How Does the Minimum Wage Impact the Economy?

The federal minimum wage provides compensation increases at a different rate than inflation increases, leaving many workers behind economically. However, increasing pay too dramatically can have negative impacts.
Minimum wage business

When the United States first set a minimum wage through the Fair Labor Standards Act of 1938, the hourly rate sat at 25 cents. Prior to that, during the Great Depression, people facing up to a 25 percent unemployment were desperate for work, so employers could take advantage and pay very little. The minimum wage was then established to prevent that exploitation, said David Cooper, senior economic analyst and deputy director at Economic Analysis and Research Network at the Economic Policy Institute.

Without a wage floor, employers would continue to pay less and less, destroying the purchasing power of the consumers who would make less money, Cooper said. The minimum wage then helps mitigate that imbalance of power between employers and low-wage workers.

That 1938 rule underwent revisions, including a periodic raising of the federal minimum wage, which rests at an hourly rate of $7.25, where it was set in 2009, according to the Department of Labor. Some states and cities took it upon themselves to raise their minimum wages to much higher rates, such as New York City, which will have a $15-per-hour wage by 2018.

As municipalities, unions and advocates push for a higher minimum wage to reduce poverty, many business leaders push back out of fear that their businesses will flounder when having to increase payroll costs.

Although wages rose by $7 since 1938, purchasing power differs dramatically over time. When adjusting for inflation, today’s federal minimum wage is about the same as in the 1950s. At its highest point in 1968, the minimum wage equaled $10.90 in 2015 dollars, more than $3 off from current pay. Advocates for higher wages say today’s minimum wage is not a living wage. “Part of the problem is that we’ve let the minimum wage erode for so long that that gap has grown substantially such that now it’s hard to even consider bringing the federal wage floor up to a level that would allow someone to have a decent quality of life wherever they may live,” Cooper said.

When the minimum wage doesn’t keep pace with inflation, its power erodes. “It’s worth less and less and less,” said Sylvia Allegretto, labor economist and co-chair of the Center on Wage and Employment Dynamics at the University of California, Berkeley. “And don’t forget that these low-wage workers today, compared to their counterparts of decades ago, are more educated, they’re more productive, the economic pie has expanded greatly, yet these low-wage workers are making less today than similar workers did several decades ago.” Trends like this are why unions and activist groups march and legislate for higher minimum wages.

What is the Economic Impact of a Rising Minimum Wage?

Theoretically, raising the minimum wage would mean more money in the pockets of workers. In practice, it’s more complex.

Allegretto coauthored a report, “Effects of a $15 Minimum Wage in California and Fresno,” for the Institute for Research on Labor and Employment, finding that a $15 minimum wage in California would increase earnings for 38 percent of the state, and businesses would see a reduction in turnover and increases in productivity. Raising prices by 0.6 percent through 2023 would offset increased payroll costs, the report said.

In 1992, Alan B. Krueger, a professor of economics and public affairs at Princeton University and columnist for The New York Times, found that when New Jersey raised its minimum wage from $4.25 to $5.05, job growth at fast food restaurants was equally as strong in Pennsylvania, which did not raise wages. “If the minimum wage is set at a moderate level it does not necessarily reduce employment,” he wrote in The New York Times’ “The Minimum Wage: How Much Is Too Much?” “While some employers cut jobs in response to a minimum-wage increase, others find that a higher wage floor enables them to fill their vacancies and reduce turnover, which raises employment, even though it eats into their profits. The net effect of all this, as has been found in most studies of the minimum wage over the last quarter-century, is that when it is set at a moderate level, the minimum wage has little or no effect on employment,” Krueger wrote.

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However, not all agree on the impacts of a rising minimum wage, and results of an increase could vary dramatically based on location, industry and amount of wage boost. If a new minimum wage is set low and close to labor costs, there would be minimal harm to business; if set too high, then damage could be significant, said Mark Schug, professor emeritus at University of Wisconsin at Milwaukee, and president of Mark Schug Consulting Services.

One main criticism of a minimum wage hike is that it would harm businesses, especially small, independently owned stores. The National Retail Federation found in a survey that 37 percent of small retailers would see serious threats to their ability to continue operating under a minimum wage of $15 per hour.

