Minimum wage and taxes – are minimum wage effective?

Wage illusion is a popular concept in economics, and it describes a situation where an increase in wages, which is implemented by a government to address the high inflation, results in reflation. This theoretically acclaimed principle in economics is also connected to movement in taxes. There have been historical periods when an increase in minimum wage fails to achieve its desired objective. Typically, the government will initiate an increase in minimum wage when there is a sharp decline in household real income caused by a recession-induced decline in wages and high inflation. When the increase in minimum wages is in play, the government expects household income to grow and improve overall living standards. However, this is not usually the case. Besides inflation, an increase in minimum wage will lead to an increase in government budget deficit, which has to be financed either through public borrowing or taxes. If the government decides to fill the deficit with public borrowing, an increase in public debt is expected, and in the long run, the capital for the debt servicing and principal repayment will fall on households either directly through higher taxes or indirectly through a crowding out effect of private capital. In practice, the government would follow up an increase in minimum wage with higher company income taxes and value added taxes, which drives inflation as companies pass on the higher taxes on households. The goal of this article is to provide historical evidence on the link between movement in taxes and minimum wage. 

In the United Kingdom, the government regularly adjusts its minimum wage under the National Living Wage initiative. In April 2024, the UK government increased the national living wage from £10.42 per hour to £11.44 per hour, on the back of rising cost of living, induced by the high interest rate environment. Britain’s new Chancellor of the Exchequer, Rachel Reeves, recently muted an increase in different tax rates. For instance, the government will implement its policy to add 20% value-added tax to private school fees from January 2025. Bloomberg noted that tax breaks for people with non-domiciled status would be removed for income arising after April 2025 and Britain’s energy profits levy would increase to 38% from November 2024. However, the government has no plans to raise the income tax, the national insurance payroll tax or value-added tax, but failed to commit to other taxes. In July 2012, France raised its minimum wage by approximately 2% to €9.40 per hour and equally increased the taxes on high earners and corporations. For instance, a tax rate of 75% was implemented on incomes exceeding €1 million. In January 2024, Brazil also raised its minimum wage to 1410 Brazilian reais per month and also raised the level of taxes to finance the wage hike. 

On the other divide, there are examples where the minimum wage was raised and there was no corresponding increase in the tax rate. In January 2019, Greece raise its minimum wage by 11% from €586 per month to €650 as part of a broader effort to improve living standards after a prolonged period of austerity measures. The government additionally trimmed the level of corporate income tax gradually from 28% in 2019 to 20% in 2020 to alleviate the effect of the harsh recession on companies. In other countries like Argentina and South Korea, where there has been an increase in the minimum wage in the past; there was no corresponding growth in the tax rates. A clue from the experience of Argentina and Greece is that the minimum wage was raised when there was a stagflation, that is, a coexistence of recession and inflation. In this economic environment, raising taxes is likely to be counterproductive as it simply gulps the additional income from the higher wages paid to households. On the other hand, if the economy is not in a recession, but inflation is growing, which is the case with most developed countries after the Covid pandemic; raising minimum wage can be counteracted with higher taxes. 

Given this background, below is a hypothesized matrix on how increase in minimum wage and taxes can evolve under different growth and inflationary scenarios

Having established the contexts for interaction between wage and tax policies, it is imperative to note that there are certain conditions which ensure that an increase in minimum wage results in an overall improvement in living standards. First, the increase in minimum wage should be modest and phased over time. A sudden and colossal increase in minimum wage can increase the unemployment rate. Increase in minimum wage should also coincide with a strong labour market, where there is an existing low level of unemployment and high demand for labour. Additionally, instead of an outright directive from the government to private business to increase the minimum wage; the government could consider providing financing and subsidies to improve labour productivity first. This would then motivate businesses to pay a higher minimum wage. Inflation should also be at a controlled level at a time when minimum wage is implemented. When inflation is low and controllable, the economy is able to absorb the demand pressure stemming from an increase in minimum wage. 

Written by Michael Ogunremi

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