This article is taken from our fortnightly Growth Bulletin, authored by Ryan Bourne and Tim Knox. To sign up for our mailings, use the form on the left of our newsletter page.
LIVING WAGE WEEK – A FLAWED IDEA
This week has been the annual “Living Wage” week, when campaigners attempt to draw focus to the fact that millions of people are paid below what focus groups determine should be an acceptable wage to account for the basic cost of living in the UK, given the current tax and benefit structures. The Centre for Research in Social Policy (CRSP) at Loughborough University (for the UK, excluding London) and the Greater London Authority (for London) calculate family size-adjusted hourly wage rates that are necessary to cover “minimum living costs”, rent, council tax and childcare provision, such that someone working a 37.5 hour working week would be able to live comfortably. This year, given that the cost of living is currently rising faster than average earnings, the CRSP decided to limit the increase to reflect the ability of employers to pay the increased rate. The hourly wage rates suggested by the Living Wage Foundation to constitute the Living Wage for 2013 are therefore £8.80 for London and £7.65 for the rest of the country.
This official campaign has become somewhat of a moral crusade in recent years. Officially, campaigners do not advocate statutory implementation of the concept, as seen with the minimum wage, but emphasise that it is a voluntary act by business. Nevertheless, the political weather is such that we currently face the unedifying sight of politicians climbing over each other to pursue ownership of this policy, and the idea of a significant increase in the minimum wage, or policies designed to incentivise or cajole businesses into living wage uptake, make this an important current issue.
This brief note will argue that, while well-intentioned, the living wage is a flawed idea. To all intents and purposes, the living wage idea is simply an attempt to increase the minimum wage through concerted pressure on certain companies and public sector institutions. As such, it risks similar economic impacts as are well documented beyond the point at which the minimum wage is said to “bite” – many of the people it purports to help will suffer as a result. Much of the economic evidence in its favour is based on flawed extrapolations from patchy evidence.
But worse than that, the “Living Wage” concept is flawed on a philosophical level. It is based on the idea that an employer has a moral duty to provide his/her workers with an income enough to live on. As such, it believes wages should be set not by supply and demand, but by a sense of justice. In reality, this punishes employers looking to take a punt on unskilled labour by effectively taxing them for their intention, by putting the full cost of the worker maintaining a decent standard of living onto the employer and/or the customers of the employer. As Paul Krugman has therefore pointed out, the whole concept is based on the idea that human beings’ wages should not be set by market forces – an idea which if rolled out widely would have profoundly dysfunctional effects on our labour market.
Even on its own terms, the case for the “living wage” concept is weak. It is calculated using a weighted aggregation of various household types, meaning that in reality the final number isn’t particularly instructive of what a certain family would “need” to live comfortably. It is largely meaningless for those working part-time. Furthermore, much of any gross income gains will subsequently be taken in increased tax revenue or withdrawn benefits, and not reach the workers themselves. Many activists, rather than seeing it as a flaw, seem to see it as a positive of the scheme, which probably shows that in some circumstances the living wage is seen as a way of cajoling businesses into achieving politicians’ desired social ends “off balance sheet”.
THE ECONOMIC IMPACT OF A LIVING WAGE
We’d all like to see higher wages – especially for those near the bottom of the income scale. But the idea that these can just be imposed or lobbied for without economic consequences in the absence of improved productivity performance is just wrong.
There was a huge debate in the UK when the minimum wage was introduced about its effects on jobs. The Low Pay Commission was tasked with judging its effects - and the general consensus appears to be that the rate has broadly been low enough such that the effects on the labour market have been small.
However, this is no reason to extrapolate into suggesting that the living wage would have similar sanguine effects. The most recent academic literature from the US – as opposed to self-reinforcing literature reviews – has suggested that minimum wage increases negatively affect new job creation, rather than cause unemployment. Economic theory suggests it’s the young and most unskilled who suffer most in terms of constrained opportunities – we already have 15.1% of young people not in education or training. Furthermore, the increasing prevalence in recent years of unpaid internships suggests that the idea there are no jobs lost between £0 and £6.31 per hour at which employer and employee would come to an agreement to work is flawed.
