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James Galbraith: CBO Not Competent to Assess Economics of Minimum Wage

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James Galbraith: CBO Not Competent to Assess Economics of Minimum Wage

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Yves here. I’m delighted to see Jamie Galbraith take up the heavy lifting of debunking an obviously bogus CBO analysis attacked raising the minimum wage to $15 due to alleged large job losses and fall in Federal tax receipts. Galbraith points out that he isn’t attacking the CBO’s competence in the budget arena, although he readily could there. The CBO is not merely a deficit scaremonger; it regularly cooks its models to assure that Federal debt trees grow to the sky.

The CBO has repeatedly taken what amount to partisan positions and has skewed its analysis in gross violation of its own procedures to produce results that have had enormous impact on policy debates. We described a particularly egregious example in 2012, when two budget analysts at the Fed, as in unquestionably qualified to take on the CBO, took the unusual step of clearing their throats and depicting CBO Medicare cost projections as nonsense. Their article made clear that the CBO also violated its own procedures to come up with its estimates. From our post:

The fundamental beef of [Glenn] Follette and [Louise] Sheiner with the CBO model is that it naively assumes past growth in health care spending as the basis for its long-term projections. The result is that it shows that trees will grow to the sky. One of the things anyone who has built forecasting models will tell you is you come up with assumptions that look reasonable and then sanity check the output (for instance, does your model say in year 10 that your revenues will be 3x what you can produce given your forecast level in plant and investment? If so, you need to make some revisions). The Fed economists point out numerous ways that the model output flies in the face of what amounts to common sense in the world of long term budget forecasting. From the opening of the paper (emphasis ours):

Long-run projections of the U.S. federal budget have played a prominent role in discussions about fiscal policy and the design of major transfer programs for several decades. The projections typically show large fiscal imbalances owing to ramping up of retirement and health care costs relative to GDP. Health care costs are the key factor in these projections for two reasons. First, in current projections they are the prime source of growth of spending as a share of GDP. Second, they are the most uncertain part of the forecast. For example, the Congressional Budget Office’s most recent long run outlook shows spending on Medicare and Medicaid, the governments health programs for the old and poor, respectively, rising from 4.1 per cent of GDP in 2007 to 19.1 per cent of GDP in 2082.1 By contrast, Social Security benefits (the government’s main old-age pension program) increase only 2 percentage points, from 4.3 per cent of GDP in 2007 to 6.4 per cent in 2082. Another analysis by CBO suggests that an 80 per cent confidence band around the Social Security projection would be from 51⁄2 to 91⁄2 per cent of GDP.2 CBO did not present similar calculations for health spending; instead, they projected health spending under three different assumptions about the rate of growth of age-adjusted health care spending in excess of per capita income. Their projections show health spending ranging from 7 to nearly 40 per cent of GDP by 2082.

By comparison, defense spending as a percent of GDP peaked at 42% of GDP in World War II. A model that presents as a possible outcome that the US will devote nearly 40% of GDP to health care spending a long-term, sustained outcome, is ludicrous on its face. The CBO assuming public health care spending will sustain its growth rate of the last 50 years for as long as they do (see further discussion below) with no policy changes is like budget analysts in 1946 assuming that military spending will grow at the same rate it did during World War II without any policy changes. Yet they further assume that, having reached this crushing level, Medicare costs in 2082 will still be growing faster than GDP!

The CBO fully deserves the criticism that Galbraith levels at it, not just for being bad at economics, but also for operating in an openly partisan manner.

By James K. Galbraith, Lloyd M. Bentsen Jr. Chair in Government and Business Relations, University of Texas at Austin. Originally published at the Institute for New Economic Thinking website

Congressional Budget Office Report on the Raise the Wage Act of 2021 underpins a February 11 Washington Posteditorial headlined, “Democrats Must Listen to the Data.” The Postlaments that a $15 minimum wage would (according to CBO) eliminate about 1.4 million jobs when fully in effect, with half of the job losers leaving the workforce. Because of the projected fall in employment, the CBO also calculates that a $15 minimum wage would increase federal budget deficits by $54 billion dollars over ten years while adding $16 billion to federal interest costs.

