The Effect of Economic Freedom on Labor Market Efficiency

and Performance

By Lee E. Ohanian, Senior Fellow, Hoover Institution, Stanford University

Professor of Economics, UCLA

Introduction As the United States and the rest of the world continue to
address the health, economic, and social challenges presented
The labor market is the centerpiece of every economy. It by the novel coronavirus, sound labor market policies that
determines how society’s human resources are utilized, both respect the principles of economic and personal freedom will
over time and across individuals, and how much workers are be central for restoring economic growth, while at the same
compensated for their labor services. In all countries, the labor time promoting public safety.
market is the largest market in the economy, with workers
receiving roughly 60 percent or more of the total income that The US Labor Market: Stability Enhances Economic
is generated by market production. Growth

An equally important issue is how well the labor market This section presents employment, hours worked, and
functions. The difference between a poorly functioning labor employee compensation data to summarize the performance
market and a well-functioning labor market can mean millions of the US labor market. These data will show that the United
of lost jobs and billions of dollars in lost incomes. States has a very dynamic labor market that absorbs the large
number of new workers constantly entering the labor force
Government policies and institutions have important effects and that also reallocates workers across sectors in response
on the efficiency of the labor market. In some economies, such to the enormous changes observed in economic and social
as the United States, labor markets are not heavily regulated, conditions that have occurred since 1960.
tax rates are fairly low, and economic freedom is relatively high.
In some other countries, labor markets are heavily regulated, This section will also show that American worker compensation
tax rates are high, and consequently there is less economic has increased over time at nearly the same rate as productivity
freedom. and that the shares of income paid to labor and capital have
been roughly constant over time after adjusting for capital
This paper summarizes research on how government policies depreciation.
that affect freedom of choice within the labor market impact
its performance and efficiency. These policies include taxation, Figure 1 shows the total number of market hours worked in
minimum wages, unionization, and occupational licensing the United States relative to the US working age population:
requirements. those between the ages of sixteen and sixty-four. This is the
most complete measure of market work because it combines
This review shows that freer labor markets,
which have lower tax rates, less regulation,
and more competition, are much more
efficient and dynamic and are associated with
higher employee compensation and greater
employment.

These findings have important implications

for economic policy making. They indicate
that policies that enhance the free and efficient
operation of the labor market significantly
expand opportunities and increase prosperity.
Moreover, they suggest that economic policy
reforms can substantially improve economic
performance in countries with heavily regulated
labor markets and high tax rates. Figure 1. US annual hours of market work.
Source: Cociuba, Prescott, and Ueberfeldt (2018)

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 1
employment data with the number of hours per worker. This disrupt the US labor market. Rather, the graph shows that
ratio is naturally interpreted as the average annual number of the labor market readily absorbed this massive increase in the
market hours worked per US adult from 1960 to 2019. The supply of new workers.
data are compiled by Cociuba, Prescott, and Ueberfeldt (2018).
Another major factor impacting the labor market has been
Standard economic principles indicate that hours worked per an ongoing shift from a goods-producing economy to a
adult should be relatively stable in a well-functioning market services-producing economy, in which manufacturing’s share
economy. These data are largely consistent with this view. The of employment declined from more than 25 percent in 1960
average annual hours worked per adult per year in these data to less than 10 percent today.
are about 1,360, with a standard deviation of just seventy-six The substantial increase in labor force participation by women
hours per adult per year, which is about 6 percent of the mean. has been another key factor impacting the labor market.
Women’s participation rose from just 35 percent in the mid-
The stability of US hours worked per adult is associated with 1950s to about 60 percent by the mid-1990s.
enormous employment growth. Figure 2 shows the number
of full-time equivalent US employees between 1960 and There are other significant factors that affected the US labor
2019. These data, which are constructed by the Bureau of market since 1960. These include the enormous increase
Labor Statistics, highlight the dynamism of the American in globalization of production, investment, and trade and
economy. Full-time employment grew smoothly from about the development of information and communications
56.5 million full-time equivalent workers in 1960 to about technologies, which in turn gave rise to transformational
127.5 million in 2018. This is a gain of about 142 percent. businesses, including Microsoft, Apple, Google, and Amazon.
These businesses have not only completely
changed several major sectors of the economy
but also have created enormous cultural and
social change.

All these developments were permanent,

game-changing events in the history of the US
economy. Yet the US labor market responded
to these changes by efficiently absorbing new
workers and also reallocating workers across
firms, industries, and sectors.

The rapid reallocation of labor is particularly

striking in the United States. About 4 percent
of US employment turns over every month as
workers leave existing positions and move to
new positions. With a current employment level
Figure 2. US full-time equivalent employees (millions). of about 152 million workers, this means the
Source: Bureau of Labor Statistics, US Department of Labor equivalent of about 75 million job changes in
the United States each year.

