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Optimal Minimum Wage Policy in Competitive Labor Markets

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  • David Lee

    (Princeton University and NBER)

  • Emmanuel Saez

    (University of California, Berkeley and NBER)

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    Abstract

    This paper provides a theoretical analysis of optimal minimum wage policy in a perfectly competitive labor market. We show that a binding minimum wage—while leading to unemployment—is nevertheless desirable if the government values redistribution toward low wage workers and if unemployment induced by the minimum wage hits the lowest surplus workers first. This result remains true in the presence of optimal nonlinear taxes and transfers. In that context, a minimum wage effectively rations the low skilled labor that is subsidized by the optimal tax/transfer system, and improves upon the second-best tax/transfer optimum. When labor supply responses are along the extensive margin, a minimum wage and low skill work subsidies are complementary policies; therefore, the coexistence of a minimum wage with a positive tax rate for low skill work is always (secondbest) Pareto inefficient. We derive formulas for the optimal minimum wage (with and without optimal taxes) as a function of labor supply and demand elasticities and the redistributive tastes of the government. We also present some illustrative numerical simulations.

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    Bibliographic Info

    Paper provided by Princeton University, Department of Economics, Center for Economic Policy Studies. in its series Working Papers with number 1099.

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    Date of creation: Sep 2008
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    Handle: RePEc:pri:cepsud:178lee

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    1. Dolado, Juan J. & Felgueroso, Florentino & Jimeno, Juan F., 2000. "The Role of the Minimum Wage in the Welfare State: An Appraisal," IZA Discussion Papers 152, Institute for the Study of Labor (IZA).
    2. Robin Boadway & Katherine Cuff, 1999. "A Minimum Wage can be Welfare-Improving and Employment-Enhancing," Working Papers 980, Queen's University, Department of Economics.
    3. Emmanuel Saez, 2002. "Optimal Income Transfer Programs: Intensive Versus Extensive Labor Supply Responses," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1039-1073, August.
    4. Diamond, P., 1980. "Income taxation with fixed hours of work," Journal of Public Economics, Elsevier, vol. 13(1), pages 101-110, February.
    5. David Neumark & William Wascher, 2006. "Minimum Wages and Employment: A Review of Evidence from the New Minimum Wage Research," NBER Working Papers 12663, National Bureau of Economic Research, Inc.
    6. Hungerbühler, Mathias & Lehmann, Etienne, 2009. "On the optimality of a minimum wage: New insights from optimal tax theory," Journal of Public Economics, Elsevier, vol. 93(3-4), pages 464-481, April.
    7. Cahuc, P. & Saint-Martin, A. & Zylberberg, A., 2001. "The consequences of the minimum wage when other wages are bargained over," European Economic Review, Elsevier, vol. 45(2), pages 337-352, February.
    8. Tomer Blumkin & Efraim Sadka, 2005. "Income Taxation and Wage Policy: An Application to Minimum Wage," International Tax and Public Finance, Springer, vol. 12(6), pages 713-722, November.
    9. Emmanuel Saez, 2002. "Direct or Indirect Tax Instruments for Redistribution: Short-run versus Long-run," NBER Working Papers 8833, National Bureau of Economic Research, Inc.
    10. Acemoglu, Daron, 2001. "Good Jobs versus Bad Jobs," Journal of Labor Economics, University of Chicago Press, vol. 19(1), pages 1-21, January.
    11. James B. Rebitzer & Lowell J. Taylor, 1991. "The Consequences of Minimum Wage Laws: Some New Theoretical Ideas," NBER Working Papers 3877, National Bureau of Economic Research, Inc.
    12. Dreze, Jacques H. & Gollier, Christian, 1993. "Risk sharing on the labour market and second-best wage rigidities," European Economic Review, Elsevier, vol. 37(8), pages 1457-1482, December.
    13. Thomas Piketty, 1997. "La redistribution fiscale face au chômage," Revue Française d'Économie, Programme National Persée, vol. 12(1), pages 157-201.
    14. Philippe Chone & Guy Laroque, 2001. "Optimal Incentives for Labor Force Participation," Working Papers 2001-26, Centre de Recherche en Economie et Statistique.
    15. Swinnerton, Kenneth A, 1996. "Minimum Wages in an Equilibrium Search Model with Diminishing Returns to Labor in Production," Journal of Labor Economics, University of Chicago Press, vol. 14(2), pages 340-55, April.
    16. Atkinson, A. B. & Stiglitz, J. E., 1976. "The design of tax structure: Direct versus indirect taxation," Journal of Public Economics, Elsevier, vol. 6(1-2), pages 55-75.
    17. Maya Bacache-Beauvallet & Etienne Lehmann, 2008. "Minimum wage or negative income tax: why skilled workers may favor wage rigidities," Spanish Economic Review, Springer, vol. 10(1), pages 63-81, March.
    18. Cahuc, Pierre & Michel, Philippe, 1996. "Minimum wage unemployment and growth," European Economic Review, Elsevier, vol. 40(7), pages 1463-1482, August.
    19. Allen, Stephen P, 1987. "Taxes, Redistribution, and the Minimum Wage: A Theoretical Analysis," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 477-89, August.
    20. Guesnerie, Roger & Roberts, Kevin, 1987. "Minimum wage legislation as a second best policy," European Economic Review, Elsevier, vol. 31(1-2), pages 490-498.
    21. Mirrlees, James A, 1971. "An Exploration in the Theory of Optimum Income Taxation," Review of Economic Studies, Wiley Blackwell, vol. 38(114), pages 175-208, April.
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    Cited by:
    1. Chetty, Nadarajan, 2009. "Sufficient Statistics for Welfare Analysis: A Bridge Between Structural and Reduced-Form Methods," Scholarly Articles 9748528, Harvard University Department of Economics.
    2. Lee, David & Saez, Emannuel, 2010. "Optimal Minimum Wage Policy in Competitive Labor Markets," Institute for Research on Labor and Employment, Working Paper Series qt07w2z7t6, Institute of Industrial Relations, UC Berkeley.

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