prediction that a higher minimum wage would cause higher unemployment. It is time to move beyond that argument. Simple demand-and-supply analysis, suitable for the market for peanuts, is inappropriate for labor markets where the exchange process is so much more complex. It must therefore be replaced by a new economics of labor markets and the minimum wage.

At the core of this new economics lies the concept of bargaining power. The significance of bargaining power is clearly understood with regard to union wage negotiations. However, less well recognized is the fact that all workers, union and nonunion, are implicitly engaged in a bargain with their employers. The amount firms are willing to pay workers clearly depends in part on the productivity of workers, but this only sets an upper bound to the wage. How much of that productivity workers actually get to keep depends on workers' leverage - the extent to which workers can effectively threaten to leave and take employment elsewhere and the extent to which firms can successfully threaten existing employed workers with layoff and replacement by other workers. This implicit conflictual dimension is present in every employment relation. "Good" employers try to soften this dimension, while "bad" employers seek to exploit it by intimidating workers and playing on their economic vulnerability.

In such a world, a modest minimum wage is not a distortion that causes unemployment. Instead, it is an institutional mechanism that enhances the bargaining power of low-wage workers. By setting a legal wage floor, it helps workers obtain higher wages than they could get on their own. In the real world firms implicitly place workers in competition with one another: When one worker lowers the wage he will accept, this implicitly forces other workers to lower their acceptable wage. Minimum wages stop firms from exploiting such wage competition.

Minimum wage legislation ensures the existence of a wage floor that results in a different sharing of output. It accomplishes this by ruling out wage competition among workers that undermines their bargaining power vis-a-vis firms. Over the past two decades there has been a shift in the balance of bargaining power. This shift has resulted from technological and organizational innovations that have increased business's ability to shift jobs domestically and internationally; and it has also resulted from declining unionization rates. These developments have increased the extent of underlying wage competition, causing an erosion of wages.

The intensification of wage competition has also been driven by economic policy predicated upon the myth of a natural market. This myth paints the minimum wage as an economic distortion, and it explains why policy-makers have been content to allow the value of the minimum wage to erode slowly. However, the pursuit of the myth of a natural market has not resulted in a natural economy. Instead, it has resulted in an economy in which business dominates labor and in which wages have stagnated. Raising the minimum wage can break with this policy. The new economics of the minimum wage shows how the minimum wage is a sharing mechanism that enables the least well-off to share in society's prosperity.

The minimum wage can also have positive effects on productivity through lower turnover and and greater work effort. Here the argument is that a higher wage may reduce workers' incentive to search for new jobs, thereby resulting in reduced turnover costs for firms. Moreover, workers are concerned with fairness of treatment, and when they are treated fairly in terms of wages, they respond by working harder and better, thereby raising productivity. In this regard, firms are monopsonists when it comes to the purchase of effort from their workers, and they therefore have a private incentive to underpay with regard to the purchase of effort. A minimum wage can fix this market inefficiency.

In sum, a reasonably set minimum wage raises wages of low-paid workers, raises productivity, and need have no negative effect on employment.

Benefits for All: The Minimum Wage as a Surrogate Middle-Class Tax Cut

Another criticism of the minimum wage is that it is not well targeted, and much of the benefit accrues to households that are not poorly off. However, rather than being a weakness, the fact that households along the entire spectrum of the income distribution benefit should be considered a major strength. The past twenty years have been a period of increasing income inequality. Median family income rose a mere $272 from $40,339 in 1973 to $40,611 in 1995. However, this increase was due to more families having two working members. If it were not for this, median family income would have fallen despite a 40 percent increase in labor productivity. American families continue to feel the pressure of a wage and time squeeze, and they have reached the limits of their ability to make family income grow. A private poll conducted by Peter Hart Research for the AFL-CIO in January 1998 found that 42 percent of households believe that they have "only enough to pay the bills" and 16 percent think that they have "less than needed to keep up with monthly bills."

A rise in the minimum wage can contribute significantly to alleviating the effect of the wage squeeze. Ten million workers benefited from the most recent round of minimum wage increases, in September 1996 and September 1997. Of these, 71 percent were adult workers, and 58 percent were female. The minimum wage therefore also helps address gender-based pay discrimination.

Not only is the minimum wage an effective instrument for dealing with poverty and income inequality, it also benefits the middle class because many middle-class families have one worker who is a minimum-wage worker. Thus, the minimum wage is both an instrument of poverty relief and a surrogate middle-class tax cut. As shown in Figure 2, 39.5 percent of the gains from the 1996 minimum wage increase went to families in the bottom 20 percent of the family income distribution. The modest improvement in the wages of low-paid workers in 1997 can be attributed largely to this increase. Of the gains, 57.4 percent went to families in the bottom 40 percent of the income distribution, and 73.7 percent of the gains went the bottom 60 percent of households.

