Tag: national insurance thresholds

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Raising the minimum wage: its effects on poverty and employment

The first Budget of the new UK Labour government was announced on 30 October 2024. It contained a number of measures that will help to tackle inequality. These include extra spending on health and education. This will benefit households on lower incomes the most as a percentage of net income. Increases in tax, by contrast, will be paid predominantly by those on higher incomes. The Chart opposite (taken from the Budget Report) illustrates this. It shows that the poorest 10% will benefit from the largest percentage gain, while the richest 10% will be the only decile that loses.

But one of the major ways of tackling inequality and poverty was raising the minimum wage. The so-called ‘National Living Wage (NLW)’, paid to those aged 21 and over, will rise in April by 6.7% – from £11.44 to £12.41 per hour. The minimum wage paid to those aged 18 to 20 will rise 16.3% from £8.60 to £10.00 and for 16 and 17 year-olds and apprentices it will rise £18% from £6.40 to £7.55.

It has been an objective of governments for several years to relate the minimum wage to the median wage. In 2015, the Conservative Government set a target of raising the minimum wage rate to 60 per cent of median hourly earnings by 2020. When that target was hit a new one was set to reach two-thirds of median hourly earnings by 2024.

The Labour government has set a new remit for the minimum wage (NLW). There are two floors. The first is the previously agreed one, that the NLW should be at least two-thirds of median hourly earnings; the second is that it should fully compensate for cost of living rises and for expected inflation up to March 2026. The new rate of £12.41 will meet both criteria. According to the Low Pay Commission, ‘Wages have risen faster than inflation over the past 12 months, and are forecast to continue to do so up to March 2026’. This makes the first floor the dominant one: meeting the first floor automatically meets the second.

How effective is the minimum wage in reducing poverty and inequality?

Figure 1 shows the growth in minimum wage rates since their introduction in 1999. The figures are real figures (i.e. after taking into account CPI inflation) and are expressed as an index, with 1999 = 100. The chart also shows the growth in real median hourly pay. (Click here for a Powerpoint.)

As you can see, the growth in real minimum wage rates has considerably exceeded the growth in real median hourly pay. This has had a substantial effect on raising the incomes of the poorest workers and thereby has helped to reduce poverty and inequality.

The UK minimum wage compares relatively favourably with other high-income economies. Figure 2 shows minimum wage rates in 12 high-income countries in 2023 – the latest year for which data are available. (Click here for a PowerPoint.) The red bars (striped) show hourly minimum wage rates in US dollars at purchasing-power parity (PPP) rates. PPP rates correct current exchange rates to reflect the purchasing power of each country’s currency. The blue bars (plain) show minimum wage rates as a percentage of the median wage rate. In 2023 the UK had the fourth highest minimum wage of the 12 countries on this measure (59.6%). As we have seen above, the 2025 rate is expected to be 2/3 of the median rate.

Minimum wages are just one mechanism for reducing poverty and inequality. Others include the use of the tax and benefit system to redistribute incomes. The direct provision of services, such as health, education and housing at affordable rents can make a significant difference and, as we have seen, have been a major focus of the October 2024 Budget.

The government has been criticised, however, for not removing the two-child limit to extra benefits in Universal Credit (introduced in 2017). The cap clearly disadvantages poor families with more than two children. What is more, for workers on Universal Credit, more than half of the gains from the higher minimum wages will lost because they will result in lower benefit entitlement. Also the freeze in (nominal) personal income tax allowances will mean more poor people will pay tax even with no rise in real incomes.

Effects on employment: analysis

A worry about raising the minimum wage rate is that it could reduce employment in firms already paying the minimum wage and thus facing a wage rise.

In the case of a firm operating in competitive labour and goods markets, the demand for low-skilled workers is relatively wage sensitive. Any rise in wage rates, and hence prices, by this firm alone would lead to a large fall in sales and hence in employment.

This is illustrated in Figure 3 (click here for a PowerPoint). Assume that the minimum wage is initially the equilibrium wage rate We. Now assume that the minimum wage is raised to Wmin. This will cause a surplus of labour (i.e. unemployment) of Q3 – Q2. Labour supply rises from Q1 to Q3 and the demand for labour falls from Q1 to Q2.

But, given that all firms face the minimum wage, individual employers are more able to pass on higher wages in higher prices, knowing that their competitors are doing the same. The quantity of labour demanded in any given market will not fall so much – the demand is less wage elastic; and the quantity of labour supplied in any given market will rise less – the supply is less wage elastic. Any unemployment will be less than that illustrated in Figure 3. If, at the same time, the economy expands so that the demand-for-labour curve shifts to the right, there may be no unemployment at all.