To offset some of these rising labor costs that some cities recently enacted, some restaurants add a surcharge of 3 to 4 percent, according to The Wall Street Journal’s March 2017 story, “New on Your Dinner Tab: A Labor Surcharge.” Raising menu prices lead customers to choose less expensive items than they normally would, so the surcharge aids in mitigating increased costs of doing business, the story said.

Not all small businesses are restaurants, though, so an increase in labor costs might force business leaders to reduce staff. The Heritage Foundation published an August 2016 report, “How $15-per-Hour Minimum Starting Wages Would Affect Each State,” finding that a nationwide minimum wage of $15 per hour would lead to 9 million jobs lost, and states with lower costs of living would see the most negative impact. “Efforts to create jobs and reduce poverty should not center on forcing employers to pay higher starting wages,” the story concludes.

Flaws With the Federal Minimum Wage

A federal minimum wage will have different values based on location, due to the cost of living, hence New York City’s $15 minimum wage. The cost of living there is far different than McAllen, Texas, which has the lowest cost in the U.S., according to Kiplinger, a business forecast publication. Therefore, minimum wages set regionally make more sense, Schug said. “I think it’s very clumsy to have a federally mandated minimum wage.”

If the U.S. could do away with the minimum wage entirely, Schug said that wages could be set by supply and demand. If employers see difficulty holding onto their staff, then they should simply pay more or have greater benefits, he added. The interaction between the employer and employee would set that market rate for pay. “Why mess with a price that’s set by supply and demand?” Schug asked. Other professions compensation based on their market rates, and the minimum-wage workforce only makes up 3.3 percent of all hourly paid workers, according to the Bureau of Labor Statistics. Too much effort is spent on discussing the issue of minimum wage, which impacts only a small group of workers, Schug said.

Nevertheless, it looks as though the minimum wage will remain and continue to rise over time in some capacity. That doesn’t mean there aren’t flaws with the system. Not all who earn a minimum wage would benefit from increases in the same ways, so Schug said economists prefer policies that are designed to help the people they’re intended to benefit. According to BLS data, about half of hourly workers who earn at or below the federal minimum wage are 25 years old or younger. Some of these workers are students and young people from affluent families, Schug said, and they need a wage increase much less than a single mother, for example. Therefore, Schug said, an earned income tax credit would be more effective in reducing poverty, as it better targets those who need additional funds the most by providing additional funds to recipients based on income and number of children.

Economic Policy Institute’s Cooper also suggested supports from government programs to help mitigate wage woes. News from earlier this month cited a report from the National Low Income Housing Coalition, which found that in only 12 counties in the U.S. will a minimum wage allow a person to rent a one-bedroom apartment in a safe area without spending more than 30 percent of their income, according to The Washington Post. This differs by location, with $11.46 being the hourly wage needed to rent in Georgia, compared to $58.04 in the San Francisco Bay area.

Part of this issue is that household income has not kept pace with rent increases. However, Cooper said this isn’t only the fault of a stagnant minimum wage. Housing policy also has not responded to rising rental costs, which increased at a rate of 6 percent between 2007 and 2015, whereas federal funding for housing assistance declined 3 percent between 2010 and 2016, the same Washington Post story stated. This is all while household income dipped 4 percent. “Certainly the minimum wage being left to erode has created a situation where a lot of low-wage workers are not able to afford a place to live, certainly not in the cities where most of the job growth has been over the last 10 years,” Cooper said.

Other proposals to aid issues around costs of living include ones like the Raise the Wage Act, via current U.S. Senate Democrats and House Representatives. This bill aims to provide 41 million low-wage workers raises, reaching $15 an hour by 2024, while closing a loophole that allows for tipped, disabled and young workers to receive far less than the federal minimum wage. The act would also index wage increases to the median wage growth after 2024, the act states.

The Roles of Business Leaders

Naturally, business leaders hoping to keep their operating costs low are likely to oppose a minimum wage increase, but Cooper said this is because they’re not looking at the broader market picture. With fatter paychecks, workers have increased purchasing power, thus benefiting businesses. And with a federal minimum wage increase, it impacts more than just a single business; all other organizations with similar employee makeups will face similar changes to their payrolls.

“Good business leaders want their employees to have a decent life and want their employees to make enough money to afford to live,” Cooper said. “They just don’t want to be put at a competitive disadvantage.” If leaders think more holistically about how a rising minimum wage would affect the labor market and the economy as a whole, they’re likely to be more supportive of minimum wage increases.

Lauren Dixon is an associate editor at Talent Economy. To comment, email