Minimum wages and living wages: what happens in times of inflation?

It is widely accepted that minimum wages are an effective way to help workers at the lower end of the income distribution without damaging their job opportunities. But while the UK’s minimum wage has risen faster than the rate of inflation over the past two decades, it is now falling behind.

The UK – like most high-income countries – has a minimum wage, which sets the lowest legal hourly wage an employer can pay to workers. Since April 2022, the UK’s minimum wage has been £9.50 for those aged over 23. But it is lower for younger workers: for example, those aged under 18 are only guaranteed £4.81 per hour.

But as the cost of living is going up, workers’ wages, especially those on the minimum wage, are being squeezed. In real terms – in other words, adjusted for inflation – pay excluding bonuses dropped by 2.8% in March to May 2022 compared with the previous year, according to new data from the Office for National Statistics (ONS). This was a record decline.

Why do countries have minimum wages?

Two reasons: economics and politics. On the economic side, a minimum wage can help to prevent the exploitation of vulnerable workers by unscrupulous employers. It can also help to reduce wage inequality and poverty.

A minimum wage cannot be used to eliminate poverty on its own. It is an hourly wage and many people are in poverty because they work few or no hours. Whether a household is in poverty also depends on the number of people in the household and how much they earn. Nevertheless, it is a useful part of the policy toolkit to address poverty.

Politics also matters. The minimum wage is popular with the public, and so political parties tend to support it. For example, a September 2021 opinion poll found that two-thirds of people in the UK supported a policy of ‘the minimum wage rising gradually over the next few years to £15 an hour’. Even though the minimum wage is often thought of as a ‘left-wing’ policy, majorities of Conservative voters also support rises in it.

Many people think there is something very wrong with an economic system in which someone who works hard is still unable to provide an adequate standard of living for themselves and their families.

Are there downsides to the minimum wage?

The main concern that economists have is that there may be job losses if the minimum wage is set at too high a level. Firms will only employ workers if they think that the value of what they produce is greater than what the worker costs. If the minimum wage makes labour too expensive, there will be fewer jobs.

But how high can the minimum wage go before we start to see job losses? Economists disagree on the answer to this question. Thirty years ago, most economists would have said that any level of the minimum wage inevitably costs jobs as they believed that it is a basic principle of economics that the demand for labour always falls as wages rise.

Today, many – though not all – economists think that this view is over-simplistic and that appropriate levels of the minimum wage need not cause job losses. What changed minds was partly the research of two economists in the United States: David Card and Alan Krueger.

They argued that the empirical evidence linking the minimum wage to job losses was weak. The influence of this work was one of the reasons that Card was a co-recipient of the 2021 Nobel Prize in economics. But there has also been a change in how many economists view labour markets.

The view that the minimum wage has to cost jobs is rooted in the view that the labour market is well-approximated by what, in economists’ jargon, is called ‘perfect competition’. In a perfectly competitive market, jobs are freely available so competition among employers for workers is intense and this drives wages up until they are equal to productivity. So any attempt to legislate higher wages makes some workers unprofitable.

In the hypothetical world of perfect competition, losing a job is no big deal because finding an identical job is no harder than discovering that the local Sainsbury’s is out of milk and going to Tesco instead. But that is not most people’s experience of labour markets.

The reality is that competition for workers is not as strong as many economists would have you believe. An employer who cuts wages will find that most employees are unhappy, but that few will just walk out the door.

It therefore follows that it makes economic sense for employers to pay workers less than the marginal worker adds to revenues. Now a minimum wage will not necessarily price the marginal worker out of his or her job, although most economists think this could happen if the minimum wage is too high.

What is the appropriate level of the minimum wage?

Even once we have decided to have a minimum wage, we need to decide on its level and what, if any variation, it should have.

The UK has taken a largely empirical approach to this question. Recommendations about the level of the minimum wage in the UK are made by the independent Low Pay Commission (LPC) and the recommendations are mostly, though not always, accepted by the government.

The LPC spends a lot of its time considering whether there is evidence that current levels of minimum wages cause job losses and, to date, they have found very little evidence that they have. As a result, the minimum wage has increased over time.

This is not just in nominal terms – the adult rate today is £9.50 per hour compared with £3.60 when it was introduced in 1999. This is almost 2.5 times as high. Figure 1 shows how it has changed over time.

In reality, this is a meaningless comparison; both prices and average wages have a risen a lot in the past 20 years. But the real value of the minimum wage – its purchasing power or the amount of goods and services that can be bought with it – has also increased as it has risen at a faster rate than prices over the past two decades.

But in July 2022, the rise in the minimum wage was lower than the rate of inflation. The real value of the minimum wage today is 1.5 times the level it was in 1999. And its real value has risen faster than average earnings, which have grown by only 25% over the same period.

Figure 1: Wage progression, 2000-2022

Source: Low Pay Commission report, 2021

This means that the minimum wage has risen as a percentage of average earnings from to 42% in 1999 to close to 60% today. Since 2016, the government has given the LPC a target for the minimum wage of two-thirds of average earnings by 2024, taking economic conditions into account. To date, we are on track for this. If we meet the target, the UK will have one of the highest minimum wages in the world as a percentage of average earnings.

Others want to go further and faster. In Autumn 2021, there was a debate over whether a £15 minimum wage was feasible. If introduced now, this would be very close to median hourly earnings, affecting 50% of workers. The minimum wage is the main reason that wage inequality at the bottom end of the distribution is lower now than it has been for over 40 years (the top of the distribution is another story).

What is the difference between a minimum wage and a living wage?

When first introduced, the UK’s minimum wage was called the National Minimum Wage. Since 2016, the adult minimum wage has been called the National Living Wage. What is in the name change from ‘minimum’ to ‘living’ wage?

There are two main traditional differences between minimum and living wages. First, there is the way in which they are computed. The idea behind the living wage is a simple one: to determine the wage rate necessary to ‘ensure that households earn enough to reach a minimum acceptable living standard as defined by the public’.

Currently the living wage computed by the Resolution Foundation for 2020/21 is £11.05 inside London and £9.90 outside (reflecting differences in the cost of living). The living wage need not be the same as the highest minimum wage that does not cause job losses. This is because market economies do not, on their own, guarantee that all people will be able to find an employer prepared to pay them a wage that gives them the opportunity to earn a decent standard of living for them and their family.

The second difference between the minimum wage and the living wage is that while employers are legally obliged to pay the minimum wage, the living wage is intended as a voluntary minimum wage for employers who feel able to pay their workers more. Currently in the UK, 9,000 employers are formally accredited as living wage employers, covering over 300,000 workers. A voluntary living wage can raise wages for workers who do not directly benefit from the lower minimum wage.

But the difference between minimum wages and living wages was blurred by George Osborne’s 2016 decision to call the main adult minimum wage a living wage even though this living wage was neither voluntary nor based on an assessment of the income needed to live.

As a result, what was the living wage is now known as the real living wage. It is confusing, but testament to the view that minimum and living wages, once very controversial, are here to stay and everyone wants to claim some of the credit.