In fact, this is one of the key flaws behind the whole concept of a “living wage”. Many young people in particular circumstances are willing to do unpaid internships to obtain many of the non-wage benefits that employment or training gives: experience, acquiring skills or meeting certain people, irrespective of whether during that time they would be paid a living wage. Enforcement or wide rollout of a living wage could thus erode these benefits and actually undermine opportunities at lower wages for the young and unskilled to acquire experience.
But those in favour of further extensions to the living wage simply brush these criticisms aside. “The minimum wage didn’t lead to unemployment, did it?” they say. “Therefore, why would the living wage?”
Consider the chart below. It shows the numbers of OECD countries with minimum wage rates to median income ratios by band. Most countries have minimum wages set at between 40 to 60% of median wages. Widespread roll out of the living wage as a minimum wage would in contrast lead to a rate somewhere just under 70% for a median UK earner.
Work undertaken by IPPR and NIESR suggests this would reduce employment by about 160,000 people. They also estimate that there would be a changed composition of the workforce, as employers would seek to substitute young for more experienced workers, given the higher price that they are paying. This would see a further 300,000 fewer young people employed. With attempts to maintain pay differentials further up the scale, the effects on employment could be larger still. This might not manifest itself through falling employment numbers of course - cutting back on the hours or benefits of existing workers could also occur – but the overall effect is that workers who can’t command a market wage to justify the living wage will cease to be employed. These will often be people new to the job market, for whom these early opportunities can often provide a spring-board to move up the income scale.
Campaigners seek to get around this fact by claiming that, in fact, paying a living wage will be good for the employer – because in many cases where the living wage was introduced, businesses have seen better retention rates, less absenteeism and an improved quality of their work. Some hark back to the actions of Henry Ford, who was the poster boy for this “efficiency wage” theory, which said that by improving morale and incentivising the workforce, employers could actually see better outcomes from paying more due to improved productivity.
But again, just like extrapolating that the apparent small jobs impact of the current minimum wage means a living wage can be introduced with few consequences, assuming that improved productivity for some companies would lead to improved productivity for all is a huge leap of faith. In part it is undermined by the fact that it assumes a huge lack of rationality or knowledge on behalf of the employer: if all employers could increase productivity through just raising the wages of their low-skilled workers, why wouldn’t they do it already? It also ignores the fact that many of the gains acquired through so-called efficiency wages are “relative” – the benefits to you come because you pay higher compared to other companies, meaning you tend to attract the best workers and substitute labour for capital such that the productivity of the remaining workers is equal to the minimum wage. A huge roll-out of the living wage would thus undermine these benefits to any individual firm. We’re left then with the assumption that, from a business perspective, living wage activists know better about the productive potential of workers than all UK businesses. Some people may think this. We do not.
NO FREE LUNCH
Even if the employer decided not to cut back on jobs or hours in the event of a living wage imposition, would this be such a benevolent economic outcome? The other alternatives in the event of unchanged productivity are to pass on the costs in the form of higher prices to customers, or to eat into the profit margin of the company. In fact, evidence from Jonathan Wadsworth for the LSE’s Centre for Economic Performance suggests that the minimum wage has led to faster than average price rises in sectors where minimum wage workers operated (like fast food, domestic and hotel services). Likewise, if profit margins being squeezed contributes to a cut in investment, then this itself has consequences for economic growth.
None of this is to claim that some low-paid people won’t benefit from an increase (though evidence suggests that those with low household incomes – the real measure of poverty –won’t benefit most). And it may well be good for the deficit, as it would act much like a tax by stealth given the higher marginal tax rates low income workers face.
But there is little merit in the claims a living wage would stimulate growth. This neo-Keynesian view that increasing the pay of low wages increases demand is tempered by the effect on profit and investment. A paper released this week by Howard Reed showed the extent of the assumptions you’d have to make before a living wage had such a big effect on growth that it became a net creator of jobs. The truth is that this concept is reliant on the idea that corporations are hoarding cash piles and that hoarding cash piles has no effect on interest rates or exchange rates. Is there any evidence that those industries characterised by low wages fit this behavioural description?