When employers have a degree of monopsony power, it is not even certain that they would want to reduce employment. This is illustrated in Figure 4: click here for a PowerPoint (you can skip this section if you are not familiar with the analysis).

Assume initially that there is no minimum wage. The supply of labour to the monopsony employer is given by curve SL1, which is also the average cost of labour ACL1. A higher employment by the firm will drive up the wage; a lower employment will drive it down. This gives a marginal cost of labour curve of MCL1. Profit-maximising employment will be Q1, where the marginal cost of labour equals the marginal revenue product of labour (MRPL). The wage, given by the SL1 (=ACL1) line will be W1.

Now assume that there is a minimum wage. Assume also that the initial minimum wage is at or below W1. The profit-maximising employment is thus Q1 at a wage rate of W1.

The minimum wage can be be raised as high as W2 and the firm will still want to employ as many workers as at W1. The point is that the firm can no longer drive down the wage rate by employing fewer workers, and so the ACL1 curve becomes horizontal at the new minimum wage and hence will be the same as the MCL curve (MCL2 = ACL2). Profit-maximising employment will be where the MRPL curve equals this horizontal MCL curve. The incentive to cut its workforce, therefore, has been removed.

Again, if we extend the analysis to the whole economy, a rise in the minimum wage will be partly passed on in higher prices or stimulate employers to increase labour productivity. The effect will be to shift the (MRPL) curve upwards to the right, thereby allowing the firm to pass on higher wages and reducing any incentive to reduce employment.

Effects on employment: evidence

There is little evidence that raising the minimum wage in stages will create unemployment, although it may cause some redeployment. In the Low Pay Commission’s 2019 report, 20 years of the National Minimum Wage (see link below), it stated that since 2000 it had commissioned more than 30 research projects looking at the NMW’s effects on hours and employment and had found no strong evidence of negative effects. Employers had adjusted to minimum wages in various ways. These included reducing profits, increasing prices and restructuring their business and workforce.

Along with our commissioned work, other economists have examined the employment effects of the NMW in the UK and have for the most part found no impact. This is consistent with international evidence suggesting that carefully set minimum wages do not have noticeable employment effects. While some jobs may be lost following a minimum wage increase, increasing employment elsewhere offsets this. (p.20)

There is general agreement, however, that a very large increase in minimum wages will impact on employment. This, however, should not be relevant to the rise in the NLW from £11.44 to £12.41 per hour in April 2025, which represents a real rise of around 4.5%. This at worst should have only a modest effect on employment and could be offset by economic growth.

What, however, has concerned commentators more is the rise in employers’ National Insurance contributions (NICs) that were announced in the Budget. In April 2025, the rate will increase from 13.8% to 15%. Employers’ NICs are paid for each employee on all wages above a certain annual threshold. This threshold will fall in April from £9100 to £5000. So the cost to an employer of an employee earning £38 000 per annum in 2024/25 would be £38 000 + ((£38 000 – £9100) × 0.138) = £41 988.20. For the year 2025/26 it will rise to £38 000 + ((£38 000 – £5000) × 0.15) = £42 950. This is a rise of 2.29%. (Note that £38 000 will be approximately the median wage in 2025/26.)

However, for employees on the new minimum wage, the percentage rise in employer NICs will be somewhat higher. A person on the new NLW of £12.41, working 40 hours per week and 52 weeks per year (assuming paid holidays), will earn an annual wage of £25 812.80. Under the old employer NIC rates, the employer would have paid (£25 812.80 + (£25 812.80 – £9100) × 0.138) = £28 119.17. For the year 2025/26, it will rise to £25 812.80 + ((£25 812.80 – £5000) × 0.15) = £28 934.72. This is a rise of 2.90%.

This larger percentage rise in employers’ wage costs for people on minimum wages than those on median wages, when combined with the rise in the NLW, could have an impact on the employment of those on minimum wages. Whether it does or not will depend on how rapid growth is and how much employers can absorb the extra costs through greater productivity and/or passing on the costs to their customers.

Articles

UK Government reports and information

Data

Questions

  1. How is the October 2024 Budget likely to affect the distribution of income?
  2. What are the benefits and limitations of statutory minimum wages in reducing (a) poverty and (b) inequality?
  3. Under what circumstances will a rise in the minimum wage lead or not lead to an increase in unemployment?
  4. Find out what is meant by the UK Real Living Wage (RLW) and distinguish it from the UK National Living Wage (NLW). Why is the RLW higher?
  5. Why is the median wage rather than the mean wage used in setting the NLW?
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A Spring dose of fiscal policy

On March 23, Rishi Sunak, the UK’s Chancellor of the Exchequer, delivered his Spring Statement, in which he announced changes to various taxes and grants. These measures were made against the background of rising inflation and falling living standards.

