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The Chancellor's bet on a higher minimum wage

Newspaper article

This article was first printed by the Times newspaper on 21 July 2015 and has been reproduced here in full with permission.

Of all the announcements in all the budgets that George Osborne has delivered, this was one of the biggest. Next April all employees aged 25 or over will by law earn at least £7.20 an hour - that’s a 50p increase in their minimum wage - but by 2020 minimum hourly earnings for this group will be over £9. They will then rise every year in line with average earnings.  This change to the UK’s labour market infrastructure will have a profound long term impact. 

Some employers are pre-empting these effects. We heard on Sunday that IKEA intend to introduce an even higher minimum for all their 9,000 employees next April (£7.85 an hour, £9.15 in London). In the longer term millions of low paid workers in retail, hospitality and the care sector will benefit. It sounds like a winner, but should we be more circumspect before welcoming it?

First, let’s just be clear about its scale. Something like two and half million workers will be earning this new minimum by 2020. The Office for Budget Responsibility (OBR) thinks that more than three million other workers will have their wages pushed up as some differentials are maintained. So, remarkably, Mr Osborne’s announcement could result in pay increases for as many as six million low-paid workers. The nation’s wage bill will rise by more than £4 billion a year.

Second, this is a big change to the way that minimum wage policy is made. Since the minimum wage was first introduced in April 1999 the rate has been set by government after receiving a recommendation from the independent Low Pay Commission (LPC) which has a specific remit “to recommend levels for the minimum wage rates that will help as many low-paid workers as possible without any significant adverse impact on employment or the economy”. The LPC is explicitly asked to do this on the basis of the best available evidence.

Which brings us to the third important aspect of the new policy. Unless the LPC has been getting things horribly wrong, then this new higher minimum wage will have an economic cost: £4 billion of extra earnings can’t come from nowhere. Companies are likely to recoup the cost from higher prices, or perhaps suffer lower profits. The OBR’s central estimate is that the policy will lead to there being 60,000 fewer jobs than otherwise, but it could be as many as 120,000 fewer. National income could be 0.1 per cent, or getting on for £2 billion, lower as a result.

As with pretty much everything in economic policy, there is a trade-off to be managed. The majority of low paid workers will be made better off without suffering the negative effects of being dependent on means-tested benefits and tax credits - which inevitably reduce incentives to move into work and, once in work, to increase earnings. Much of the cost of these higher incomes for low earners will be spread across the whole population, who will face slightly higher prices.

That said, a higher minimum wage is not a direct replacement for welfare, and certainly won’t compensate most of those whose benefits will fall as a result of the cuts announced in the budget. For one thing the arithmetic makes that impossible. A £4 billion pay rise can’t fully compensate a £12 billion benefit cut. More importantly minimum wages and social security benefits do different things. The former increase the hourly pay of low earners. The latter support low-income families. Many low earners do not live in low-income families - perhaps because they have a high earning partner. And there are plenty of people in work earning more than £9 an hour who have household incomes low enough to be entitled to tax credits.

But there is a bigger and longer term bet going on here. It is a bet that forcing companies to increase wages will force them to increase productivity. If you have to pay £9 an hour then you’ll be forced to invest in the training and the machinery to ensure you get your money’s worth. Indeed this could be one of the reasons why productivity in France is so much higher than that in the UK. With high minimum wages and extensive labour market regulation French companies can only survive by being highly productive. On the other hand that same regulation probably partly explains higher French unemployment.

The minimum wage as it stands is widely seen to have been a success. It remains to be seen whether Mr Osborne’s new bet will pay off.

More on this topic

IFS Working Paper W21/48
We estimate the effect of the introduction of the UK’s National Living Wage in 2016, and increases in it up to 2019, using a new empirical method.
Press release
The UK’s National Living Wage (NLW) has increased wages not only for those who would otherwise have earned less than that, but also a wider group.