The Earned Income Credit

In late June I posted a piece about the minimum wage. I was generally opposed to it, partially because of the possible effects on employment—I thought some people would lose their jobs—but also because I saw it as a reflexive, feels-good approach to an issue that requires serious thought. At the end of the piece I noted that some policy wonks had proposed an expansion of the earned-income credit (EIC) as an alternative to the minimum wage, and I said I would write something about the EIC one of these days. That day is here.

But first I want to talk about a personal interest in the minimum wage. My younger son refused to go to college, despite being probably the brightest one in the family. Instead, he spent a year at a technical school learning to be an auto mechanic. (He’d previously done a lot of mechanic’s work fixing beat-up vehicles at a Colorado wolf sanctuary where he spent a few years.) Course completed, he went back to Colorado and took a job with an auto dealership as a “lube tech”—the guy who changes your oil, rotates your tires, and does the safety check. All for $9 an hour, raised to $10 after his third month (though he does get to buy into the company health plan at a below-market price).

It’s not enough to live on, even for a single young man. The carrot is that eventually—though it could take several years—he would move up to a real mechanic's job, where the pay is better though still not great. In the meantime, he’s working Real Hard. It’s not like bagging groceries. For one thing, to do the work well you have to know quite a few things you don’t just learn on the job. And it’s hard physical labor, not to mention that you’re on your feet almost all day. On top of all that, it costs a bit of money just to be a mechanic; it’s the mechanic, not the employer, that supplies most of the tools, and lube techs may have to pay for damage done to cars, such as scratched paint, during oil or tire changes. Both the tools and the damage can cost thousands. Finally, doing it badly, especially the safety checks, could get someone killed.

So, despite my principled objections to the minimum wage I might be in favor of Colorado enacting a $15/hour minimum as Seattle recently did. (Not that there’s much chance of that; only this past January 1, Colorado raised its minimum hourly wage to—drum roll—$8.) On the other hand, a raise from $10 to $15 might get my son unemployed; people might want fewer oil changes or tire rotations, or pay their neighbor’s kid to do it. I don’t think there would be a precipitous fall in lube tech employment, but it’s quite a risk when you consider that the job’s main attraction isn’t the pay but the opportunity for advancement. Think of lube techs (and perhaps many other low-wage workers) as extremely well-paid interns.

But why does a hard job that requires some technical expertise pay so little? The economics texts tell me it’s because there are lots of people who are able and willing to do the work for that pay. Supply and demand, if you will. Apparently there aren’t that many attractive jobs for intelligent high-school graduates. Still, it’s not clear why they should earn no more than sales clerks, who requires minimal training. Puzzling.

And now for the EIC. An EIC has the government pay low-wage workers a supplement for each hour they work. Right now the EIC is paid through tax code refunds, and participation and benefits are limited. Current proposals are to open it up to all low-wage workers and to make it more generous.

The attraction of the EIC is that there is no danger that it will increase unemployment. Indeed, it seems likely that it will decrease unemployment for the workers it covers. That’s because part of the EIC goes to employers rather than employees.

To see why employment might increase, suppose that the government starts to pay an EIC of $2 an hour to bakers, who previously earned $8 an hour. At $8 an hour, bakeries were just able to fill all their openings. (If they couldn’t, bakers’ wages would have risen.) But with a $2 EIC, the employer can now fill all the bakers’ positions while only paying $6 an hour, with the EIC raising the bakers’ total compensation to $8. But an employer who now pays a wage lower than $8 is likely to want to hire more bakers, since he can now sell more bread at a lower price, and this will raise the wage above $6.

Suppose that as a result of the EIC, the bakery winds up paying an hourly wage of $7—$1 lower than it paid without the EIC—while the bakers enjoys total compensation of $9 an hour($7 wage plus $2 EIC) , which is $1 more than they received before the EIC. The EIC raises bakers’ compensation while lowering bakers’ wages, with the difference being made up by the EIC. Both bakers and bakeries are better off, and more bakers are employed.

We don’t know a priori how much of the EIC will go to the bakery (in the form of the lower wage it has to pay), and how much to the bakers (in the form of a higher post-subsidy wage rate). That depends on market responses to the introduction of the subsidy. But statistical studies by economists indicate that employment has in fact responded to increases in the EIC, suggesting that the EIC has allowed employers to pay a lower wage.

Like the policy wonks, I prefer an EIC to a minimum wage. But most of the popular writing on both proposals refuses to come to terms with a critical question: Why do some workers earn less than others? (It’s the same question I wondered about for my son the lube tech.) Folk wisdom, too often reflected in media accounts, holds that employers are mean-spirited. The economists’ answer is that workers get the value of their marginal product; if that product is less valuable than the workers’ pay, their employer will fire them, lower their pay, or go out of business; if the workers’ product is more valuable than their pay, other employers will bid them away. Obviously, nothing in real life works that smoothly, but it’s hard to deny that the relation between the value of work product and work compensation exerts a force that over time will bring wages into line with what people are willing to pay for the workers’ product.

The direct cost of the EIC supplement will be borne by taxpayers, and there will also be indirect costs in economic efficiency: Workers will move between jobs to reflect the altered compensation landscape. Still, these efficiency losses should be less than with a minimum wage, and the benefits to low-wage workers higher.

—Stan (with help from an actual economist)