Wage Subsidies as an Alternative to Increasing the Minimum Wage

IN an op-ed for the Portland Press Herald, Martin Jones addresses the issue of the minimum wage, and whether it is the most effective tool for policymakers to use to increase employment and reduce poverty via increased wages.

The central issue opponents, like Jones, of an increase to the minimum wage (or the minimum wage in general) have is that it will lower employment by pricing workers out of the labor market.  In lieu of increasing the minimum wage, Jones makes two suggestions (one obvious, one a little less so):

But if the goal is a minimum family income, advocates should say so and lobby to make it a public good, paid for by the public, instead of making a poorly targeted minimum-wage policy a burden for employers, many of whom are small and can adjust to the extra cost only with great difficulty. An expanded Earned Income Tax Credit would at least target the individuals and families who need extra help.

Expansion of the earned income tax credit (“EITC”) has gained momentum in policy discussions as an alternative to increasing the minimum wage with bipartisan support (see here, here, here, here, and here), and it merits discussion.  The other, less obvious, idea that Jones (seemingly) suggests is a wage subsidy–something that is hardly a new idea but is not often mentioned during debates and discussions as an alternative to increasing the minimum wage.  A major proponent of the wage subsidy was Nobel winning economist Edmund S. Phelps, who in 2006 described the wage subsidy as:

[A] subsidy for low-wage employment, paid to employers for every full-time low-wage worker they hire and calibrated to the employee’s wage cost to the firm. The higher the wage cost, the lower the subsidy, until it has tapered off to zero. With such wage subsidies, competitive forces would cause employers to hire more workers, and the resulting fall in unemployment would cause most of the subsidy to be paid out as direct or indirect labor compensation. People could benefit from the subsidy only by engaging in productive work – that is, a job that employers deem worth paying something for.

 In other words, as Stony Brook economist Noah Smith described it:

But a better proposal than that one is actually wage subsidies, government wage matching, also called a negative income tax . . . When a company offers you wage, the government matching would have already done behind the scenes. Someone comes and offers to pay me $20 an hour, the government is paying $12 of that. I would be making $8 an hour, but I would feel like a person who making $20 an hour. Unlike the Earned Income Tax Credit where you get a check from the government based on how much income you earned, I think people would feel a lot better in term of the framing of it if the government matched their wages instead.

The incentives to hire are clear as businesses no longer independently shoulder paying wages.  If firms are willing to pay $8 an hour, but potential workers are only willing to accept $10 an hour, that $2 an hour gap can be made up by a wage subsidy.  With wages subsidized, firms would then bid for workers, increasing employment while also bidding up wages.

Theoretically, the program appears to be sound.  However, the empirical evidence leaves several questions–not to mention that while there is a fair amount of literature on the topic, there are not a lot of wage subsidy programs to provide economists with adequate empirical evidence.  Moreover, what work that exists, both empirical and theoretical, is split on the efficacy of wage subsidies.

From a 2013 paper by Kristiina Huttunen et al:

Low-wage subsidies are often proposed as a solution to the unemployment problem among the low skilled. Yet the empirical evidence on the effects of low-wage subsidies is surprisingly scarce. This paper examines the employment effects of a Finnish payroll tax subsidy scheme, which is targeted at the employers of older, full-time, low-wage workers. The system’s clear eligibility criteria open up an opportunity for a reliable estimation of the causal impacts of the subsidy, using a difference-in-difference-in-differences approach. Our results indicate that the subsidy system had no effects on the employment rate. However, it appears to have increased the probability of part-time workers obtaining full-time employment.
These findings comport with the theoretical models used in the 2006 paper by Frank Oskamp and Dennis Snower:

The calibration shows that low-wage subsidies have a negligible effect on aggregate employment. Although they do stimulate low-skilled employment, they also reduce medium-skilled employment, and the net effect is very small.

