Author: Edward Thater

The Economics of the Minimum Wage

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If you’ve been following the news beyond what’s happening in Sochi, Kiev, and Syria, you’ve almost certainly noticed the recent debate about raising the minimum wage, sparked by President Obama’s State of the Union speech in January. The debate sharped with a report by the Congressional Budget Office this week predicting that a minimum wage hike would raise 900,000 families out of poverty but would cost 500,000 individuals their jobs.

So what effect, exactly, does raising the minimum wage have on unemployment? The traditional analysis is that a minimum wage is just another type of price control. Specifically, it’s a price floor: the government requires that the price of good not drop below a certain number. If the price floor is set above the current market price (what’s referred to as a binding price floor), the price will be so high that demand will drop, supply will increase, and we have an artificially created surplus. So the idea here is that a suitably high minimum wage might attract more people into the labor force than there are now, but employers who have to pay the higher wage are going to cut back on workers to keep their payrolls low, resulting in greater unemployment and fewer people employed overall.

However, things are not so simple when it comes to the labor market. For starters, there aren’t a lot of substitutes for labor, as least in the short term. Thus, a fast food restaurant can’t really buy a machine that will take your orders, prepare and wrap burgers, pull fries and nuggets out of the frier, etc. Right now, developing and purchasing such a machine will cost more than the human labor that does it now. If the fast food place reduces it’s work force, then it will suffer from being slower in food delivery. Believe it or not, it’s speed, not quality of food, that fast food markets really sell. Therefore, there is only so much a fast food restaurant can do to cut it’s work force before it starts losing more money than if it just kept its workforce the same and paid the higher wage.

Another complication is that the minimum wage workers of the world don’t save much of the income, which is a combination of the facts that most are younger workers (who rarely save) and that minimum wage puts you below the poverty line (so you can’t afford to save because you have to use all of your income to live). This means that any increase in the minimum wage translates into more money being spent directly, effectively translating was previously profit for the employer, which was being partially saved, into income for the worker, which is being spent at or near the rate of 100%. At that point, the multiplier effect (which I talked about in this SLACE post) kicks in, and the overall economy grows.

So how do these competing economic forces shake out when the minimum wage is actually raised? In a now famous study by David Card and Alan Krueger, the found that a minimum wage increase in New Jersey in 1992 actually increased employment at New Jersey restaurants. Economists have argued back and forth about the effects of a minimum wage ever since, without a true consensus about what the effect is. However, what is certain is the effect is definitely not one of simply increasing unemployment without any beneficial economic effects.

Fed’s Tapering of QE3 Has Begun

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So, despite the consensus of pundits I reported in this post, the Fed has begun tapeing off its third round of quantitative easing earlier than expected, known in economist parlance as QE3. Apparently, the Fed is taking it slow and wants to be cautious about its reduction of quantitative easing so as to not jeopardize the current recovery. The Fed’s stated unemployment rate target is 6.5%, and most pundits seem to feel that the Fed won’t start to raise interest rates until April of 2015. But the pundits were also wrong about when the Fed would start easing off the gas peddle that is quantitative easing, so take those predictions with a grain of salt.

On an addtional note, Janet Yellen has been sworn in and started her tenure as the first female chair of the Fed. Obviously, she’s not even a full week into the job yet, but it seems she will break with Ben Bernanke’s policy of putting the Fed’s cards on the table and going to great lengths to explain what they were doing and way. Instead, it seems she prefers the style of Alan Greenspan: speak rarely, do what you think is best, and don’t worry about the pundits. So where will the Fed be headed for the next year? Your guess is as good as mine, but watch this space.

Who really pays taxes, and why should you care?

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In a follow up to this post from last year, I want to circle back and actually explain tax incidence and why understanding it will make you a better citizen. Tax incidence is the economic inquiry to answer the question: who actually pays a tax?

Some advocates will argue for higher taxes to pay for greater social services and reduce excessive business profits. Yet many businesses will often tell you that they don’t actually pay taxes. Instead, the businesses argue, that all taxes get passed on to the consumer in the form of higher prices to cover the costs of the tax. It turns out, neither answser is 100% correct.

Let’s say I impose a $1 tax on widgets, levied by requiring all widget manufacturers to pay $1 for each widget they produce. The manufacturer would love to increase its widget price by $1, thereby keeping its revenue at exactly the same level as before. And while it is true that the manufacturer’s per unti revenue will be the same, it still might see its overall revenue fall. Why? Because for some consumers, the extra $1 cost will make the widget too expensive, so they won’t buy it. If sales fall off too much, then the widget manufacturer might lose more money than if it instead eats some of the cost out of its own revenue (and thus profit) by raising the price by less than a dollar. Thus, in order to maximize its total revenue, the manufacture will likely have to share some of the cost of the tax with the consumers.

What if I instead collects the tax by an excise tax? (An excise tax is a type of sales tax levied against only a specific item. Like a general sales tax, it is collected at the point of sale by the retailer.) Here you might think that the consumer will pay 100% of the cost of the tax, as the manufacturer never sees the tax. However, from the consumer’s perspective, the price is effectively the same whether there is an excise tax of $1 added in the store or whether the manufacturer raises its price by $1 before sending it off to the retailer. So, again, the effect is the same on the manufacturer in terms of drop-off of sales. Thus, in order to maintain its revenue, the manufacturer will again have to eat some of the tax by lowering its prices a little, despite the fact that the manufacturer is never directly involved in the collection of the tax.

