Increasing minimum wage may lead businesses to reduce their capital expenditures

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Research conducted by Matt Gustafson, Penn State Smeal associate professor of finance and Stuart and Michele Rothstein Early Career Professor, reveals that, particularly in industries most exposed to minimum-wage labor, minimum wage increases lead these firms to cut capital expenditures.

In recent years several states—including California, Illinois, Maryland, Massachusetts, New Jersey, New York, as well as Washington D.C.—have passed laws to increase their minimum wages to $15 per hour—more than double the current federal rate of $7.25.

"This movement has created immense political pressure to raise the federal ," said Gustafson. "But policy debates are complicated because the effect of higher minimum wages on businesses and low-wage workers remains uncertain."

In a recent research paper published in Management Science, Gustafson, along with Jason D. Kotter, assistant professor of finance at Brigham Young University, examined the effect of minimum wages on the capital expenditures of U.S. public firms. They report that, particularly in industries most exposed to minimum-wage labor, minimum wage increases lead these firms to cut capital expenditures.

In the United States, the industries that employ the most minimum-wage workers by far are retail, restaurants and entertainment. In fact, in 2012, the Current Population Survey used in the study showed that retail, restaurant and entertainment employ over 70% of minimum wage labor, with no other industry employing over 10%. (2012 was the final year of the researchers' sample, and there hasn't been a federal minimum wage increase since 2009.)

"We found that when the minimum wage is raised and therefore labor costs go up, these companies are going to take on fewer capital expenditures as investment projects," Gustafson says. "One of the main ways in which restaurants, stores, and entertainment venues invest is in new establishments. Our research showed that as a state's minimum wage goes up 10% to 20%, these businesses will invest in fewer establishments in that state in the subsequent year or two. So, let's say there are 10 people thinking about opening up a second store. One or two of them will decide not to—they'll cancel or delay that new establishment—because of that minimum wage hike."

In the United States, each state is required to follow federal minimum wage law. But states can also pass their own laws to make the wage higher than what federal law dictates. Gustafson emphasizes that his research focuses on states that don't have their own minimum wage laws and therefore must change their minimum wage according to federal mandate. For these states, if the federal government increases the minimum wage from $7.25 to $8, the decision is made for them. In contrast, states that already have their own minimum wage established—$12 or $15, for example—won't be affected.

That's an important distinction, Gustafson explained. "We're looking at how firms in those 'bound' states—those that don't have their own minimum wage laws—are responding when their minimum wage is moved for them by the federal government. When 'unbound' states decide to move their minimum wage on their own, there might be certain economic conditions that are changing investment too. States tend to increase minimum wages when the local economy is doing well. We don't want prevailing business conditions to be the reason minimum wage is changing and the reason capital expenditures are changing at the same time. So, by focusing on states that are bound by the federal minimum wage, we can identify a causal effect of minimum wage on capital expenditures."

Gustafson said some colleagues were surprised by the research findings because they initially thought investments might go up as a result of an increase in minimum wage. For example, restaurants might react by opening up more automated kiosks since they don't want to hire as many employees. "That's a valid competing hypothesis—that these businesses will invest more in capital to substitute away from labor—but we didn't find that to be a big effect," he said. "Rather, the more predominant effect is that these businesses find fewer profitable opportunities to open new stores or locations."

The researchers used a regression-based difference-in-differences design that compares changes in the investment of firms headquartered in states whose minimum wages were increased by changes in federal laws to the change in investment of firms headquartered in less affected at the same time.

The literature on the effects of minimum wage includes an ongoing debate about reasons to have higher or lower minimum wage rates, Gustafson said. "This research contributes to that debate—it's all about managing a variety of tradeoffs. From a finance perspective, you're always looking at the cash flows, all the costs and benefits to whatever new project you're considering. We're not claiming that this relationship between minimum wage and capital expenditures is the only thing that's going on, but we think showing that these minimum-wage-reliant industries having to scale back in response to minimum increases is an important factor to consider when looking at the pros and cons. We're looking at one piece of the whole picture."

More information: Matthew T. Gustafson et al, Higher Minimum Wages Reduce Capital Expenditures, Management Science (2022). DOI: 10.1287/mnsc.2022.4430

Journal information: Management Science

Citation: Increasing minimum wage may lead businesses to reduce their capital expenditures (2022, September 15) retrieved 8 December 2022 from https://phys.org/news/2022-09-minimum-wage-businesses-capital-expenditures.html
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