While there are some fluctuations from trend growth, This remarkable level of job reallocation highlights a rapidly
particularly around the recessions of the early 1980s, 2000–01, evolving and growing economy in which the labor market
and 2008–09, the otherwise fairly smooth operation of the US quickly moves workers from slower growing firms and
labor market is striking. Looking at these graphs, one would industries to more rapidly growing firms and industries.
be hard-pressed to identify many of the large economic and
social changes that occurred over this period and that could The impact of COVID-19 on the US labor market is not
have significantly impacted the labor market’s ability to absorb seen in these annual data which end in 2019. Figure 3 shows
and allocate workers through 2019. the monthly US unemployment rate, which clearly shows
the impact of COVID-19, combined with federal, state,
One such factor is the 38 million-person baby boom cohort and local government policy responses on the labor market.
that entered the labor market between the late 1960s and These include shelter-at-home orders, social distancing,
the early 1980s. This large influx of young workers did not and restrictions on large gatherings, among others. Retail,

2 Hoover Institution
hospitality and leisure, and the travel sectors have been hit has grown very little over time. The other is that the distribution
particularly hard, as the US unemployment rate increased of net income has substantially shifted from workers to capital.
to over 14 percent in April, a level not seen since the Great
Depression. In a competitive, well-functioning labor market, worker
compensation grows with worker productivity.
Higher productivity means higher value
added and growing worker productivity leads
businesses to bid up compensation as they
compete for workers.

Figure 4 shows real GDP per worker, which

is the most common measure of economy-
wide labor productivity, along with three
different measures of inflation-adjusted
compensation, two of which are commonly
used but are plagued by significant conceptual
and measurement flaws. Taken together, these
three series show why some commentators
claim that compensation has grown very little
Figure 3. US Unemployment Rate (Monthly) over time and that it has not nearly kept up
Source: Bureau of Labor Statistics with productivity increases—and why these
views are mistaken.
With the anticipation that safe and effective treatments and
vaccines ultimately will become available, this paper assumes The brown line shows worker wages divided by the Consumer
that COVID-19 will not present the same economic challenges Price Index (CPI). This measure is frequently cited by
in the long run. The paper presents a policy discussion about commentators who argue that workers have not received
how to safely restore work over the next few months before any significant, inflation-adjusted salary increase for decades,
new treatments and vaccines are widely available. This is even though their productivity has increased (Nichols 2019).
discussed just before the conclusion.
There are two key problems with this frequently used measure
Figures 4 and 5 present data on average worker compensation, that make it inappropriate for inferring compensation growth
which is the price of labor. These two figures clarify two and for comparing compensation to worker productivity. One
commonly held but misunderstood views about worker is that nonwage benefits, which include employer-provided
compensation and the distribution of income. One health plans and vacation among other compensation, have
misunderstood view is that inflation-adjusted compensation become an increasingly large fraction of total compensation.

In the 1960s, nonwage benefits accounted

for only about 6 percent of employee
compensation. Today, they have grown to
about one-third of total compensation as the
value of employer-provided health plans has
grown substantially. This large component of
compensation is omitted by those who focus
just on wages. Moreover, this indicates that
while wages may have been a reasonably
accurate measure of compensation sixty years
ago, they are not today, and should not be used
as a proxy measure of employee compensation
now.

Figure 4. Productivity, hourly wage, and total compensation, inflation-adjusted with The second problem with this measure arises
CPI and GDP deflator. when comparing it to productivity. This is
Source: US Department of Labor, US Bureau of Economic Analysis because the GDP deflator is used to construct

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 3
worker productivity but the CPI is used to deflate the wage. Rather, this view about labor’s share of the economic pie is
Comparing worker compensation to productivity requires largely based on a conceptual error. To see this, figure 5 shows
that the same price index be used to deflate both measures. the distribution of income between labor and capital, net of
The appropriate price index for making this comparison is capital depreciation. The data exclude the self-employed,
the GDP deflator because it is by far the broadest price index for whom income attribution between labor and profits is
available, covering all market goods and services. ambiguous. The figure shows a relatively constant share of
income paid to labor at about 66 percent. These data stand in
It is well known that the CPI overstates economy-wide sharp contrast to the view that owners of capital are receiving
inflation. This means that wages deflated by the CPI will a considerably larger share of net income at the expense of
not only be biased downward because of omitted nonwage workers.
compensation, but also because the CPI grows considerably
faster than the GDP deflator. Rising capital depreciation rates are the reason why labor’s
share of income net of depreciation has remained constant,
To see how much the errors of (1) using wages rather than even if its share of gross income has declined. The US Bureau
total compensation and (2) using the CPI instead of the GDP of Economic Analysis has changed the definition of capital
deflator matter for these issues, figure 4 shows two additional investments to now include what are known as intangible
measures: total compensation deflated by the CPI and the investments that previously had been expensed items, such
appropriate measure for comparing to productivity (total as computer software.
compensation divided by the GDP deflator).
These newly classified investments tend to have very high
The figure shows that total compensation deflated by the CPI depreciation rates. In addition to expenditures that are now
grows over time, in contrast to wages. The difference between being classified as capital investments, there is also a greater
these two measures shows the difference between using the share of business investment in previously existing, high-
appropriate measure of total compensation versus wages and depreciation categories, such as computer equipment, which
highlights the large quantitative error induced by using just depreciates must faster than other investments, such as office
wages as a measure of living standards. buildings and factories.