This note examines the so-called data: should they be taken seriously as economics? Without in any way criticizing the competence of CBO’s budget analysts, the answer is clearly “no.” In particular, the CBO’s employment forecast is unsupported. As a result, its deficit forecast, though trivial in magnitude, is also unsound.

Much of the CBO report details the effects of an increase in the minimum wage on Medicare, the Affordable Care Act, SNAP, the Earned Income Tax Credit, and on tax revenues, which would increase due to higher payroll taxes on higher rates of pay. Some of this analysis is apparently novel and represents a significant advance on earlier CBO work in this area. However, the net estimated budget effects are small, since the total increases in spending are roughly offset by increases in tax revenue or reductions in tax expenditure. Of the cumulative estimated increase in the (on-budget) deficit, almost $53 billion are due to spending increases in just three areas: unemployment insurance, Medicaid, and CHIP. These expenses CBO attributes to its projection of job loss. The job loss projection is therefore the nub of CBO’s deficit projection, and it is important to understand how CBO arrived at its number.

The method is not explained in the CBO’s analysis, and a paper cited does not offer much explanation either. CBO merely states that it “has formed distributions of values for both wage growth and [employment] responsiveness” and “to generate an average estimate, CBO simulated a distribution of possible changes in employment by drawing randomly from these distributions.” The distributions themselves are said to be based on economic research, presumably academic research by labor economists.

The first problem is that the academic “literature” on which the distribution of estimates of an increase in the minimum wage is based is deeply uncertain and highly controversial. A predominance of studies are based on the simple idea that demand curves for labor slope downward, the proposition that with a higher average wage, fewer people necessarily will be employed. This is a textbook verity, often repeated, and beloved by business lobbies. But it is eminently doubtful in the real world. The real world is shot through with high unemployment in low-wage regions and fuller employment in high-wage regions, and it is also a fact, looking around the world, that more egalitarian regions have lower unemployment, generally, than less egalitarian regions.[1]

A second problem is that few if any studies can fairly assess the effect of a large increase in the minimum wage, which is a different animal from the average wage because no such large-scale increase has occurred in the record. Instead, academic studies generally confine themselves to projecting estimates from small changes that have been observed, out into an environment in which they provide little to no useful guidance. That is what CBO has also done here.

In any event, the minimum wage is a peculiar thing. It is very low and applies to a very small and marginalized fraction of the working population. Who are they? In the main, they are teenagers working a first job, women and minorities in low-income communities and regions, day laborers, and migrant workers. What happens to these workers when the minimum rises is far from clear since one must also take account of the effect on workers who make a bit more than the present minimum, whose pay will also be increased, many of whom are in the same families as minimum wage workers.

For instance, some young people in low-wage employments will find that their family incomes have gone up by enough to justify quitting their jobs and (say) returning to school. Others, working two or more jobs, will be able to reduce their hours or quit extra jobs with little or no loss of income. The fact that these low-wage workers may leave the workforce is a good thing, not a bad thing as both CBO and The Washington Post suggest.

As a famous study found,[2] some employers will increase their employment without even thinking about it, because with higher wages job turnover declines, there are fewer vacancies to fill, and such employers will make back part of what they lay out in higher wages through lower training costs. This is a characteristic situation facing fast-food restaurants, a major employer of low-wage teenagers. Some other employers, unable to recruit cut-rate illegal labor from across the border, will offer the same jobs at the higher wage to documented legal residents and US citizens. In these cases, legal employment will go up, not down.

Finally, some employers, perhaps a vast majority, will face an unchanged need for strawberry pickers or wait-staff, and will simply pay the higher wage. They won’t like it but they will do it. And they may find that what they pay out in higher wages, they make back because their customers have more money to spend. What is the net effect of these different forces? The literature cannot say.

