Minimum Wage Hikes vs. Tax Rebates - What's More Effective?

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There's been much talk in the blogosphere lately about what happens to unemployment levels when the minimum wage is increased (the consensus is that there is no consensus), but what happens to the people who see their wages go up?

Nobel-winning theory from Milton Friedman says that when a person knows his income will increase, he'll spread out those gains over the rest of his life and not spend it all at once. In the case of a $1 minimum wage hike, annual spending should increase by about $400.

But that grossly understates what actually goes on, write economists Daniel Aaronson, Sumit Agarwal, and Eric French in a new Federal Reserve Bank of Chicago working paper.

The trio examined what happened to the consumption and debt levels of households that experienced either a federal or state minimum wage hike.

First, they found that spending didn't increase when the legislation was passed, but when it went into effect. This goes against Friedman's theory, which assumes that a person will change spending as soon as he learns of his future income stream.

Second, spending increased by a whopping $800- to $1,000-per-quarter compared with a $250 increase in pay as a result of a minimum wage hike. This means that debt levels also rose.

"If households were spreading the income gain over their entire lifespan, the spending increases should be far smaller than what we observe in the data," the researchers write.

So, where does the money go? The researchers found evidence that the bulk of it is spent on big-ticket items like cars and trucks. All this implies that a pay bump allows minimum wage earners to make down payments on expensive items that they wouldn't have been able to otherwise. To me, this spending behavior seems remarkably similar to what we wanted from the $120 billion stimulus plan. So, could a minimum wage hike be more effective?

Right now, the national minimum wage is set at $5.85/hr and will get a bump in late July to $6.55/hr followed by another boost to $7.25/hr next July. The Economic Policy Institute says that 5.6 million workers will be affected by this change. Aaronson, Agarwal, and French estimate that a $1 minimum wage increase translates into a $2,000 boost in annual spending.

A back-of-the-envelope calculation (assuming that 5.6 million minimum wage earners experience a $1 gain in pay) would put new spending at $11.2 billion. The cost to businesses would be $2.8 billion in increased wages.

On the other hand, past research has shown that consumers spent about two-thirds of their stimulus checks back in 2001. This time around, that would translate into an additional $80 billion in spending. So, what's better, spending $120 billion to stimulate $80 billion in consumption, or $2.8 billion to stimulate $11.2 billion?

Obviously, it's much more complicated than this simplistic scenario. Getting $80 billion in additional spending from minimum wage increases would mean boosting pay way more than $1, which could cause all sorts of unexpected side effects not limited to higher unemployment in the economy. But given the evidence here that workers are quick to spend their income gains perhaps -- assuming it's not very costly for businesses to implement -- even a temporary minimum wage hike could be more cost-effective than a tax rebate.

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