Total compensation divided by the GDP deflator is the third Higher depreciation means a higher gross payment to capital,
measure presented in the figure. This measure shows very all else equal. This is because investors require a specific rate
strong growth over time. There is some divergence between of return, net of depreciation, in order to bear capital risk as
productivity growth and compensation growth after 2000. well as postpone consumption. This rate of return must allow
Economists are studying potential factors accounting for for depreciated capital that must be replaced. After accounting
this divergence. While this remains an open question, this for higher depreciation, it is striking that the net payments
divergence has not been caused by a shift of net income from to capital and labor have not changed in any quantitatively
workers to capital, which is another widely held perception. important way over time.

Taken together, these data indicate that the

US labor market has functioned efficiently
over most of the last sixty years in terms of
absorbing new workers, reallocating workers
across firms, industries, and sectors, and
providing compensation that grows roughly
with worker productivity and whose share of
net income has not changed over time.

American labor market efficiency coincides

with a significant amount of economic freedom
and lack of economic policy distortions. The
next section compares measures of US labor
market freedoms with those in some other
countries.
Figure 5: Labor share of net income in non-farm business sector.
Source: US Bureau of Economic Analysis

4 Hoover Institution
Comparing Labor Market Freedom and Policies across While inexperienced workers may be paid relatively low wages,
Developed Countries their pay would rise as their skills increased with experience
and job training.
The efficient operation of the US labor market in absorbing
new workers has been the exception more than the rule when Those who may be priced out of the market due to a high
compared to other developed countries. Today, several major minimum wage include workers who have not yet acquired
economies with far fewer young workers than the United sufficient skills to realistically compete for higher wage jobs,
States, such as France, Italy, and Spain, currently have youth such as young workers, immigrants, and workers who have
unemployment rates of at least 20 percent, even ten years been out of the labor force for a considerable period of time,
after the global financial crisis. This compares to a youth such as parents who left the labor force to raise children and
unemployment rate of about 8 percent in the United States workers recovering from long-term disabilities.
(OECD 2019b).
The remaining Heritage Foundation measures of labor
This section provides international perspectives on labor market market freedom are the expenses associated with adjusting
freedom across countries. This comparison is informative and managing a company’s workforce. In an efficient and
because different countries have adopted very different labor free labor market, these costs should be relatively small on a
market policies which in turn have had large effects on the per-worker basis. However, these costs can be significant and
incentives and opportunities within the labor market. This may materially affect firms’ human resource decisions when
comparison will show that the US labor market is much freer regulations substantially affect these choices.
than labor markets in most other countries.
These adjustment and management costs include overtime
The Heritage Foundation (2020) and the Organisation for premiums and the costs of dismissing redundant workers,
Economic Co-operation and Development (OECD 2019a) including the amount of severance pay and the mandated
systematically rank countries on labor market freedom and notification period of dismissal notice, as well as litigation
flexibility. Both these rankings have been conducted for costs and penalties for noncompliance.
many years and they are widely cited and used in making
comparisons across countries and analyzing labor market As these costs rise, they tend to reduce employment and
outcomes. economic activity because they raise the cost of employing
a worker without increasing worker productivity. Over time,
The Heritage Foundation (2020) ranks the United States as higher employment costs resulting from regulations will tend
having the most labor market freedom among all countries. to reduce wages.
The ranking is based on six factors: (1) The minimum wage
relative to average value added per worker, (2) the cost of The OECD’s ranking (OECD 2019a) focuses on what
hiring new workers, (3) the cost of adjusting worker hours, economists refer to as labor market flexibility. The OECD
(4) the cost of dismissing redundant employees, (5) the length measures the extent of regulations on individual and collective
of term of mandated notice of dismissal, and (6) the extent job dismissal across countries. These regulations make it
and size of mandatory severance pay. Each of these factors more expensive to dismiss workers, which in turn reduce
in the Heritage Foundation index has important economic employment by raising employee costs. High dismissal costs
implications for the efficient and free operation of the labor also impede resource reallocation across different sectors of
market. the economy, and this also slows economic growth. The United
States is also ranked first in the OECD’s index.
The minimum wage relative to average worker productivity
gauges how many workers may be negatively affected by the The Heritage Foundation and OECD measures of labor
minimum wage because their employment cost exceeds the market freedom and flexibility summarize factors that directly
value of their production. Specifically, if the minimum wage affect business’s demand for labor by affecting the cost of labor.
is higher than a worker’s productivity, then the worker will Labor supply, which is the other side of the labor market, is
not be hired because the hiring organization will take a loss directly affected by other policies.
on that worker. Instead, it will focus hiring efforts on workers
whose productivity exceeds the minimum wage. Some of the most important policies that affect labor supply
are tax rates. Tax rates change the incentives to work either
In a free labor market, inexperienced workers would have many by reducing a worker’s take-home pay (labor income taxes)
more opportunities because employers would not be restricted or by making consumption goods more expensive (sales taxes
to paying them a wage exceeding the value of their production. or value-added taxes).
Instead, workers would be paid according to their productivity.

