Tuesday, July 21, 2015

Ceilings, Floors, Taxes, Subsidies and Inequality, Oh my!

In popular economics and the field as a whole inequality is one of the hot button issues everyone has emotions about and thinks about. The question of how to deal with such inequality is one of the big questions in economics, with a lot of questions about how to weigh the costs and the benefits of each, along with understanding what things we view as costs and benefits is at issue as well. There are of course several major ways people deal with inequality, the most popular being the minimum wage and progressive income tax. These do reduce inequality, but have other effects as well.

So, basic economic theory uses the supply and demand diagram to analyze the effects of various policies. The minimum wage is one of the most studied as a way of introducing this concept to people new to the subject so I will start there. The minimum wage is a price floor, meaning that it then is illegal for a firm or individual to pay someone less than that amount. The line in the following diagram demonstrates what this creates:

This diagram clearly demonstrates what we generally find is the effect of a minimum wage. First of all we observe a raise in the wage, which is of course the goal, but this isn't free and comes at the cost of unemployment. At a minimum wage above the equilibrium (where supply meets demand) more people are willing to work (the supply of labor) than people are willing to hire them. This creates unemployment. While it does increase wages it does so at a real cost.

The idea of a maximum wage has the opposite problem, for the same reason. Capping CEO salaries means the number of firms seeking high value added individuals cannot find enough individuals with those skills to match market demand, meaning a reduction in productivity.
This is similar to the idea proposed to Milton Friedman of the Earned Income Tax Credit. We can raise real incomes to the same level as we could do with a minimum wage but we get an increase in labor which means a reduction in unemployment and a bigger overall boost to the economy and reduction in inequality than we would have with a minimum wage (assuming the funds to fund such a plan are done in a reasonable way). Imagine if you can make your pie and eat it to? Welcome to the world of the EITC.
Finally, because this post couldn't be complete without it is the impacts of an income tax. It increases the cost of hiring for firms as well as reducing overall income employees receive. The overall number of workers at this new point is lower than it would have had at equilibrium creating a reduction in the work force. (which is technically different from unemployment) The only other question remaining is what the government does with the revenue in who will ultimately benefit from such policies.

There you are, the four major ways the government can effect the labor market with taxes, subsidies, floors and ceilings.

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