A MEANINGLESS MEASURE?
The living wage is therefore more about a sense of justice than a sensible policy based on rigorous economic evidence. But does it even stand up on its own terms? The answer for most is: no. That’s because the figures are calculated according to averages based on weighting different family structures. Outside of London, all are assumed to face similar living costs in essentials. This is quite clearly not the case – so even if every individual earned the notional living wage figures presented by the Living Wage Foundation there would be some who would struggle with the cost of living and others who would be able to live comfortably. For those working part-time, a pay rise might be a nice thing, but the value as a “living wage” has no meaning whatsoever.
The calculation also assumes that the tax and benefit system is fixed – but given that what really matters for people is their disposable income, not gross income – pure focus on earnings is a curious position. The take away seems to be that campaigners believe employers have a responsibility for the living standards of their employees over and above judgment of the value of their work. This is a radical shift in outlook from the idea that you allow markets to operate and then intervene to assist people left behind, or seek to incentivise work – as is done in the US using the earned-income tax credit. If rolled out across the economy, it would be hugely distortionary for the labour market.
This creates an odd outlook too: we treat employers that pay the living wage and decide to employ less labour (and many of those that are signed up do not employ much cheap labour anyway) as if they are virtuous, whereas we treat those employers who give an opportunity at low wages to those whose productivity does not merit the living wage as behaving immorally. It is a strange moral view that treats reducing one’s workforce as morally better than employing people who would otherwise not have a job.
Instead campaigners seem to believe that employers are somehow free riding on state subsidies of wages through tax credits – thus why they even explain “improving the public finances” as a positive of the living wage. Yet this supposed positive is simply indicative of the high marginal tax rates that low income workers face as their earnings go up.
Despite these economic criticisms of the living wage though, it still seems to acquire a real appeal, increasingly from politicians. Even though the Living Wage Foundation itself has campaigned for it on a voluntary basis, the political actors talk of the need to “go further”, with the mooted idea of pursuing the living wage through legislation or else incentives in the tax system, as seen in Ed Miliband’s speech on Tuesday.
It’s worth asking: why? A cynic might argue that in an age in which the Government is struggling to reduce the deficit and the opposition is seeking to find ways of imposing its social ambitions without new government spending, pushing the costs of living onto employers and away from taxpayers has its merits.
The consensus since our founder Keith Joseph explained the downsides of wage and price controls has been that markets should be allowed to operate, providing wage signals, with the inevitable people who are unable to command a “living wage” assisted through the in-work benefit system. The living wage is a direct counter to this. Instead it sees virtue in the employer paying the living wage, and any in-work benefits as a taxpayer subsidy to employers, allowing them to pay low wages. It suggests that employers are fundamentally exploitative.
Yet there is a more noble justification than this left-wing anti-capitalism for why many support the living wage, and it may even appeal to some conservatives: the idea that it is morally superior for an individual to think they have earned their wage as opposed to have received a significant benefit ‘top-up’. The problem of course is that just setting all low income workers’ wages to an arbitrary value can never be reflective of genuine “earned income”.
ED MILIBAND’S PROPOSAL
If all sides really do believe there is a policy problem to solve here, is there any way of squaring the circle? Can we recognise that those on low incomes are struggling, but that imposing a living wage might have negative consequences for jobs and opportunity? Is there any way for individuals to keep more of their earned income without cajoling business to increase wages irrespective of its effects on the company?
Two proposals have been doing the rounds in recent weeks. Ed Miliband has outlined his idea for a “make work pay” contract. This would give a tax rebate to firms who pay the living wage for one year. Miliband believes that the link between growth and living standards is fundamentally broken, and that the power of the state should be used to incentivise higher wages for those on low earnings. The fact that such a convoluted scheme has been concocted perhaps shows that Miliband understands that widespread rollout of the living wage on a statutory basis would be economically damaging.
