Tax cuts, the minimum wage, and incidence

Posted by: Matt Nolan on: December 2, 2008

• In: Government Policy | Microeconomics | New Zealand Economics | Political economy
• 6 Comments

The Standard has been stating that tax cuts should be “fairer”. Now in principle I have no problem with things being “fairer” – however, defining what is fair very is subjective, and what the Standard sees as fair and what I see as fair might be different.

Still, both the Standard and No Right Turn go on to quantify what they feel is an injustice – the fact that a greater proportion of the tax cut will go to the wealthy. However, for what they are saying to be true, the wage everyone is paid following a tax cut must not change (or must change by the same lump sum) regardless of their current income – yet this is not the case.

Many moons ago we discussed tax incidence – I think it is time to run with this again, taking for granted some of the assumptions about the labour market that the Standard has provided us with over time.

Now I find this statistic misleading – however, it is a statistic that the good people at the Standard swear by, so I am willing to use it for this discussion.  As a result, I can take it that people at the Standard believe that the minimum wage is a significant determinant of wages for the “low skilled” – not just because it provides a direct floor, but because it drives up wage for other, unconstrained jobs, given that firms like to keep certain wage differentials.

Furthermore, the people at the Standard believe that a minimum wage does not decrease the employment of people in this bracket – again, I am taking them at their word on this.

Ok, so the “poor” have a wage that is strongly fixed by the minimum wage.  As a result, any tax cut will COMPLETELY flow into their pockets – as the minimum wage is a gross measure.  This implies that the low income people that the Standard discusses will receive the entire tax cut – as their gross wage will not change.

Now, people on higher incomes (where the minimum wage is not a relevant factor) will not receive the entire benefit of the tax cut.  Fundamentally, these people have some “bargaining power” and their employer has some bargaining power.  As a result, the tax cut “increases the surplus” associated with the persons employment, and as a result that surplus will be split between the employer and employee.  Ultimately, people on higher incomes will experience slower wage growth for a few years following the tax cut, until the additional surplus has been distributed.

As a result, according to the fundamental assumptions that the Standard makes about the labour market in New Zealand, the “gains” from the tax cut fall more heavily to the poor than their graph indicates.  Does this make the current tax cut appear more fair?

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