Why are some employees paid a low wage? In the run up to the UK Budget on Wednesday, some commentators are arguing that the answer is, in effect, “because employers can get away with it”. Why not, then, the logic goes, simply raise the national minimum wage (£6.50 until October for over-21s; £6.70 thereafter) to the level of the so-called Living Wage (£7.85 outside of London; £9.15 in the capital)?

Why not, while we’re at it, cut tax credits, since they are “subsidies” to employers? After all, the argument continues, since employers can pay higher wages, tax credits allow them to pay lower wages than they otherwise would and to pocket the extra.

In a much-needed riposte on Monday, Gavin Kelly, chief executive of the Resolution Foundation, a think tank focused on low pay, argues against simplistic reasoning.

The Living Wage, as Mr Kelly explains, is a different beast to the minimum wage. It does not look at how jobs might be lost if employees were paid more; in contrast, the Low Pay Commission, the body that recommends the minimum wage rates, has a responsibility to suggest how high the wage can rise without hurting employment. The Living Wage is based on assessments of need, which vary by location, family size and the availability of benefits such as housing benefit and, yes, tax credits.

So, if tax credits were to be cut, the Living Wage would naturally rise. The idea that tax credits can be easily replaced by wage rises is wishful thinking. What evidence we have suggests that employees, not employers, benefit most from tax credits. What is more, the scale of tax credit cuts being suggested would mean that employees would require huge wage rises to make up the difference. Mr Kelly adds (my emphasis):

Perhaps the biggest misconception is the voguish notion that if tax credits are cut, employers will somehow decide to offer pay rises to fill the gap. This is saloon-bar economics espoused by some on both left and right. The available evidence suggests that the great majority of the gains from tax credits flow through to employees, not employers.

What about the claim that those working families should be able to absorb cuts in tax credits and other benefits by securing a commensurate pay rise? It doesn’t wash either. To illustrate, consider the idea that’s been floated of cutting Child Tax Credit by £5 billion (accounting for under half of the proposed welfare cuts). A single parent with one child, working 16 hours a week on the NMW could experience a cut in annual income of £845. To prevent this income fall they would need to boost their earnings by nearly £1,500 (due to high effective tax rates) ­– equivalent to a 26 per cent pay rise. Alternatively, it would take 12 years of incremental 2 per cent real pay rises (well above the pre-downturn trend) simply for this family to recover their position. If the family had two children then we can practically double the figures in this particular example.

None of this necessarily rules out the possibility that the minimum wage could be raised further than is recommended by the Low Pay Commission. The impact of minimum wage rises on employment is one of the most studied areas of economics and, while there is still a lot of debate about their precise effects, it is clear that they are not those predicted by the simplest of models: wages up; employment down.

The UK experience with the minimum wage is that employers who can adjust often do so in ways other than cutting jobs: they may reduce hours, squeeze wages, chivvy workers to be more productive, invest in new machines, or narrow profit margins.

We await to see what happens in the US cities that have recently announced steep hikes in their minimum wage but anecdotal evidence suggests that companies are making similar trade-offs: restaurants in Seattle, which is committed to a $15 per hour wage, are raising prices and in some cases cutting back on wait staff’s tips.

So, while there may be more scope than commonly assumed to raise the minimum wage, this is neither (a) a cost-free exercise, nor (b) a substitute for tax credits.

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