Minimum Wage and Capital Taxes

• Published date: 01 May 2014
• Author: Eden Siu Hung Yu,Chi‐Chur Chao
• Date: 01 May 2014
• DOI: http://doi.org/10.1111/rode.12078

Minimum Wage and Capital Taxes

Chi-Chur Chao and Eden Siu Hung Yu*

Abstract

Using a general equilibrium model, this paper examines the employment and welfare effects of minimum

wages coupled with capital taxes in a small open economy. The individual and joint optimal policies for a

minimum wage and capital taxes are derived and explained. Specifically, policy reform to introduce a

minimum wage while lowering the capital tax can be justified for some economies, notably, Hong Kong.

1. Introduction

The first minimum wage was introduced in New Zealand in 1894. It has become a

popular practice for protecting workers, especially unskilled workers, and narrowing

the income gap of the rich vs the poor in many economies. In the USA, for instance,

the minimum wage was enacted in accordance with the Fair Labor Standard Act of

1938. In 1999, Britain adopted a minimum wage based on approximately 46% of its

median wage rate to reduce poverty and mitigate income inequality. In response to

the increased Gini index on income inequality,1Hong Kong introduced its first

minimum wage legislation on 1 May 2011 and the rate was increased by 7% in May

2013. As of today, 197 countries and territories have official minimum wage rates in

place.2

Although the goal of a minimum wage is to help low income workers, a binding

minimum wage set at a rate above the market-clearing wage rate could raise the cost

of production and hence result in involuntary unemployment in the labor market.3

The effect of the involuntary unemployment can be to adversely affect the social

welfare of an economy. Hence, to evaluate the economic costs and benefits of imple-

menting a minimum wage, analysis should be extended to examine the effects of

factor mobility and social welfare on the economy, rather than focusing exclusively on

the effects on employment. Neary (1985) takes this approach by considering factor

prices and factor movements in a general-equilibrium trade model with a minimum

wage, and Kreickemeier (2005) emphasizes the employment-induced effect of trade

reforms on welfare in a small open economy experiencing unemployment.

Broadly speaking, there are two ways to implement a national minimum wage: one

approach is to impose the same minimum wage rate uniformly across all sectors, as in

Hong Kong, or possibly to vary the rate based on the age groups of workers across

the country, as in the UK. The second approach is to enact a minimum wage appli-

cable only to certain sectors, cities or regions in the country, as in China and

* Chao: Graduate School of Business, Deakin University, Australia. Tel: 61-03-92445070; E-mail: c.chao@

deakin.edu.au. Yu: Faculty of Commerce, Chu Hai College, Hong Kong. E-mail: edenyu@chuhai.edu.hk.

The authors are grateful for useful comments from a referee and the participants at the 2012 Taipei–

Tokyo–Hong Kong three-party conference at Tamkang University, the 2012 IEFS (China) Conference at

Nankai University, the 2011 European Economics and Finance Society meeting in London, and the Uni-

versity of Macau. This research was started when Chao was at the Chinese University of Hong Kong and

Yu was at the City University of Hong Kong.

Review of Development Economics, 18(2), 195–202, 2014

DOI:10.1111/rode.12078

© 2014 John Wiley & Sons Ltd