CPI inflation, currently at 6.2%, is still rising and the Office for Budget Responsibility forecasts that inflation will average 7.4% this year. The poor spend a larger proportion of their income on energy and food than the rich. With inflation rates especially high for gas, electricity and basic foodstuffs, the poor have been seen their cost of living rise by considerably more than the overall inflation rate.

According to the OBR, the higher inflation, by reducing real income and consumption, is expected to reduce the growth in real GDP this year from the previously forecast 6% to 3.8% – a much smaller bounce back from the fall in output during the early stages of the pandemic. Despite this growth in GDP, real disposable incomes will fall by an average of £488 per person this year. As the OBR states:

With inflation outpacing growth in nominal earnings and net taxes due to rise in April, real living standards are set to fall by 2.2 per cent in 2022/23 – their largest financial year fall on record – and not recover their pre-pandemic level until 2024/25.

Fiscal measures

The Chancellor announced a number of measures, which, he argued, would provide relief from rises in the cost of living.

  • Previously, the Chancellor had announced that national insurance (NI) would rise by 1.25 percentage points this April. In the Statement he announced that the starting point for paying NI would rise from a previously planned £9880 to £12 570 (the same as the starting point for income tax). This will more than offset the rise in the NI rate for those earning below £32 000. This makes the NI system slightly more progressive than before. (Click here for a PowerPoint of the chart.)
  • A cut in fuel duty of 5p per litre. The main beneficiaries will be those who drive more and those with bigger cars – generally the better off. Those who cannot afford a car will not benefit at all, other than from lower transport costs being passed on in lower prices.
  • The 5% VAT on energy-saving household measures such as solar panels, insulation and heat pumps will be reduced to zero.
  • The government’s Household Support Fund will be doubled to £1bn. This provides money to local authorities to help vulnerable households with rising living costs.
  • Research and development tax credits for businesses will increase and small businesses will each get another £1000 per year in the form of employment allowances, which reduce their NI payments. He announced that taxes on business investment will be further cut in the Autumn Budget.
  • The main rate of income tax will be cut from 20% to 19% in two years’ time. Unlike the rise in NI, which only affects employment and self-employment income, the cut in income tax will apply to all incomes, including rental and savings income.

Fiscal drag

The Chancellor announced that public finances are stronger than previously forecast. The rapid growth in tax receipts has reduced public-sector borrowing from £322 billion (15.0 per cent of GDP) in 2020/21 to an expected £128 billion (5.4 per cent of GDP) in 2021/22, £55 billion less than the OBR forecast in October 2021. This reflects not only the growth in the economy, but also inflation, which results in fiscal drag.

Fiscal drag is where rises in nominal incomes mean that the average rate of income tax rises. As tax thresholds for 2022/23 are frozen at 2021/22 levels, a greater proportion of incomes will be taxed at higher rates and tax-free allowances will account for a smaller proportion of incomes. The higher the rate of increase in nominal incomes, the greater fiscal drag becomes. The higher average rate of tax drags on real incomes and spending. On the other hand, the extra tax revenue reduces government borrowing and gives the government more room for extra spending or tax cuts.

The growth in poverty

With incomes of the poor not keeping pace with inflation, many people are facing real hardship. While the Spring Statement will provide a small degree of support to the poor through cuts in fuel duty and the rise in the NI threshold, the measures are poorly targeted. Rather than cutting fuel duty by 5p, a move that is regressive, removing or reducing the 5% VAT on gas and electricity would have been a progressive move.

Benefits, such as Universal Credit and the State Pension, are uprated each April in line with inflation the previous September. When inflation is rising, this means that benefits will go up by less than the current rate of inflation. This April, benefits will rise by last September’s annual inflation rate of 3.1% – considerably below the current inflation rate of 6.2% and the forecast rate for this year of 7.4%. This will push many benefit recipients deeper into poverty.

One measure rejected by Rishi Sunak is to impose a temporary windfall tax on oil companies, which have profited from the higher global oil prices. Such taxes are used in Norway and are currently being considered by the EU. Tax revenues from such a windfall tax could be used to fund benefit increases or tax reductions elsewhere and these measures could be targeted on the poor.

Articles

OBR data and analysis

Questions

  1. Are the changes made to national insurance by the Chancellor progressive or regressive? Could they have been made more progressive and, if so, how?
  2. What are the arguments for and against cutting income tax from 20% to 19% in two years’ time rather than reversing the current increases in national insurance at that point?
  3. What will determine how rapidly (if at all) public-sector borrowing decreases over the next few years?
  4. What are automatic fiscal stabilisers? How does their effect vary with the rate of inflation?
  5. Examine the public finances of another country. Are the issues similar to those in the UK? Recommend fiscal policy measures for your chosen country and provide a justification.