The CBO study states that “when the cost of employing low-wage workers goes up, the relative cost of employing higher-wage workers or investing in machines and technology goes down.” This is another textbook verity that does not withstand scrutiny. High-wage labor is not a more-efficient substitute for low-wage labor at a checkout counter or in a burger joint. The entire reason that those jobs are low-wage is that they have been engineered to use people who have few skills, require little training, and are easily replaced! Filling the slots with college graduates does not make the checkout lines any shorter or the burgers any better.

As for machines, CBO’s assertion overlooks the fact that many low-wage people are employed in the business of making machines – if not on the assembly line, then in packing, distributing, cleaning the factory floors, and in many other essential occupations. It is therefore not obvious that raising minimum wages across the board makes machines cheaper – even if there is a good automated substitute for human hands, which there often is not. Further and finally, when such a substitute does exist, it is often no less competitive with labor at $7.25 as at $15. Machines do not shirk, strike, or talk back.

What will happen to jobs when the minimum wage goes up? The truth is that CBO does not know. Its estimates are a hotchpotch of guesses, entirely without serious basis in either fact or theory. They were crafted, one may credibly suspect, to conform to an irrelevant body of textbook doctrine, so as to minimize criticism from people who write and read textbooks, and political figures who pretend to believe them. One can understand this impulse without sympathizing with it.

Since the unemployment estimate drives the deficit estimate, that too should be disregarded. Still, it is worth noting that CBO’s number, $54 billion in increased deficits over ten years, is tiny by present standards. The federal budget deficit for 2020 alone is estimated at $3,300 billion, so the estimated annualized increase in the budget deficit from raising the minimum wage to $15 per hour is less than two-tenths of one percent of the actual deficit last year. Even if the estimate were valid, which it isn’t, it is of no economic significance and the claim that it might lead to a rise of interest rates is entirely preposterous on that ground alone. CBO has a long track record of predicting increases in interest rates that never happened; this is just another bad forecast in that line.

 

A final issue concerns CBO’s assumption that the growth of nominal GDP (real growth plus inflation) would be unchanged by the increase in the minimum wage. The assumption of unchanged nominal GDP growth is a feature of CBO projections generally, not particular to this report, it is useful for standardizing comparisons of different legislative proposals. But because in this case income would shift toward lower-income families, CBO also predicts that “total demand for goods and services would increase for several years, boosting overall real output.”

In other words, raising the minimum wage is good for the economic growth rate! But if nominal GDP is constant while realGDP is higher, it is mathematically necessary that the rate of inflation must be falling under these projections, relative to the CBO baseline. So we have the following predictions all bundled together: higher wage costs, higher interest rates, more economic growth, but fewer jobs and lower price increases. The story makes no sense at all.

The Congressional Budget Office performs a useful function, in ordinary times, by estimating the budget consequences of spending and tax legislation on the basis of standardized economic projections. These projections are not proper forecasts of the economic future and should not be treated as such. But it is within CBO’s competence to use them as a common baseline for assessing the size of various tax and spending measures, and that is the legitimate function of the CBO.

An analysis of a major increase in the minimum wage is different. CBO can correctly analyze some of the mechanical consequences of such a measure, and it does so in this report. Those consequences include a major increase in the total income of low-income families, especially minorities, a large reduction in poverty, an increase in total demand for goods and services, higher payroll tax revenues, and changes in eligibility for and use of various federal programs in health care, nutrition, and the EITC. None of these, taken together, have much net effect on the budget.

As for the effect on jobs, CBO does not know. Its estimate has no valid foundation. Its deficit score for the fifteen-dollar minimum wage is therefore also meaningless. The blatant contradictions, cited above, in the macroeconomic inferences concerning the Raise the Wage Act are sufficient proof that CBO should not have published this report, and no one should rely on it.

Notes

[1] James K. Galbraith and Enrique Garcilazo, “Unemployment, Inequality and the Policy of Europe, 1984-2000,” Banca Nazionale del Lavoro Quarterly Review, Vol LVII, No. 228, March 2004, 3-28.

[2] David Card and Alan Krueger, Myth and Measurement, Princeton: Princeton University Press, 1995.

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