Most arguments in favour of a mandatory living wage, or a large hike in the National Minimum Wage (NMW), are playing to a left-wing gallery. There is the paleo-Keynesian argument that a higher NMW would stimulate demand; there is the egalitarian argument that it would decrease inequality; there is the fallacious idea that free labour markets lead to a ‘race to the bottom’; and there is the failure to distinguish between the total and the marginal product of a particular type of labour (‘binmen and cleaners do a vitally important job, therefore, they ought to be highly paid’).

But supporters of an NMW hike raise at least one point which can have a certain appeal to free marketeers as well.

The argument goes that taxpayers are subsidising low-paying employers through the tax credit system, to the tune of over £29 billion per year. These employers can offer lower wages than they could otherwise get away with, knowing that the taxpayer will top them up, so they are effectively outsourcing part of their wage bill to the general taxpayer.

The conventional free-market argument that wage-setting should be the contracting parties’ business, and nobody else’s, therefore no longer applies. A high NMW becomes a necessary intervention to limit abuse of the tax credit system. The socialist columnist Owen Jones, for example, is clearly not playing in front of a home crowd when he argues:

‘Why are we, the taxpayer, subsidising the poverty wages of the likes of Tesco and Sainsbury’s, to the tune of tens of billions of pounds each year? Instead, let’s have a deficit-reducing living wage.’

We cannot know how market wages in low-skill sectors would have evolved in the absence of tax credits, but economic theory tells us that some degree of substitutability between the two must exist.

We know that taxes on labour are always split, in one way or another, between employers and employees: the former pay higher gross salaries, and the latter receive lower net salaries, than they otherwise would. Since tax credits are a bit like ‘negative taxes’, the same mechanism must logically also work in reverse. Thus, if we could definitely rule out any negative impact on the employment prospects of those with the greatest difficulties in the labour market, hiking the NMW would be a no-brainer, benefiting low-paid workers and taxpayers at the same time.

However, in a comprehensive review of the theoretical as well as the empirical literature, my colleagues Ryan Bourne and J.R. Shackleton show that negative impacts cannot be ruled out. They concede that the standard anti-NMW argument presented in most economics textbooks is probably overly simplistic. But so is the conventional counterargument, which holds that the absence of layoffs after the introduction of the NMW ‘proves’ that NMWs have no effect whatsoever, and can be easily hiked further.

There are many different ways in which employers can respond to NMW-hikes, most of which are much more subtle than outright layoffs. They may, for example, retain their current staff in order to avoid disruptive restructuring, but become more reluctant to hire new staff in the future. They may reduce working hours, so that the NMW would not literally create unemployment, but it would still contribute to underemployment. They may also become pickier about whom they hire, and less willing to give a chance to somebody who does not have an ideal employment history. With this in mind, tax credits could well be a less bad way to support the low-paid, even if there is some degree of free-riding by employers.

So the crucial question is how big a problem this really is: to what extent can the exorbitant tax credit bill be blamed on low wages?

The answer is: not nearly as much as you probably think. The government’s own figures suggested raising the NMW to £7 would save just £30 million a year. Moreover, 44 per cent of those with hourly wages below the Living Wage are in the upper half of the distribution of household incomes. In most cases, these will be secondary wage earners, who are unlikely to qualify for large tax credit payments because entitlement to tax credits is assessed on the basis of household income rather than individual earnings.

At the same time, nearly a third of all tax credit recipient households – 1.4 million out of 4.6 million – have no adult in paid employment. Their share of the tax credit bill – £8.1 billion out of £29.2 billion – can hardly be blamed on low wages when these people do not even earn a wage to begin with. Another 0.7 million tax credit recipients work fewer than 24 hours a week.

The explosion in the tax credit bill has more to do with an overuse of the system than with ‘subsidising poverty wages’. Tax credits were originally intended to be a wage supplement, not a wage replacement. The best way to bring tax credit spending under control again is restoring the system to its original purpose, rather than interfering with market wages.

But ultimately, unless we come to grips with the now much cited ‘cost of living crisis’, neither wage controls nor income redistribution are cost-effective ways of boosting the living standards of the least well off.

There is scope for massive reductions in living costs by developing scenically unattractive parts of the green belts, ditching the green agenda, getting rid of agricultural protectionism, deregulating childcare and ending the overuse of regressive ‘sin taxes’. These measures would do more to improve the living standards of the low-paid than any NMW hike ever could, and without jeopardising their employment chances in the process.

This article was originally published on ConservativeHome.

Follow @K_Niemietz on Twitter.