All Commentary
Tuesday, November 29, 2016

Stay East, Young Man

Today's reality for Puerto Rico is the prospect for the California economy.

I am an Enrolled Agent tax pro based in California with clients all over the country. Recently, the son of a client who had moved to a more free state than ours asked whether I thought he should move back here to start a business.

I suggested not. Why?

The Competition Here

Businesses must compete with other businesses. Some only have local competition, such as most grocery stores. Large stores in a market have a huge advantage over small ones by being able to move much greater volume. They can afford either to pay higher wages or to purchase labor-saving machinery, such as scanners and self-checkout lanes, which will help them avoid paying those higher wages. But startups are much less likely to be able to do either, whether to pay these higher wages or to purchase labor-saving machines and equipment.

Other businesses have national and international competition. Nationally, my budding young entrepreneurial client will be competing with employers in other states who can pay as little as $7.25 per hour. Not that many do so, but they clearly can pay less and hire more where the cost of living is so much lower. Internationally, he will be competing with employers in emerging economies where capital hasn’t been around long enough to make good economic sense of paying the same wages as Hong Kong, Singapore or the United States.

The Minimum-Wage Prospects Here

While California suffers from the highest income tax rate in the country and mountains of regulations that cause everything from housing costs to the price of power to be among the highest, the most destructive regulation of all is arguably an up-and-coming one. It mandates annual increases in the minimum prices of wages. They will go from $10.50 to $15 per hour in five years – a nearly 50% increase, which will end up at twice the current national minimum wage. 

As government demands higher minimum prices for labor, more workers will be priced out of jobs. Many currently employed workers will become unemployable at the higher mandated wages in California. And this will affect those currently earning higher wages: as they see lower-skilled workers earning as much as they do, they will demand even higher wages and increasingly price themselves out of jobs, too.

Today’s reality for Puerto Rico is the prospect for the California economy.Government-imposed mandates do not create wealth. Instead, they create a misallocation of resources. For example, a minimum mandated price for cars would eliminate the economic demand for many of the cheaper models, leaving only the more upscale cars on the market. Think of an unskilled young person as one of those cheaper models, and 40- to 60-year olds as upscale models. Under minimum prices of wages, the unskilled, the newly sober, the recently-released felon, and those re-entering the workforce for other reasons (such as raising children) are reallocated from starter jobs where they can acquire basic job skills, to the unemployment line. And because less is produced, lower overall aggregate living standards are the long-term result.

The higher the mandated minimum relative to median wages, the greater is the damage. Puerto Rico offers a shining example. Its minimum wage is the same as the US minimum, $7.25 per hour; that is 77% of the Puerto Rico median wage. One-third of Puerto Ricans earn that minimum wage. At the same time, Puerto Rican employers are required to provide 15 days of vacation and 12 sick days annually, equivalent to an 11% increase in the minimum wage, on top of the cost of worker-related administrative burdens and risk of lawsuits for labor law violations. Not surprisingly, the labor force participation rate – the percent of able-bodied adults working – is only 40-43%. All this in an economy where the annual per capita income is $11,000, half that of the US’s poorest state, Mississippi.

By comparison, in the US, only 16% of the workforce with less than one year on the job earns the minimum wage (the relatively unskilled and teens, especially in lower cost-of-living rural areas); only 5% of the workforce earns the minimum wage after they’ve been on the job for a year; the minimum wage is only 28% of US median; and 63% of able-bodied adults (down from 69% in 2008) are in the workforce. No wonder Puerto Ricans are relatively poor and the commonwealth is effectively bankrupt.

Today’s reality for Puerto Rico is the prospect for the California economy our budding entrepreneur would be joining if minimum wages are hiked far enough.

I love higher real wages, created by supply and demand and fueled by increasing productivity as people voluntarily interact in the marketplace. But government can’t create wealth by mandate. If it could, why doesn’t it reach all the objectives of a minimum wage in one fell swoop and enact a minimum of $100 an hour? It can’t. Government is, however, very good at destroying jobs.

