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What's the best way to help the poor?

There has been a recent debate among economists about whether the minimum wage and the Earned Income Tax Credit (EITC) are "complements" or "substitutes." That question might seem arcane, but the answer is important in figuring how to help poor families while also boosting the economy.

What are complements and substitutes? Complements are goods that tend to be purchased together – when the purchase of more of one type of good leads to an increase in the purchase of some other type of good. For example, French fries and ketchup, tennis rackets and tennis balls, cars and tires, golf balls and golf tees, and so on.

Substitutes are, as the name implies, goods that can to some extent be used interchangeably. Pepsi and Coke, potatoes and rice, different brands of butter, and jam and jelly are generally viewed as interchangeable. If, for example, the price of Coke increased substantially, then even diehard Coke drinkers would be tempted to switch to Pepsi.

 An easy way to classify a pair of goods as substitutes or complements is to examine how purchases change if the price of one of the goods goes up. If, when the price of one good goes up there is an increase in the purchases of some other good, then those goods are substitutes – one was substituted for the other due to the increase in price. For example, if the price of beef goes up we might observe a decrease in the consumption of beef and an increase in the purchase of chicken.

But if an increase in the price on one good leads to a decrease in the purchase of some other good, then the goods are complements. An increase in the price of skis might, for example, lead to a reduction in the purchase of both skis and ski boots.

Recently, this has been applied to the debate over the minimum wage versus EITC, a government program to raise the income of poor Americans. The question is whether the EITC is a substitute for the minimum wage – a superior approach to the minimum wage according to many – or complementary. 

 But this is not actually a question about substitutes and complements. We are not asking whether an increase in the “price” of the minimum wage leads to an expansion or contraction in the EITC. Instead, this is a question about whether we can help lower income individuals best by either the minimum wage or the EITC alone, or whether we can do better by providing some combination of both types of aid to low income households.

The answer to this question is controversial. Many people believe that the EITC alone is the best approach while others believe that some combination of both works best. For example, economist Arin Dube of the University of Massachusetts, well-known for his work in this area, says in an op-ed in the NY Times:

The minimum wage can also increase the efficacy of a policy that is sometimes pushed as a substitute: the earned-income tax credit. This encourages more people to seek work, but can push wages down; a minimum wage ameliorates this. Of course, many families under the poverty line simply have no workers, making any work-based policy of limited help. This is why raising and indexing the minimum wage is just a part of the portfolio of policies we need to enact to ensure a decent living standard.

Adds University of California, Berkeley economist Brad DeLong:

... I like the EITC. ... But the EITC is a program that uses the IRS to write lots of relatively small checks to tens of millions of relatively poor people who satisfy picky eligibility rules. This is not the IRS's comparative advantage. ... The EITC is a good program, but it a costly program to administer, and it is administered imperfectly to say the least.

The minimum wage, on the other hand, is nearly self-enforcing: its administrative costs are nearly nil, for workers (legal workers, at least) have a very strong incentive to drop a dime on bosses who violate it. From a government-administrative and error-rate perspective, it's a very cost-effective program.

The right solution, of course, is balance: use the minimum wage as one part of your program of boosting the incomes of the working poor, and use the EITC as the other part. Try not to push either one to the point where its drawbacks (disemployment on the one hand, and administrative error on the other) grow large. Balance things at the margin.

However, there are dissenting voices. Argues Tyler Cowen, and economist at George Mason:

I’ve been hearing the argument again that the minimum wage and wage subsidies are complements.  According to this view, if you have only wage subsidies, employers will lower what they offer to the workers and capture too much of the value of the subsidy.  A higher minimum wage is supposed to prevent this from happening and thus ensure that workers capture more of the gains.

Even if you accept every premise of this argument,… the employment problem today is almost purely one of demand, not labor supply.  To spur more hiring, we therefore should wish the employers to capture more of the surplus. …

So a higher minimum wage and wage subsidies might be complements at some time period, but they should not be effective complements today. …

My view is that the minimum wage and the EITC work best in tandem, and that if we wish to spur hiring during recessions there are much better ways to do it than to allow employers to “capture more of the surplus,” -- that is, to keep more for themselves by paying workers less. A carefully designed tax credit, for example, or monetary and fiscal policy measures that spur demand would both promote employment without lowering the income of the most vulnerable households. That’s particularly important in a time of rising inequality.

Finally, apart from the economics, the politics of the minimum wage versus the EITC are also important. The costs of the minimum wage come mainly from higher prices (for example, an increase in the price of fast food, and a reduction in corporate profits), while an increase in the EITC is paid for mainly through increases in taxes.

For this and other reasons, an increase in the minimum wage appears to have more political support than an increase in the EITC. If we want to help low-income households, and if increasing both the EITC and the minimum wage is not politically possible, an increase in just one of these two legs of support – in this case an increase in the minimum wage – is better than doing nothing at all.