Critics of minimum wages often argue that introducing them, or indeed raising them, will result in higher unemployment as lower-skilled people are simply not productive enough to produce enough value to warrant higher wages.

By and large, that hasn’t materialized in the numerous places where minimum wages have been introduced, but research from Penn State proposes another possible issue. The researchers argue that when minimum wages are introduced, it results in firms reducing their capital expenditure.

Capital expenditure

The authors explain that sectors such as retail, hospitality, and entertainment typically hire the most minimum-wage workers. Indeed, recent data suggest that around 70% of workers in these industries are minimum wage, with no other industry employing over 10%.

“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,” the researchers explain. “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.”

Federal minimum wage laws in the United States require each state to follow what is centrally determined, but despite this, each state can choose to enact higher minimum wages than those dictated by the government. The researchers focused their attention on states with no state-level minimum wage who therefore had to take their level from the government. This means that if the government raised the minimum wage then they too would have to follow suit, but this wouldn’t be the case in states that already set a higher level.

“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,” the authors explain. “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.”

Tightening belts

The findings are somewhat surprising as one might intuitively believe that investments might rise in response to increases in the minimum wage. For instance, restaurants might respond to the rise by investing in more automated kiosks as labor costs have risen.

“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,” the authors explain. “Rather, the more predominant effect is that these businesses find fewer profitable opportunities to open new stores or locations.”

Suffice it to say, the debate around the merits, or otherwise, of minimum wages is ongoing, and often has a more political than economic flavor to it. Nonetheless, the researchers hope that their work contributes to the debate and highlights the tradeoffs that are likely to result.

“From a finance perspective, you’re always looking at the cash flows, all the costs and benefits to whatever new project you’re considering,” they conclude. “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 wage increases is an important factor to consider when looking at the pros and cons. We’re looking at one piece of the whole picture.”