The Minimum Wage Dilemma

The leader of the Labour Party, Ed Miliband, has today announce his desire to "significantly increase" the national minimum wage if elected at the general election in 2015. Last September, the party commissioned Alan Buckle, former deputy chairman of KPMG, to investigate how to restore the value of the national minimum wage which has fallen behind inflation since the recession in 2008. It is due to increase by 19p an hour to £6.50 in October, giving a 3% pay increase to around four million workers, the first real-terms increase in six years.

Many economists are scathing about the impact of a minimum wage as it creates an arbitrary wage floor, pricing people whose potential output is less than the minimum wage out of the labour market and distorting real wages by creating a cliff-edge effect at its particular level. Earlier this year, the Chancellor of the Exchequer, George Osborne, suggested that the economy was growing strongly enough to be able to support a rise in the minimum wage to £7 per hour, a much larger increase than the Low Pay Commission decided to implement.

The debate around minimum wages, whether to have them and, if so, at what level they should be set, tends to polarise between the left and the right. The former believes they have an important social effect in ensuring that people can afford to live a comfortable life when in work and should not rely on state benefits to top-up their income, and the latter says that the economic distortionary effects create huge problems, primarily in driving up the input costs of businesses and in increasing unemployment, particularly amongst the young, the low-skilled, and those furthest from the labour market.

As always, the truth lies more between these two polar opposites. The positive and negative effects are rarely considered side-by-side and the potential side-effects of any policy are often not weighed carefully, with the outcome failing to deal with some of the unintended outcomes that all policy proposals generate. For what it's worth, here are my thoughts.

First, let's deal with the social issue. The left argue that a higher minimum wage, perhaps at the level of the living wage, will lift people out of poverty, reduce their reliance on state top-up benefits, giving them more money to spend in the economy and reducing state spending: fundamentally a win-win situation. It is hard to argue against the case that work should pay, but this will produce some side-effects. For those who are in work but have low skills or low output, an increase in the minimum wage can cause employers to pay more in salary than an employee actually produces. If an employees output potential (i.e. the amount of money that they can generate for the company) is £6.50 per hour, a minimum wage set above this level (never mind the employers' NI, pension contributions, etc) means the employer is losing money by hiring them. Of course, in reality the equation is not so simple and costs are usually spread across a number of people rather than output per head directly, but this clearly can have some severe effects: the employee may be made redundant, and/or the job they previously did may be automated or off-shored to a cheaper jurisdiction.

However, if we are to begin to make work pay - a clear ambition of both the coalition government and the Labour party - then something needs to be done. The coalition is tackling this primarily by benefits reform, ensuring those who aren't in work cannot receive more in benefits than if they were working. Labour is committed, too, to reform of the benefits system but desires to see employers paying their staff more so they can enjoy a dignified life. Again, the answer is probably somewhere in between. Society needs to come to a clear answer on who subsidises "unprofitable" labour. If John's potential output is £5 per hour and society deems he needs £7 per hour to live a suitable quality of life, who should make up the difference? You can probably argue a case for employer and state here, but this needs to be answered, and we could do with seeing more research and thinking from the main political parties on this issue, because this is an important point.

Secondly, the unemployment issue. Many fear that an increased minimum wage will lead to higher unemployment as non-economically productive employees are laid-off if salaries rise too high. The evidence from a number of advanced economies with minimum wage legislation is unclear at best but, as with everything in economics, the one thing we can be certain of is there will be an effect: what's up for debate is its type and scale. Many people on the national minimum wage (around 4% of the UK workforce) are in jobs that cannot easily be mechanised or outsourced, e.g. cleaners, receptionists, bar and restaurant staff, etc. It is possible that a large number of employers would swallow the rise and pass the costs on to their consumers, increasing prices and potentially reducing competitiveness across borders, though for the roles outlined above this may not be problematic.

For me, my bigger concern is for the unemployed. The more and more expensive it becomes to hire a new employee, the less likely they are to be employed, particularly if low-skilled or with little work experience. Committing more money to someone you currently work with, and have experience of, is an easier thing to do than with an unknown person. There are substantial risks for businesses hiring new staff - these are often underplayed by politicians - and the higher the financial costs, the riskier it becomes. This is why small incentives such as £2,000 "handouts" to employers to hire young people are so ineffective: put alongside the other risks, the money is not enough to have a significant effect.

Any rise in  the minimum wage should be delivered alongside a significantly improved offer to the unemployed, the young, the low-skilled and the disenfranchised. These are the people most likely to suffer any ill-effects of an increase in the wage floor. More must be done to raise their abilities so that they can compete with the better-skilled for employment. It is only fair that if government is to raise the barrier to entry in the workforce, it must help those who are furthest away from it. Only by doing this can a "make work pay for all" policy support everyone and not leave people behind.

So, put together, what does all this mean? Socially, there's a strong argument for ensuring work pays, but instead of debating the issue of levels and broad policy direction, we need to focus on my earlier point of who "makes up the difference"? Economically, we've got to avoid disincentivising employers from hiring the young and low-skilled. A recent survey of over 7,000 businesses who are members of Chambers of Commerce was overwhelmingly in support of an inflationary rise in the minimum wage; around one-in-five were supportive of a higher rise. The evidence is that business is much more pragmatic than many large business representative organisation would have you believe, and many of them are in the press today saying exactly what you would expect them to about Labour's proposal.

We're proud here at Greater Manchester Chamber of Commerce to be more pragmatic, acknowledging our key role in bringing together not just the business and the economic, but the social too. We, and all businesses, have a wider place in society than being just income generators. Making work pay is a truly laudable aim, and ensuring that all people who engage in the workforce can have a dignified standard of living is vital. But policies around minimum wage levels will have an effect and, as long as those effects are understood as best as we can, and handled non-politically, I believe that business can, and will, support them. But the case needs to be better made, and the tensions between left and right need to be ironed out. The right path is in the middle, and we should all work together to help us find it.