The fact that better-off families also benefit should not be construed as a problem. The bulk of the gain is still concentrated at the bottom end of the family income distribution, and families in the middle of the income distribution have also been negatively affected by the wage squeeze. Alleviating their income strain is a legitimate high-priority policy goal.

This suggests that the minimum wage may be a much more effective way of providing family income assistance than tax cuts, the benefits of which all too often accrue to those who are the best off. Tax cuts that provide broad-based relief are the most expensive precisely because all gain. Thus, such tax cuts have tended to be rare. Instead, tax cuts have tended to target those at the top of the income distribution, which keeps the cost down because the number of well-off households is relatively small. This is exemplified by the 1997 tax-cut package, in which 44 percent of the benefit went to the top 5 percent, and 76.7 percent of the benefit went to the top 20 percent. Another minimum-wage increase may be the most effective way of putting income in ordinary families' pockets, and it could do so with no negative effect on the budget.

This leads to the larger point that the wage and family income squeeze is corroding the fabric of American political life. Despite current strong job conditions, wage gains remain modest. In 1997 the median hourly wage was $10.56, which is below the 1989 level of $10.93, and below the 1973 level of $11.35. This wage squeeze is undermining the national commitment to both government quality services and social insurance provided through the social security program.

Although Americans remain fairly favorably disposed toward the activities of government and see a continuing need for government, the wage squeeze is continually forcing them to call for tax cuts. This process is evident in the push for expanded individual retirement accounts, special tax-deductible saving accounts, deductible health and education accounts, and child-care deductions. Pushed by the wage squeeze, the electorate is trying to make the "cost of living" tax deductible. This is unworkable, and it will defund government and strip us of the benefits and protections that only government can provide. The real solution is to end the wage and family income squeeze, and adjusting the minimum wage is one of the most effective instruments for doing so.

If the wage squeeze is the problem, then the wage squeeze needs to be addressed directly by a policy instrument that fixes the problem. That instrument is the minimum wage. Cutting taxes for upper-income groups, creating a patchwork quilt of exemptions, and cutting government provision of services is not the right answer.

That is not to say that cutting taxes and government spending are always out of bounds. Rather, these measures are warranted only if there is a consensus that taxes are excessive and there is too much government. Trying to solve the wage squeeze by cutting taxes and government will backfire because this approach uses the wrong instrument. Broad-based relief is either too expensive or involves cuts in government that threaten the very operation of society and the economy. Tax cuts and exemptions therefore narrowly focus on the top of the income distribution, which ends up producing a tax system perceived as both more unfair and more complicated. Meanwhile, government is progressively drained of adequate funds, making it less capable of delivering the things that people want from it. The result is that both the government and the tax system become more unpopular. This fuels further resentment with government, even though government has historically been a net provider for those in the bottom half of the income distribution. Fixing the wage squeeze is the only way out of this maze, and raising the minimum wage is a simple and clean policy for doing this.

Conclusion

Debate over the minimum wage has historically focused on its purported negative employment effects. However, it has now become clear that this old argument, which is based on the demand-and-supply model of low-wage labor markets, is at odds with the facts. Instead, modest minimum wage increases need have no negative effect on employment and unemployment.

The inadequacy of the old minimum-wage paradigm has opened the opportunity for a new debate that recognizes the important contribution the minimum wage can make to building prosperity from the bottom up. The minimum wage is good for families and can put more money in families' pockets than can any feasible tax cut. The minimum wage can therefore help alleviate the wage squeeze, and in doing so it can also open the way for a healthier national discussion about taxes and government.

Not only is the minimum wage good for family income, but it is also good for the general level of wages. By providing a wage floor, it bumps up wages along the entire lower end of the wage distribution. Women and minority workers are disproportionately concentrated in this segment of the wage distribution, which means that the minimum wage is also an effective means of dealing with the problem of pay discrimination. Finally; raising the minimum wage can provide a way out of the poverty trap whereby the value of welfare exceeds the value of wages. A higher minimum wage therefore improves the incentive to work, and in doing so it can improve government's finances by reducing welfare payments and increasing tax revenues.

These are the arguments that should constitute the basis of a new minimum-wage debate. The prosperity that ruled in the twenty-five years after World War II was a bottom-up prosperity, and its reconstruction requires an effective minimum wage. However, it is not enough merely to restore the "level" of the minimum wage: The minimum wage must be embedded in the fabric of labor markets. One possibility is to index it to inflation, thereby preventing the type of erosion that occurred in the 1980s. Another possibility is to fix the minimum wage at 50 percent of the average wage, as was the case in the "golden age" between 1950 and 1973. This would mean that the minimum wage would be pulled along in the wake of economic growth, and it would also be protected against inflation to the extent that market wages match inflation. Both measures are consistent with the bottom-up approach that was the true foundation of the prosperity of the "golden age."

THOMAS PALLEY is assistant director of public policy for the AFL-CIO and author of Plenty of Nothing (Princeton: Princeton University Press, 1998).