Other work suggests the inverse regarding employment.  From a 2007 paper by Aki Kangasharju:

This paper examines whether subsidized jobs have contributed to employment in subsidized firms or have merely substituted for non-subsidized ones. The data-set is an unbalanced panel of some 31,000 firms that are followed annually between 1995 and 2002. The analysis is based on difference-in-differences, which is adjusted by regression and matching methods. The results indicate that wage subsidies stimulate employment, and that the magnitude of the effect is as aimed. I also found that subsidies have no sizeable effects on non-subsidized firms of the industry or the geographical area in question.

Likewise, in his study of the German wage subsidy program, Gesine Stephan found that:

The results indicate that subsidized jobs are not associated with gains or losses regarding daily wages, which might be contributed to wage setting within the German system of industrial relations. Nonetheless, because subsequent employment rates of subsidized persons are higher on average, we find a positive relationship between cumulated wages and subsidization.

Despite the split in the literature on the ability of a wage subsidy (and similar programs) to increase employment and wages without having the possible dis-employment effects of an increase to the minimum wage, there are two issues.

First is funding.  Where will the subsidies come from?  There are economic and political problems here.  As to the former,  the U.S. tax system is less than ideal, and there are concerns that a wage subsidy program would fall hardest on the shoulders of the middle class. Moreover, it’s almost certain the conservatives and Republicans would balk at such a program given the heated debates over the budget/deficit/spending of the past few years.  For instance, the program would cost $1 T for a $3 subsidy for every worker.  No one is seriously suggesting that costly a program, and the figures can move around a bit.  One suggestion on a wage subsidy program has the price tag at $400 billion.  By comparison, the EITC costs the government $60 billion.  (Furthermore, “wage subsidy” does not exactly sound like a program GOP candidates would want to run on and support).

The second issue, and counter to Phelps’ argument that wage subsidies would bid up wages, is the concern that firms would use the subsidies to bid down wages.  Phelps’ argument holds true only if the labor market is healthy and unemployment is relatively low; fewer workers in the applicant pool means firms have to bid up the prices.  To prevent workers from capturing the subsidy by demanding outrageous wages knowing that the government will subsidize some of portion of the wage, the subsidy will taper off when wages reach a certain level (in effect a price ceiling as far as subsidies are concerned).  For instance, if a worker knows that a firm can only pay $20 an hour, but there is a $2 an hour subsidy, then the worker can demand a wage of $22 an hour knowing the firm can meet that price given $2 of it is subsidized.

Conversely, when the labor market is struggling and unemployment is relatively high, firms then have the ability to bid wages down.  If a firm knows a worker is willing to work for $8 an hour, and there is a $1 an hour subsidy from the government, the firm can capture the $1 subsidy by offering $7 an hour (which, together with the $1 an hour subsidy, will bring the workers’ subsidized wage to their demand wage of $8 an hour).  To prevent this from happening, some price floor (minimum wage) will have to remain in place, and the minimum wage and subsides could be indexed to inflation to prevent businesses from capturing the subsidies as inflation erodes the real value of the subsidized wages.*

Concern over businesses bidding down wages is legitimate, but a wage subsidy program might be effective during economic downturns in increasing employment.  This would address the current issue of long-term unemployment, which can become more persistent and lead to people eventually being un-hirable.  Of course, political concerns, program costs, and wage depression once the economy improves all call into question the feasibility of implementing such a program.


* Of course the issue of inflation eroded wages brings us back to the issue of whether critics of the minimum wage (in general or specifically to increasing it) are being consistent.  Remember that opponents of a minimum wage increase (or the minimum wage in general) is that it will price workers out of the labor market.  In other words, employment and labor cost are inversely related.  An increase in labor costs results in a decrease in employment.  Wage subsidies work the other way; decrease the cost of labor to firms, thereby increase hiring.  There is some question as to whether this inverse relationship is as concrete as some suggest.

John Haskell

About John Haskell

John graduated from the University of Southern Maine with a degree in Political Science, and from the University of Maine School of Law. He has worked in both the public and private sectors, and currently, works with a small business services company in the Mid-Coast area.