It’s time to dump the neo-classical bogey on base wages

At least half a dozen states of India are in a rush to pass a law that reserves 75% of all jobs for locals. Such a law would be deemed unconstitutional, and is unlikely to increase employment by much for locals, as compared to other strategies such as subsidizing skill-building and training, or enabling affordable dormitory or rental housing, or improving commuting infrastructure, or creating an efficient jobs marketplace. Rather than the stick approach of a job quota, a carrot approach of giving fiscal incentives for creating jobs for locals has a better chance of success. Thus, the choice is between imposing an unworkable quota, which is illegal but has no fiscal cost, and incentives that need public funds.

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What if we change the discourse from job reservations to minimum wage legislation? Will that not have a greater and more decisive impact on the well-being of workers, especially in the lower skill band, and also their employment situation? The need to create large-scale sustained employment is a national priority, and not just for individual states. India recently passed its Code on Wages Act, 2019, which combined four older labour laws on payment of wages, remuneration and bonuses. Labour is a state subject, and hence the minimum wage too varies from state to state, but the new law provides for a national minimum, which is roughly around ₹176 per day at present. This is for unskilled labour. It is barely above the World Bank poverty norm of $2 per day. India’s current minimum wage translates to an income of ₹4,400 per month, which cannot raise a family of four out of poverty. Of course, there are many other anti-poverty schemes that provide in-kind and in-cash benefits. The actual prevailing minimum wage and salary varies not only by state, but by industry, occupation, skill level and the job’s location (whether it’s in a backward area or not).

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But let’s step back and talk theory. The knee-jerk reaction to minimum wages of the pro-market school is that it leads to rationing and shortages. It has the same impact as any other price ceiling. A wage floor will neither create employment nor reduce poverty. This is the neo-classical position, most vehemently articulated by Milton Friedman and George Stigler back in the 1940s. Their reaction was to the first ever minimum wage legislation of 1938, ushered in by US President F.D. Roosevelt as part of the New Deal, which was a response to the Great Depression of the 1930s. It’s amazing how much traction and longevity that argument against minimum-wage legislation has had. Minimum wages won’t help workers, will lead to more automation and skew the mix away from labour to capital. This dogma had such a stranglehold that despite a federal law, the US did not change the national minimum wage for a decade during the two terms of President Ronald Reagan. It remains a dogma built on an elegant theoretical model, but was never rigorously tested against empirical data. Resultantly, the present US minimum wage of $7.25 that was fixed in 2009 is lower than what it was in the 1970s, adjusted for inflation.

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This dogma began to change with more nuanced models that looked at imperfections in labour markets. But it was changed decisively by an empirical paper. This was the seminal 1994 paper by leading economists David Card and Alan Krueger. They showed that on-ground data did not at all corroborate the theoretical prediction of Friedman et al. Using inter-state data, they were able to show that changes in minimum wage did not affect employment. Their study was replicated and also extended to several other labour markets. The finding was the same: minimum wages had no impact on employment. This hypothesis was examined in the context of other countries, too, such as the UK. The stylized fact is that if you pay a McDonald’s worker 10% more, the price of a burger goes up by maybe 25 cents. That does not affect sales volumes at all. The extra cost of paying a higher minimum wage is passed on to the consumer. Indeed, the Big Mac is 60 cents more expensive in Denmark than in New York. But the Danish minimum wage is twice of America’s. Higher pay for low-skilled workers also reduces churn and decreases the overall cost of training and retention of workers for their employers. Such a phenomenon of moderately higher wages being passed on to consumers works in non-tradable service sectors, or indeed for a variety of jobs (janitors, cleaners, courier or security services).

The empirically confirmed fact is that minimum wages are mostly paid to unskilled workers who work in non-tradable sectors. Raising that minimum makes it possible to pass on the cost through a price increase to consumers. Instead of it being funded by the fiscal pot, their welfare is paid for by a large diffused mass of consumers. This is a social tug-of-war, whose equilibrium must surely move towards low-paid workers. There is no worry that, unlike for the manufacturing sector (which has tradable goods), higher wages will make jobs vanish to other lower wage countries. Besides, even in manufacturing sectors such as footwear and garments, there is a wholesale loss of jobs to automation anyway. Those jobs are moving back to high-wage countries.

How much the minimum wage should be raised is a matter of empirics. It has to be large enough to make a material difference to workers, but small enough to keep demand inelastic. The UK’s conservative government has raised it to two-thirds of the median wage, and the liberal government of the US may follow suit. Is India ready to do likewise?