Opinion: Supersize Deductions to Cope with Higher Minimum Wage

Andrew Sidamon-Eristoff | December 12, 2017 | Opinion
Supersizing employer deductions for compensation could help jobs, consumers, and employers weather a much higher minimum wage

Andrew Sidamon-Eristoff
Only the details remain. Now that progressive Democrats will control the governor’s office as well as both houses of the state Legislature in January, the question is not whether but how the New Jersey minimum wage will increase to $15 an hour.

That’s good news for low-wage earners who already have secure jobs, the unions who will leverage the higher minimum as a new floor in wage negotiations, and employers who are planning investments in labor-saving automation.

But unless the state Legislature can somehow repeal the laws of economics, it’s not such great news for employers who can’t invest in automation and can’t pass the cost of artificially higher wages on to customers; for consumers who will pay higher prices for everyday goods and services; and most especially for workers with limited skills who don’t already have a secure job and who face being displaced by automation or being priced out of the labor market.

In other words, hiking the minimum wage will inevitably impose a range of costs on various groups, some obvious and others more obscure. Even though the political and policy debate is all but over, I respectfully suggest that, in working out the details, the Democrats should strive to allocate these costs in a way that maximizes fairness and economic efficiency (or at least minimizes economic inefficiency). To that end, I submit the following idea for consideration: supersizing the employer tax deduction for compensation paid.

Supersizing made simple

The concept is simple. Under current state tax laws, employers can generally deduct 100 percent of the salary, wages, and other compensation they pay their employees as a cost of doing business. To offset some of the impact of increasing the minimum wage to $15 an hour — a 78 percent increase over the current minimum in New Jersey — why not increase the deduction to something like 200 percent of compensation paid at the $15 per hour level?

How would this work? As an example, let’s consider a service business with a current operating margin of 35 percent, paying a 10 percent tax on profits, and whose only expense is 15 employees working 2,000 hours a year, five earning minimum wage, five earning $30 an hour, and five earning $45 an hour. That translates into a total annual payroll of $834,400, gross revenues of $1,126,440, a pre-tax cash flow margin (or profit) of $292,040, and a tax bill of $29,204. All of which leaves the business with $262,836 in after-tax income.

At a $15 minimum wage, our business’s gross payroll would increase to $900,000, reducing its profit margin to $226,440 and after-tax income to $203,796 — a 22.5 percent reduction — unless it can raise prices or cut labor costs without reducing revenue.

Doubling the deduction

However, supersizing the deduction for compensation paid at $15 an hour to 200 percent would increase the business’s overall deduction for compensation paid from $900,000 to $1,050,000. That reduces the tax bill from $22,644 to $7,644, yielding after-tax income of $218,796. Although that’s still a significant 16.8 percent reduction, it’s certainly more manageable than a 22.5 percent reduction.

Supersizing has several advantages:

First, a significant portion of the cost of the minimum-wage hike would be borne by all the state’s taxpayers, not just an unlucky subset of New Jersey’s employers, consumers, and wage-earners. That’s fair.

Second, employers’ marginal tipping point between maintaining jobs and investing in labor-saving automation would tilt slightly in favor of job retention. That’s good for limited-skills workers.

Third, employers would have less incentive or need to raise prices. That’s good for consumers.

Fourth, compared to the existing jungle of state job-creation tax incentives, supersizing the employer deduction for compensation paid will be comparatively easy to comply with and administer. That’s good for employers as well as government tax administrators. Not so good for lawyers, accountants, and lobbyists.

Finally, supersizing will be a powerful incentive for employers to keep employees on the books and otherwise comply with tax and labor laws. That’s good for everyone.

Are there issues? Of course.

Temporary measure

Increasing the deduction will result in some foregone tax revenue from individual firms (although, by definition, the overall revenue loss should be negligible if the minimum wage advocates’ claim that a $15 wage will not damage the overall economy proves correct). One way to mitigate any potential loss would be to adopt the higher deduction as a temporary measure to help businesses absorb the shock of a rapid and substantial minimum wage increase.

Moreover, to avoid a “cliff” effect that traps employees at the $15 an hour level, or that gives employers an incentive to lay off employees making just over $15 an hour, the higher deduction amount would have to be phased out for wages above $15 an hour. Although this would result in further revenue loss, it would be possible to structure a phase-out to provide additional incentives for higher wages.

Some will object that this proposal would deliver an unnecessary subsidy to giant retail chains who can already afford to pay their workers higher wages. Perhaps. If that proves a major concern, it would be easy to limit the supersized deduction to small businesses based on objective criteria such as number of employees, gross payroll, and the like.

I get it. The election is over. Whether we think it’s good economics or not, a dramatically higher minimum wage is coming to New Jersey. Here’s hoping that our friends in the new governor’s office and the state legislature will take the time to consider the details carefully.