On Nov. 3, Washington State voters made economic history when they passed the first law to adjust the state minimum wage automatically for inflation every year. The law is likely to spur renewed action in Washington, D.C., where Democrats have been trying to index the federal minimum wage to consumer price hikes since the high-inflation 1970s. Senator Edward M. Kennedy (D-Mass.) proposed indexation when the minimum was lifted in 1996, but the proposal was dropped before the law passed. He's sure to try again now that there are more Democrats in the House and Republicans are desperate to appear more moderate.
Indexation makes sense for both economic and political reasons. Recent studies have found that raising the minimum wage means the loss of few, if any, jobs, as long as it isn't too dramatic an increase. And making the adjustment automatic would at last stop the decades of political bickering.
But while indexing the minimum wage would solve many political problems, linking future increases to the wrong peg--inflation--might create some new economic ones. In particular, the supply of low-end jobs might suffer.
Indexing proponents frequently advocate the Consumer Price Index (CPI) as a wage peg because it's the most obvious and convenient benchmark. The government, for example, uses the CPI to calculate annual cost-of-living increases for Social Security payments. Bottom-end workers living on the edge of poverty, proponents argue, need a similar cost-sensitive system.
But there's a good reason not to use inflation as a minimum-wage peg: Lifting up wages of bottom-end workers faster than those of middle-income employees could price some minimum-wage workers out of the market, particularly as the economy slows. In the 1980s and early 1990s, for example, the hourly wage of middle-income employees lagged behind inflation. If the minimum had risen over this period, it could have hurt the growth of low-skilled jobs. "Even economists who support a higher minimum worry about this," says Jared Bernstein, an economist at the Economic Policy Institute, a liberal think tank in Washington, D.C.
The ideal solution would be correlating wage gains to productivity gains. Tying the minimum to annual productivity hikes would cause the fewest economic distortions and would make the most economic sense. After all, if low-wage workers are more productive, employers can afford to pay them more. And the most logical approach would be to tie the legal minimum to the efficiency gains of low-wage industries, such as fast food.
Unfortunately, the productivity peg is a wobbly one. Government figures on industry-level productivity aren't very good, especially in hard-to-measure service jobs where many minimum-wage workers are employed.
LEVEL BEST. The next best thing, then, is to peg minimum-wage hikes to annual changes in average wages. That way, the fate of low-wage workers would be no worse than of those a few rungs up. If average workers manage to beat inflation, those on the bottom would do so, too. This would also be the least objectionable to employers of minimum-wage workers, since the increases would tend to be smaller (chart).
The most difficult indexing issue is picking the percentage of the average wage at which the minimum should be set. In other words, one wouldn't want to set a minimum so low that it would forever keep low-end wage earners in poverty. The Washington State referendum dealt with this by first raising the minimum to $6.50 in 2000 and then indexing it. Backers chose $6.50 because that's about the annual poverty line for a family of three today. However, it's still below the inflation-adjusted peak of $6.81 the minimum hit in 1968.
Proponents of an average-wage index suggest starting at 50% to 60% of the private-sector hourly rate. Economics offers little help on picking the right number, since no one has figured out how to tell at what level significant job losses would start to occur. Still, a solution is possible: Pick a compromise level, do the math, and put a stop to the endless battles.