In this follow-up to my previous post, which links to a thoughtful piece by Professor Jonathan Meer on the hidden costs of minimum-wage laws, I debunk the myth that the Earned Income Tax Credit is a subsidy to employers. Addressing this issue is important to the debate because most economists who oppose the minimum wage are not motivated by a desire to eliminate support for the working poor. On the contrary, they oppose minimum wage laws because they believe that such laws often hurt the same people they purport to protect, whereas policies like the Earned Income Tax Credit (EITC) are much more effective. Defenders of the minimum wage often respond by claiming that the EITC is a subsidy to employers that drives wages down, thereby making the establishment of a minimum wage even more necessary. Unfortunately, this claim shows a poor understanding of economics. Sadly it is often made by people who have advanced training in economics, and should therefore know better. Bellow I explain why the EITC is not a subsidy to employers as well as why it likely raises, not lowers, wages for low-skilled workers.
First, let's look at how the EITC works. The IRS offers an explanation here, but briefly, the EITC is a payment made to people who are earning an income, but that income is "too low". The IRS describes the EITC as "a benefit for working people with low to moderate income". The credit is more generous for people with children, declines gradually as someone's income rises, and disappears once a person's income has reached a threshold.
Second, let's look at how subsidies work. A subsidy is in essence a negative tax. It is a payment made to one or both trading parties each time a transaction takes place. As an example, let's look at how a subsidy to orange farmers could work. Such subsidies were popular in Greece, where I grew up, in the 1980s so I have an eye-witness account of their impact. Under one scenario, the government could pay a farmer some amount, say 50 cents, each time the farmer sold a pound of oranges. The impact of the subsidy is therefore to reduce the marginal cost of production. For example, suppose that to produce an extra pound of oranges, the farmer had to spend $2. By getting 50 cents back from the government, her cost effectively drops to $1.50. It doesn't take much economic training to conclude that the decrease in cost motivates farmers to produce and sell more oranges. The problem is, however, that to sell more oranges, farmers have to lower their price to entice consumers to buy the added production. Hence, the subsidy becomes self-defeating to some extent. Farmers receive a payment from the government for each pound of oranges they sell but because they now want to produce and sell more they must charge less. Some of the benefit is lost and captured by the buyers. To prevent the price from falling, the Greek government first engaged in an advertising campaign to convince consumers that they should eat at least three oranges per day, and when that failed it was forced to buy and bury in dump yards large portions of the production so that it wouldn't reach the market. What a waste! Today, to avoid this problem, most subsidies to farmers impose production quotas that limit the amount that farmers can produce. Still a waste, this time of land.
Applying this concept to the labor market would involve the government paying workers some amount for every hour they work. This would motivate employees to work more hours, and in the absence of a minimum wage it would indeed drive wages down as workers would have to accept lower wages to convince employers to hire the added labor. The employers would reap some of the rewards of the subsidy, just like the buyers of oranges did even though the subsidy was directed at the farmers. But the EITC works the opposite way. An employee that worked more hours and earned a higher income would get less money from the government, not more. Therefore, the EITC recipients are discouraged from working since any increase in income is offset to some extent by a loss in government assistance. To convince workers who receive the EITC to work more hours despite that loss, employers would have to pay not a lower but a higher wage. This is the exact opposite of what defenders of the minimum wage suggest. In economic jargon, if leisure (the time spent not working) is a normal good, then any increase in non-labor income should make people consume more leisure by working less. The decrease in the supply of labor should then raise the equilibrium wage.
In conclusion, the EITC is not a subsidy to labor. The credit is more generous to those who have lower income, and typically these are people who work fewer hours, not more. Because the EITC benefits more those who work less, it reduces the willingness of its recipients to work. To make them overcome their hesitation, employers would have to pay them higher wages, not lower. Given that the minimum wage is a blunt instrument with several harmful unintended consequences, there is no reason why we should keep it, let alone raise it. We should focus instead on reforming the EITC or, even better, instituting a national dividend. But more on the national dividend in the future.
First, let's look at how the EITC works. The IRS offers an explanation here, but briefly, the EITC is a payment made to people who are earning an income, but that income is "too low". The IRS describes the EITC as "a benefit for working people with low to moderate income". The credit is more generous for people with children, declines gradually as someone's income rises, and disappears once a person's income has reached a threshold.
Second, let's look at how subsidies work. A subsidy is in essence a negative tax. It is a payment made to one or both trading parties each time a transaction takes place. As an example, let's look at how a subsidy to orange farmers could work. Such subsidies were popular in Greece, where I grew up, in the 1980s so I have an eye-witness account of their impact. Under one scenario, the government could pay a farmer some amount, say 50 cents, each time the farmer sold a pound of oranges. The impact of the subsidy is therefore to reduce the marginal cost of production. For example, suppose that to produce an extra pound of oranges, the farmer had to spend $2. By getting 50 cents back from the government, her cost effectively drops to $1.50. It doesn't take much economic training to conclude that the decrease in cost motivates farmers to produce and sell more oranges. The problem is, however, that to sell more oranges, farmers have to lower their price to entice consumers to buy the added production. Hence, the subsidy becomes self-defeating to some extent. Farmers receive a payment from the government for each pound of oranges they sell but because they now want to produce and sell more they must charge less. Some of the benefit is lost and captured by the buyers. To prevent the price from falling, the Greek government first engaged in an advertising campaign to convince consumers that they should eat at least three oranges per day, and when that failed it was forced to buy and bury in dump yards large portions of the production so that it wouldn't reach the market. What a waste! Today, to avoid this problem, most subsidies to farmers impose production quotas that limit the amount that farmers can produce. Still a waste, this time of land.
Applying this concept to the labor market would involve the government paying workers some amount for every hour they work. This would motivate employees to work more hours, and in the absence of a minimum wage it would indeed drive wages down as workers would have to accept lower wages to convince employers to hire the added labor. The employers would reap some of the rewards of the subsidy, just like the buyers of oranges did even though the subsidy was directed at the farmers. But the EITC works the opposite way. An employee that worked more hours and earned a higher income would get less money from the government, not more. Therefore, the EITC recipients are discouraged from working since any increase in income is offset to some extent by a loss in government assistance. To convince workers who receive the EITC to work more hours despite that loss, employers would have to pay not a lower but a higher wage. This is the exact opposite of what defenders of the minimum wage suggest. In economic jargon, if leisure (the time spent not working) is a normal good, then any increase in non-labor income should make people consume more leisure by working less. The decrease in the supply of labor should then raise the equilibrium wage.
In conclusion, the EITC is not a subsidy to labor. The credit is more generous to those who have lower income, and typically these are people who work fewer hours, not more. Because the EITC benefits more those who work less, it reduces the willingness of its recipients to work. To make them overcome their hesitation, employers would have to pay them higher wages, not lower. Given that the minimum wage is a blunt instrument with several harmful unintended consequences, there is no reason why we should keep it, let alone raise it. We should focus instead on reforming the EITC or, even better, instituting a national dividend. But more on the national dividend in the future.