So how can we figure out who will pay more of a tax? The answer lies in a concept called price elasticity. I won’t explain how to calculate price elasticity, continuing my policy of minimal math, but you can watch some videos here for a longer tutorial .

Essentially, price elasticity is how sensitive demand or supply is to price. Take for example gasoline or cigarettes. Even though the price may go up and up, consumers will still buy these goods in roughly the same amounts. Why? Because there aren’t any real substitutes for these goods, so if you have a car or are addicted to cigarettes, you will need to buy these goods. Economists say such goods are price inelastic, which is jargon for saying that the quantity demanded doesn’t move much despite changes in prices. Your electric utility is another example of an inelesatic good, since it’s tough to live in a modern home without electricity. On the other hand, if, say, ramen noodles were to go significantly up in price, there would be a huge reduction in the quantity of ramen sold, because there are lots of other cheap foods that college students can eat instead. So elasticity is all about substitutes and whether the consumer needs to buy the good or merely wants to buy the good.

What does this tell us about tax incidence? Well, whether the manufacturer or the consumer pays more of the tax depends on how elastic their demand or supply. So, if the government increases taxes on gas or cigarettes, the consumeer will pay basically 100% of the tax because there aren’t good substitutes for those goods and the manufacturer knows it. Since you need to buy gas to run your car, you will pay the higher prices at the pump. However, tax something price eleastic like ramen, and the price will not go up by very much. Otherwise, consumers will just stop buying the good altogether.

What about payroll and income taxes? After all, these aren’t levied on goods. True. They are levied on services, in this case the provision of labor, but the analysis is the same. For most companies, there is no good substitute for labor, at least in the short term. Likewise, for most workers, there is no substitute for actually working, since you’re trying to earn an income. Thus, it turns out, these taxes are paid about 50/50 between employers and employees.

So here’s why you should care: Every year, governments, both state and local, have debates about what and how to tax. If government is going to raise taxes, you (as a consumer) want them to raise them on elastic goods, since that won’t much affect the prices you see. Alternatively, if the government wants to lower taxes, you want them to lower taxes on inelastic goods, like gas or payroll taxes, so you can reap the maximum benefits.

I realize this post was long, but I hope it has made you a smarter citizen and consumer of government. As School House Rock use to tell me every Saturday morning, knowledge is power. Next time, I promise to return to more mundane topics like the happenings at the Fed. As always, feedback is appreciated and encouraged through the comments.

Janet Yellen before the Senate Banking Committee

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If you happen to follow the Federal Reserve, then you are aware that Ben Bernanke’s tenure at chair of the Fed will be up soon. President Obama has nominated Janet Yellen to the post, making her the first woman nominee. There doesn’t appear to be too much push back from the Senate, and in all likelihood she will be confirmed as the first woman chair of the Fed. You can read a good description of the hearing, including Yellen’s articulation to her intention to continue QE3 into the future, here.

It’s worth noting that, despite the obscurity of the position, the chair of the Federal Reserve is probably the most influential person in the U.S. economy, in many ways much more influential than the President or Congress. In that regard, I think you could classify this breaking of a glass ceiling on par with Nancy Pelosi becoming the first woman Speaker of the House.

What do you, dear readers, think of Yellen as a pick? A victory for modern feminism? Smart/ disastrous continuation of the Bernanke policies? Sound off in the comments.

Fed Continues QE3

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When the Open Market Committee of the Federal Reserve met earlier this week, it decided to continue its third round of quantitative easing, known as QE3, until at least its next meeting in six weeks.

Quantitative easing is a technique of monetary policy where a central bank, in our case the Federal Reserve, will purchase financial assets for freshly “printed” money, thereby increasing the money supply and stimulating the economy. The basic idea is this: all macroeconomic slow downs, recessions and depressions included, are ultimately caused by a reduction in the overall spending by economic actors. This reduction is aggregate spending has a multiplier effect, because my spending is someone else’s income, which ripples across the economy and causes a bigger drop in gross domestic product than the actual reduction in spending. (For a more detailed discussion of the multiplier effect, you can read my earlier SLACE post about the shutdown and its economic effects.) With more money in circulation, economic actors can build up savings in weaker economic times and yet still have enough money left over to go and spend at their old levels. Of course, this can lead to inflationary pressures, with too many dollars chasing too few goods, so the Open Market Committee has to walk a fine line.

QE3 is already the the largest round of quantitative easing since the 2007-2008 recession, and it is on pace to be the largest round of quantitative easing ever. Critics of quantitative easing policies are asking the legitimate question of whether we will see a crash of asset prices, in particular in the stock and real estate markets, after the Fed decides to scale back QE3 since it has been pumping $85 billion into the economy every month since last fall. However, with GDP growth still relatively anemic and no signs of inflation on the horizon, most Fed watchers predict the Open Market Committee won’t begin scaling back until sometime well into 2014, at the earliest.

As an aside, dear readers, we here at SLACE would love for you to leave us some comments and let us know what you think about our posts. In particular, if you have economic topics you’d like to see blogged on in the future, let us know and we will try to accommodate.