Wages are a business cost. Miliband is thus asking businesses to permanently increase their cost base in return for a one off tax rebate. Economically sensible companies are therefore only likely to accept his offer if they believe that their undertaking of this extra cost will help improve productivity significantly, or if the rebate is generous enough to significantly make up for the extra cost, coupled with any improvements to firm PR as a boost to demand. In the first case, they would rationally choose to pay more anyway – the tax break is unnecessary. The second effect is likely to be small. The scheme is thus likely to have very small effects, with deadweight losses in terms of tax revenues, and require a hugely intrusive bureaucracy to implement (just what we need!)
Miliband’s colleagues have made great play that this can somehow be a win-win-win for business, employees and government. But the idea that this scheme can be good for employers, employees and government, as Miliband’s colleagues are claiming, is just nonsensical unless you believe each and every company would benefit from hugely improved productivity.
A CONSERVATIVE OR CLASSICAL LIBERAL ALTERNATIVE
A more sensible alternative, which has been pushed by Tim Worstall at the Adam Smith Institute, is to continue to raise the personal income tax allowance (as we’ve long advocated) and to raise the starting point for employee national insurance contributions to a level such that an individual on the minimum wage no longer pays any tax. This would broadly give the same disposable income as that outlined by living wage campaigners, without the deleterious effects on employment or prices. It would mean that people get to keep more of their own earnings, with the government taking away less of their money. The minimum wage notwithstanding, it would have a far less distortionary impact on the labour market, provided the lost revenues were accounted for by continuing to bear down on superfluous state spending elsewhere. Given that the principle of everyone paying some income tax and NICs has already been ceded with the existence of personal allowances, having these allowance set at the gross income of someone working full time at the minimum wage would provide a coherence to the tax system. Campaigners would have the disposable income uplift that they are looking for, without increasing the cost of employment for businesses. Living Wage ends through Tory means.
When this idea is put to some campaigners, they say: “but that wouldn’t help the people working part-time who currently earn below the current thresholds.” This has some validity (though the current employee NICs threshold is below the income tax personal allowance). In a way, it shows the failures of the living wage concept in itself. The whole living wage concept is about how much a person working full-time would have to earn to live comfortably given the cost of living. Saying an alternative policy is wrong because it achieves that same aim a different way is somewhat disingenuous.
Of course, pressure for action on wages is coming primarily because of the current squeeze on living standards. But this can only be alleviated through a combination of measures to improve productivity in the long-term and action to reform planning laws (to reduce the cost of living), deregulate industries like childcare (to reduce the cost), and reduce the burden of high state spending and taxes, which squeezes household budgets. The living wage does not solve any of these underlying problems.
The living wage concept is not based on sound economics, but is an emotional campaign that implicitly believes that market outcomes for low paid workers are unfair and that the employer should be responsible for the living standards welfare of his/her employees. This is a huge break with previous orthodoxy of allowing markets to broadly work and then intervening to top up earned income.
The only way to raise wages sustainably is to raise the productivity of workers. Artificially setting wages at arbitrary levels therefore risks reducing employment and opportunity from what it may otherwise have been. Damage caused by the existing minimum wage has so far been small due to its moderate level, though the huge number of unpaid internships and highlevel of youth unemployment means it’s pretty incredible to conclude that no jobs would exist below the current £6.31 or £5.03 youth rate. A much higher “living wage” on the other hand would certainly have negative consequences.
Though the living wage is in itself a pretty meaningless measure, the concept has become a moral crusade for many politicians. All the while it remains voluntary this is largely unproblematic. But politicians have a tendency to try to legislate problems away, often with negative consequences. It’s worth reminding them that the aim of the “living wage” concept in terms of disposable income can also be achieved by taking those working full-time on the minimum wage out of employee taxes altogether. This of course will require spending cuts to make up for lost revenues – but surely if this is such a moral issue, our political friends will be happy to do what it takes to help those on low pay, rather than putting the burden on those businesses that provide the opportunities for the low paid in the first place.
This article is taken from our fortnightly Growth Bulletin, authored by Ryan Bourne and Tim Knox. To sign up for our mailings, use the form on the left of our newsletter page.