Today, besides teenagers and other unskilled people with little job experience (especially in rural areas), very few workers actually earn the minimum wage. As that minimum is hiked, more workers will earn it, true – at least the ones who manage to get and keep a job. But, unfortunately, there will be fewer of them.

Why Do Real Wages Rise?

The example of Hong Kong versus Mainland China is instructive. In 1950, they had roughly equal per capita annual incomes. Thirty-five years later, Hong Kong’s per capita income was roughly 30 times that of the Mainland. Yes, Hong Kong benefitted from the totalitarian Mainland’s brain-drain, but they had zero natural resources, demonstrating that natural resources are unrelated to societal wealth. The entire time, Hong Kong had no minimum wage (and didn’t until recent years – silly Hong Kong). Wages, then, increased for some other reason.

Wages increase naturally from capital, not inflation.That reason is capital, which poured into Hong Kong but not into the socialist Mainland, giving Hong Kong the machinery and equipment that allowed for a massive increase in living standards.

What makes those of us working at a desk more valuable than we were 50 (or even 30) years ago? Computer chips, which require billion-dollar factories in faraway lands to produce. What makes those who haul goods from one place to another so much more valuable than the Chinese coolie of yesteryear? Motorized vehicles, especially trucks and ships, requiring billions of dollars of capital to produce. What makes actors so much more valuable today than in Elizabethan times? Networks, cables, television, and movie theaters – all recipients of massive amounts of capital. And that capital makes us all more productive. Which is the primary reason wages rise.

(Education and training can be considered capital, but they are at best secondary reasons why wages rise in the aggregate. Greater education and training primarily give some people an advantage in societies with large amounts of capital; without capital, little if any advantage is provided.)

The Balance Sheet

The problems with a $15-an-hour mandated minimum are many. Small employers starting out and those with little capital will not be able to pay unskilled workers so high a wage; workers who would be hired at lower wages will not be hired. Small businesses, which sometimes become big businesses later, will not be able to start, lowering long-term employment and wealth creation. Those thinking of starting a business won’t; or they’ll move to another state (or another country) more hospitable to entrepreneurs; or those looking for a place won’t come here to start a business. Californians will forever forfeit the brilliance and productivity and an unknown number of entrepreneurs; the state government will never see the tax dollars of any of those.

The fact there are more customers is the primary reason city wages in the aggregate are always higher than rural ones.Consider, too, the effect of $15 an hour on rural areas. Picture a store in an urban area with shoppers coming and going in massive numbers. Compare that to a similar store in a rural area with an occasional shopper. A store in an urban area can afford to pay much higher wages to workers because they are much more productive than employees of a similar store where customers are few and far between. The fact there are more customers is the primary reason city wages in the aggregate are always higher than rural ones. It’s the reason people left farms for cities in early America; it’s the reason today’s Chinese peasants move to cities in increasing numbers.

Robotic-enhanced businesses will do well. Young, unskilled workers, newly sober addicts, and newly-released felons may never get their first job. What do young men sometimes do when they don’t work? Make trouble. This does not bode well for California’s civil society.

I must add that the biggest reason to oppose mandated prices for labor is not a matter of economics at all, but of rights – property rights and contractual rights. Viewing my body as my property, I have an inalienable right to agree to work for $1 per hour if someone else will have me. I don’t have to do so, but I want to know I have that choice. After all, it’s my time and effort.

If I were a budding young entrepreneur I’d find a state or country more hospitable to and appreciative of those willing to forfeit current consumption for the opportunity to build a business and provide value for others. I do love California. It has about the best weather on the planet, the best water skiing (the Sacramento Delta), and the best snow skiing (Mammoth). But it’s like a gorgeous alcoholic: enabled because of her beauty but, without recovery, due for a premature death.

  • Doug Thorburn, EA, CFP, Alcoholism Researcher, Author of "Alcoholism Myths and Realities" and numerous other books and articles. "Protect yourself from financial abuse."