Minimum Wage Indexation

Picture: Carol Simpson

Currently in the US, President Obama and other Democrats are proposing a rise in the (federal) minimum wage, with the minimum wage to be indexed to inflation thereafter. In the US, because the minimum wage is adjusted infrequently - the last increase was in 2009 – the pattern of the real value of the minimum wage (i.e. the minimum wage adjusted for the cost of living) in the US has been for it to increase sharply, and then to decrease for years at a time. The current proposal would make the real value of the minimum wage more stable than it has been in the past.

While this proposal would enable the value of the minimum wage to keep up with the cost of living, it also means that the minimum wage would likely fall, on average, relative to the wages of other workers in the medium to long term. Average wages should grow faster than inflation over the medium to long term because: a) one would normally expect labour productivity to increase over time; and b) one would normally expect average real wages to broadly increase in line with increases in labour productivity (warning: this does not always happen). If the minimum wage is only being indexed to changes in the cost of living (i.e. real minimum wages are constant), then increases in the minimum wage are not capturing any of the increases in the productivity of minimum wage workers.

In Australia, there are a few commonly used measures of changes in average wages. One measure is the Wage Price Index (WPI), which measures ‘wage inflation’; that is, the average changes in wages abstracting from changes in hours worked or the composition of the workforce. Other common measures are average weekly ordinary time earnings for full-time adults (“AWOTE”) and average weekly earnings. These two measures are affected both by changes in hours worked (less so for the full-time AWOTE measure) and changes in workforce composition. If average hours worked are increasing, or the workforce is shifting towards working in higher-paid occupations, then these measures would be expected to increase at a faster rate than the WPI over the medium to long term. So if minimum wages in Australia were indexed to the WPI, we would still expect minimum wages to fall relative to average wages, albeit the drop would probably not be nearly as much as if they were just indexed to inflation. 

All these points are summarised in the table below:

Indexation method	Real minimum wages	Accounts for:	Does not account for:
Consumer price inflation	Remain constant	Increases in prices	Increases in labour productivity   Increases in hours worked Shift towards higher-paid occupations
Wage Price Index (Australia)	Expected to increase	Increases in prices   Increases in labour productivity	Increases in hours worked   Shift towards higher-paid occupations
Average earnings	Expected to increase	Increases in prices   Increases in labour productivity   Increases in hours worked   Shift towards higher-paid occupations

As the graph below shows, in Australia increases in average weekly earnings and the WPI have, on average, been greater than increases in the Consumer Price Index in recent years. Increases in average earnings have also been greater than increases in the WPI, reflecting the shift towards higher-paid occupations. However, the other point to take away from the graph is that increases in the WPI are less volatile than increases in average earnings, which might make the WPI more palatable as a (hypothetical) indexation method for minimum wages.

Of course, average changes in the cost of living for minimum wage workers will not be exactly equal to changes in the cost of living across the population (though they will be close). And average changes in labour productivity for minimum wage workers will not be exactly equal to average changes in labour productivity for the rest of the workforce, and so on for hours worked, and shifts towards higher-paid occupations*. The main point to take away from all this though is that while indexing the minimum wage to inflation would allow it to keep up with the cost of living, we would expect that in the long run (assuming that labour productivity increases), the gap between the minimum wage and wages in the rest of the market would further increase.

*Indeed, one might argue it is not the best idea if part of the adjustment to the minimum wage for each occupation was a result of workers having shifted into higher-paid occupations (although you could still make the argument for doing so from a ‘relative living standards’ point of view). My main reason for mentioning these shifts though is just to point out that they have an effect on boosting average wages, and therefore on lowering the relativities between minimum and average wages.