Volume 1 April 2007

China in international imbalances
Yu Yongding

International trade and poverty: cause or cure?
L. Alan Winters

Making the boom pay
John Freebairn

Reforming Australian industrial relations
Joe Isaac

Minimum wages and inequality
Andrew Leigh

Does the Fair Pay Commission decision matter?
Mark Wooden

The corporate political environment and big business response
Geoff Allen

Stock return predictability in rational markets
Bruce D. Grundy

Passive profits from accounting indicators
John D. Lyon

A 'Battle of Ideas'
Tom Elliott

On painting one's life picture
Peter Yates

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By Andrew Leigh

Minimum wages are sometimes promoted as a valuable tool in the battle against poverty. Yet the effect of minimum wages on the income distribution depends crucially upon who earns them. If minimum wage earners are disproportionately teenagers from affluent families then a minimum wage rise will have less of an impact on poverty than if minimum wage earners are mostly lone parents.

Analysing the effects of minimum wages is more relevant to inequality and poverty in Australia than in most other developed nations, for the simple reason that Australian minimum wages are high. What is typically referred to as the ‘Australian Federal Minimum Wage’ (the lowest step on a scale of federal awards) is $13.47 per hour, which is approximately 68 per cent of median hourly earnings.

In weekly terms, the Federal Minimum Wage is $511.86. This equates to about 58 per cent of full-time median weekly earnings, as compared with 45 per cent for the United Kingdom minimum wage, and 34 per cent for the United States minimum wage. In 2003, the United Kingdom Low Pay Commission found that – relative to median earnings – our Federal Minimum Wage was the second-highest among 12 developed countries, with only France having a higher wage floor. Assuming a similar distribution of hourly wages in these countries, this suggests that the Federal Minimum Wage will affect proportionally more workers than the minimum wage in the United Kingdom or the United States.

Understanding the distribution of minimum wage workers (those earning at or just above the minimum wage) and subminimum wage workers (those earning just below the minimum wage) is also important for knowing what impact an increase in the minimum wage might have on inequality. While there is no disputing the fact that an increase in the wage floor reduces hourly wage inequality among those who keep their jobs, it is possible that minimum wages also have disemployment effects. If these effects are sufficiently large, then it is conceivable that an increase in the minimum wage might actually reduce the total market income received by low-wage workers.

The impact of minimum wage rises

The impact of minimum wage rises on the social welfare of low-income households depends on three parameters: the distribution of minimum wage earners across more and less affluent households; the elasticity of hourly wages with respect to the minimum wage (the degree to which minimum wages increase hourly wages); and the elasticity of labour demand with respect to the minimum wage (the degree to which minimum wages reduce employment).

One way of estimating the impact of minimum wage rises on inequality and poverty is to focus on the first question: who earns minimum wages?

Combining seven Income Distribution Surveys conducted by the Australian Bureau of Statistics between 1994-95 and 2002-03, two categories of near-minimum wage employees are defined. ‘Minimum wage workers’ are those earning between 100 per cent and 120 per cent of the minimum wage. ‘Subminimum wage workers’ are those earning below the Federal Minimum Wage (e.g. juniors, workers on state awards, and employees in the underground economy).

Regression analysis reveals that those who earn near-minimum wage in Australia are disproportionately female, unmarried and young, without post-school qualifications and overseas born. The age distribution of subminimum wage workers peaks around 21, while the age distribution of minimum wage workers peaks around 32. Across family types, subminimum and minimum wage workers are over-represented in single-person families, and underrepresented in couple-only households. Individuals with and without children are equally likely to be earning the minimum wage (implying that the minimum wage is not a particularly well-targeted instrument for affecting the wellbeing of children). About one-third of subminimum and minimum wage workers are the sole breadwinner in their household.

Another way of asking the question ‘who gets minimum wages?’ is to consider the relationship between hourly wages and family income. If each family had one full-time worker, the correlation between hourly wages and family income would be about one. In practice, the correlation between hourly wages and family income is 0.43.

Comparing hourly wages and family income across the distribution, individuals in poor families are disproportionately likely to be out of the labour force. If individuals from poor households are in the labour force, there is a greater than 50 per cent chance that they will be in the bottom quintile of hourly wage earners. But due to low labour force participation rates among poor households, subminimum and minimum wage workers tend to be clustered around the middle of the family income distribution. Across all adults, the median subminimum wage worker is at the 44th percentile of the family income distribution, while the median minimum wage worker is at the 53rd percentile of the family income distribution. Even excluding those aged over 55 years, the typical subminimum wage worker is in a household at the 35th percentile of the family income distribution, while the median minimum wage worker is in a household at the 45th percentile of the family income distribution

Using these figures, it is possible to consider how raising the minimum wage might affect the distribution of hourly wages, the distribution of individuals’ weekly earnings, and the distribution of pre-tax family income. As noted earlier, there are three relevant parameters in determining the impact of a minimum wage rise on the distribution of incomes: the hourly wage elasticity, the employment elasticity, and the distribution of minimum wage earners across households.

While there is a robust debate in the Australian literature over the elasticities, most estimates of the hourly wage elasticity lie between zero and one, while most estimates of the labour demand elasticity (extensive and intensive margins combined) lie between zero and -1. In effect, the extreme cases are that a 10 per cent minimum wage rise will lead to all minimum wage workers getting a 10 per cent pay rise, will cause 10 per cent of minimum wage workers to be fired, or both.

Distributional effects of minimum wages

Simulations demonstrate that under all scenarios, an increase in the minimum wage reduces hourly wage inequality. It is straightforward to see why this should be the case. If raising the minimum wage boosts hourly wages for the low-paid, and has no disemployment effect, then the minimum wage rise will reduce hourly wage inequality by pushing up the bottom of the distribution. If raising the minimum wage does not boost hourly wages at all, and only has a disemployment effect, then the rise will reduce hourly wage inequality by truncating the bottom of the distribution.

Simulating the effect of a minimum wage rise on the distribution of income assuming a large positive hourly wage elasticity and a zero labour demand elasticity, earnings inequality and income inequality fall slightly. Assuming a zero hourly wage elasticity and a large negative labour demand elasticity, earnings inequality and income inequality rise substantially. And assuming a large positive hourly wage elasticity and a large negative labour demand elasticity, simulations also suggest that earnings inequality and income inequality will rise.

In effect, the disemployment effect in this simulation overwhelms the hourly wage effect, since firings have a much larger impact on the family income distribution than modest wage rises. (Note however that these estimates do not take account of income support and taxation. Since income support and progressive taxation typically act as a buffer against falling family incomes, the disemployment simulations likely overstate the extent to which increasing the minimum wage would raise disposable family income inequality.)

Since the scenarios modelled above are extreme cases, one can also estimate the hourly wage and labour demand elasticities that would be necessary for a minimum wage rise to reduce pre-tax family income inequality (as measured by the Gini coefficient). Assuming an hourly wage elasticity of one (all minimum wage workers receive the full amount of the increase), a minimum wage rise will lower inequality if the elasticity of labour demand is smaller than -0.4. Assuming an hourly wage elasticity of 0.5 (minimum wage workers receive on average $0.50 for every $1 increase), a minimum wage rise will lower inequality if the elasticity of labour demand is smaller than -0.2. Given that the typical minimum wage worker lives in a middle-income household, it appears unlikely that raising the minimum wage will significantly lower family income inequality.

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