Certainty or Efficiency: The Economic Consequences of Arizona’s Indexed Minimum Wage

By Kyle Rose

The minimum wage in the US is at a stand-still. The Federal minimum wage, which as of October 2022 stands at $7.25 an hour, has not increased since 2009 and its real value is the lowest it has been in 66 years. Failure to raise this wage, on top of rampant inflation that reached a 8.2% early average in September, will likely lower its real value to levels not seen since World War II. In light of this erosion, 30 states and hundreds of local governments have stepped in to raise the minimum wage in their jurisdictions. Arizona is one of them and, with a minimum wage of $12.80 an hour in 2022, is the 9th highest minimum wage in the country. It also has the distinction of being one of 13 states that indexes the minimum wage to inflation, which will raise the minimum wage to $13.85 in 2023. However, indexing comes with a price.

While indexing might prevent minimum wages from losing their value, a one-to-one tie to inflation is likely too mechanical and blunt and may cause undue harm to low-skill workers and the economy. In particular, directly linking inflation and the minimum wage will likely contribute to lower employment for low-skilled workers and price increases for any products and services produced or rendered by low-skilled work. 

To understand why this might be the case, particularly in Arizona, a look at the wage’s history and its economic impacts is in order. Arizona’s indexing of the minimum wage started in 2006 with Proposition 202, which both created a state minimum wage of $6.75 and indexed it to the Federal Consumer Price Index. Needless to say, the rise and the indexing were highly controversial. The measure was opposed by numerous Arizona business coalitions like the Arizona Chamber of Commerce, the Arizona Restaurant Association, and the Arizona Farm Bureau Federation, which cited decreased employment and higher prices due to increased labor costs. The law was also opposed using non-economic considerations, with then-State Senator Dean Martin labeling the legislation the “Illegal Immigration Incentive and Rewards Act”. Despite this opposition, the proposition was passed into law with 65% in favor.

A decade later in 2016, another increase was introduced as Proposition 206, which raised the minimum wage by $1.95, introduced paid sick leave, and imposed these new rules on local governments. Like Prop 202, the measure was opposed by the state’s Republicans and the Arizona Chamber of Commerce. The reasons for opposing it were also the same, although the attacks on migrants were also significantly toned down. That measure also passed, this time with 58% in favor. 

Despite its popularity, raising the minimum wage causes significant economic impacts. Raising the minimum wage increases the costs of hiring and employing low-skilled labor, which causes employers to have to either increase their revenues or decrease their expenses in order to return to profit maximization. Decreasing expenses means either decreasing the costs of inputs, such as staff and equipment, increasing business efficiency in some way, or some combination of the two. In practice, this usually means lay-offs, reduced hours and benefits for workers, and automation of previously human performed tasks. It can also lead to higher prices, since when the costs of inputs increase, the cost of the final good also needs to increase in order to ensure that profits remain the same. In either case, the result is more unemployment, higher costs for goods and services, or both. In economic terms, if a minimum wage raises the cost of labor past its optimal market value, it produces structural unemployment and deadweight loss. This is borne out by economic projections by the Congressional Budget Office, who estimated that raising the minimum wage to $15 an hour would cost an estimated 1.4 million jobs, increase structural unemployment by 700,000, and raise the national debt by at least $54 billion.

However, there is a large catch to this. In the broader labor market, if the value of the minimum wage is below the market’s equilibrium wage, changing it will have little effect on the economy unless it is moved above it. After all, if everyone’s actual wage is already above the minimum wage, changing it on paper will make no difference to businesses or employees. This fact is key to understanding why many states can get away with deferring to the federal minimum wage without causing a mass exodus of low-skilled workers to states with higher wages. The demographic make-up of minimum wage workers supports this. Bureau of Labor Statistics demographic data from 2020 on minimum wage workers found that only 1.5% of all workers actually had wages that equaled the minimum wage. Put another way, 98.5% of all workers made above the minimum wage, i.e., were paid at market-determined wage rate. 

Combining these dual tracks together and applying them to minimum wage indexing leads to several interesting outcomes. First, the economic effects of an indexed minimum wage would vary from state-to-state depending on whether it pushes wages above the market equilibrium. If it is above equilibrium, structural unemployment and deadweight loss are created and are permanently baked into the economy. If it is below, nothing really changes save for the laws on the books. In terms of economic impact, however, indexing would minimize people's loss aversion and create more fiscal certainty for workers, even beyond those who earn the minimum wage. It could also result in net gains in income for areas where the market conditions push wages below their productive value, such as in towns where a few companies employ the majority of the low-skilled workforce. Increasing certainty would also boost economic growth, as economic uncertainty causes people to spend less. It would also reduce the poverty rate by raising the real incomes of minimum or near-minimum wage earners.

In other words, indexing the minimum wage to inflation is an incomplete policy. On the one hand, raising the minimum wage too much creates permanent job losses and higher costs if the resulting wage is above the market one. On the other hand, not raising it at all reduces economic growth, sacrificing income gains in areas with low-skilled labor monopolies, and lower the chance of people moving out of poverty. These factors increase political pressure to raise the minimum wage to a level that is above the market rate, with all the economic problems that that implies. 

However, if the minimum wage index included a measure that took into account other economic factors such as structural unemployment or the market wage itself, the minimum wage could be adjusted to preserve its positive aspects without causing major market distortions. Furthermore, the data to quantify these factors is already available from state and federal government statistical agencies such as the U.S. Census and the Bureau of Labor Statistics. Indeed, any number of different publicly-available economic indicators can be experimented with to find the right balance between efficiency and certainty. 

Here is one possible index that ties the minimum wage to the state’s employment rate and inflation rate. Arizona’s current indexed minimum wage simply multiplies the current minimum wage by the preceding year’s inflation rate and adds that onto wage. If that rate could be subtracted from the state’s employment rate, it would allow the minimum wage rate to grow faster in times of high inflation but low unemployment and slow or stop growth in times of low inflation and high unemployment. It would also prevent it from exacerbating wage-price spirals in times of high unemployment and high inflation. However, in a deflationary scenario where prices fall, this same trigger would cause wages to fall, which would disproportionately hurt minimum-wage workers by lowering their real incomes and by increasing the poverty rate. To prevent this scenario, an arbitrary cut-off point could be placed where the minimum wage stays the same during a deflationary period. By keeping the wage the same, the proposed index would then increase the effects on job numbers, and the broader economy in a deflationary period would be minimized while at the same protecting the incomes of minimum-wage workers and preventing an increase in the poverty rate. In all cases, the wage would rise more in tune with the market’s demand for labor than it otherwise would with just inflation.

Another possible solution could be introducing an independent commission styled on the Federal Reserve to study and control the inflation index. In this scenario, a non-partisan group made of economists and community stakeholders would be able to study how any potential changes in the wage would affect low-skilled workers, businesses, and the economy as a whole. This method would allow professional input onto what would otherwise be a mechanical rate increase and allow for unforeseen circumstances to be taken into account. Furthermore, it would also help to diffuse the potential for politically motivated increases in the minimum wage, which can be arbitrary, unpredictable, and divisive.

In both cases, if these changes were implemented in Arizona, minimum wage increases would likely be more modest, both minimizing its negative impact on employment and wages and maximizing its power to preserve incomes and consumer spending. Finally, they would keep the minimum wage from constantly being a major political football.

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