The (supposed) rationale for the National Living Wage

What with Aldi’s recent announcement that they are going to be paying the “Living Wage” to their employees (see here), it seems as good a time as any to re-visit the possible motivations behind the UK government’s introduction of a National Living Wage above the level of the National Minimum Wage recommended by the Low Pay Commission.

It seems as though the standard theoretical argument that imposing a minimum price on a product results in the oversupply of that product (resulting in more people wanting to work than there are jobs available – i.e. higher unemployment) has been put to bed, albeit perhaps for the wrong reasons. For example, the simple argument that unemployment did not increase after the introduction of the Minimum Wage in 1999 is fallacious because it fails to take into account the fact that the economy was growing at the time and, as such, does not use the correct counterfactual (i.e. it does not compare what did happen to what would have happened to unemployment had the minimum wage not been introduced).

Instead, the more relevant results are those that allow one to control for other factors that might have changed over time.  For example, Dube at al. account for this by comparing areas of the US that introduced minimum wages with those that did not do so, and find that the introduction of a minimum wage did not result in an increase in unemployment.Similarly, Leonard et al. conducted a meta-study for the UK and found that the national minimum wage did not affect unemployment. For an interesting discussion regarding why the predictions of standard theory are not borne out by reality, see Schmitt.

These results are, of course, conditional on the minimum wage not being set “too high” – obviously, if the minimum wage was set at some absurd figure, then the aforementioned results would not apply.  However, it is not clear at what level the “absurdity” kicks in. It could well be that anything above the current UK minimum wage could result in unemployment (indeed, the Low Pay Commission takes the impact on unemployment into account when determining the minimum wage).  In other words, it is still entirely possible that the introduction of the National Living Wage could result in an increase in unemployment, albeit perhaps a rather negligible one.

So, given the limited downsides of the Living Wage, what are the (economic) upsides from the government’s perspective? First, and most obviously, is that the population has more disposable income, leading to them being able to spend more, thereby resulting in an increase in GDP.  Moreover, one can expect (almost) the full amount of the difference between the minimum wage and the Living wage to be spent rather than saved, due to lower-income people having a higher propensity to spend rather than save.

Second, and more insidiously, the fact that the Living Wage is higher than the National Minimum wage means that the government can keep its pledge of ensuring that all those who are paid the Minimum wage do not pay income tax (although note that they would still pay National Insurance), while making sure that they still receive income tax from those low earners.  To see this, note that a 25 year old working 30 hours a week at the National Minimum wage of £6.50 per hour would earn about £195 per week, whereas if after the change to being paid the Living Wage they would earn about £216.

Given that the personal income tax allowance amounts to £204 per week, it is clear that someone earning the Minimum wage does not pay any income tax, but someone earning the Living Wage would do so (they would pay about £2.40 income tax per week). While just over £2 per person per week might not seem like a lot for a government that runs a deficit in the billions of pounds, when combined with the number of people affected by the increase, the amount of tax raised is quite substantial.  Indeed, assuming that roughly five million employees are paid less than the Living Wage (see here) and also assuming that all of these would subsequently be paid the Living Wage (i.e. it does not include any of the “grey economy”) the implementation of the Living Wage would benefit the government by about £10 million per week – i.e. £520 million per year.  (Note that this figure may well be an underestimate of the benefit to the government because it does not include the extra National Insurance receipts that would also be obtained.)

Hence, it is possible that, rather than being for the benefit of the working people, the government has introduced the Living Wage as a somewhat roundabout way of increasing tax receipts, making it a very cunning ploy (almost worthy of Baldrick).