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 5
In the standard model of labor supply, an individual weighs 2 shows how these tax rates have changed between 1950 and
the costs and benefits of working and chooses how much to 2015. The table shows the difference between each country’s
work at the point where the incremental cost of working, 2015 tax rate and its 1950 tax rate in percentage points.
which tends to rise with hours worked, is equated to the
incremental benefit of working, which tends to decrease with In Europe, these tax rate increases range from 26.5 percentage
hours worked. Higher taxes reduce the benefit of working, points (Germany) to 36.7 percentage points (Italy). The mean
which means that taxes induce workers to reduce their labor tax rate increase among the continental European countries
supply and work less, all else equal. is 31 percentage points. In contrast, the US tax rate increased
by only 11.6 percentage points. The next section summarizes
McDaniel (2007, 2011) has constructed panel data covering research that uses tax rate data to analyze how tax rates have
fifteen OECD countries beginning in 1950. These data have affected labor supply in the OECD countries.
been updated to 2015. These data show that there have been
enormous changes over time and across countries in the labor How Tax Rates and Other Policies Affect Labor Markets
and consumption tax rates that affect labor supply. across Countries

Since labor income taxes and consumption taxes have similar Figure 6 shows hours worked per adult for the United States
effects on labor supply, I have combined McDaniel’s data and for three major European countries: France, Germany,
on labor income taxes and consumption taxes into a single and Italy. The most striking feature of these data is the large
composite tax rate by adding them together.1 drop in the number of market hours of work in the European
countries, which are the countries with the
Table 1. Combined 2015 Tax Rate on Labor Income and Consumption, in Percent largest increase in tax rates.

Hours of market work per adult in France

fall from about 1,600 in 1950 to about
1,000 in 2015. Similarly, hours of market
Source: McDaniel 2011 work per adult fall in Germany from about
1,550 to about 1,100, and from about 1,450
Table 2. Percentage Point Change in Tax Rates: 1950–2015
to about 1,050 in Italy. These are enormous
declines. In contrast, US hours worked
change little, rising from about 1,250 to
about 1,300.

Source: McDaniel 2011

Table 1 shows this composite tax rate for selected

countries, including several European countries
where these tax rates are particularly high. The
data are for 2015, which is the most recent year
that the data are available, and include national
as well as state and local rates.

The table shows that the United States by far has

the lowest composite tax rate at 28.7 percent. The
composite tax rate for the European countries is
much higher, ranging from 42.7 percent (United
Kingdom) to 64.8 percent (France).
European tax rates were not always so high. In
the 1950s, some European tax rates were lower
than the American tax rate. These tax rates rose
substantially in the 1970s and early 1980s as
many European countries expanded the size and Figure 6. Annual hours of market work: France, Germany, Italy, and United States.
scope of government during that period. Table Source: Ohanian, Raffo, and Rogerson (2008)

6 Hoover Institution
These very different patterns in hours Table 3. Actual and Predicted Percentage Change in Hours Worked: 1950–2015
worked coincide quite closely with
changes in the tax rate reported in
the previous section. In particular, the
composite tax rate increases by about
30 percentage points on average in the
three European countries. Hours worked Source: Ohanian, Raffo, and Rogerson (2008)
in those same countries decline by about
31 percent. US tax rates rise modestly and Of the twelve countries that experienced at least a 15 percent
US hours worked are unchanged. decline in hours worked, tax changes account for about 85
percent of the overall drop.2
Several studies have found that a standard model of labor
supply that includes taxation accounts quite closely for these Some economists have argued that taxes play a smaller role
very different changes in hours worked. than in the studies cited here. Blanchard (2004) and Alesina,
Glaeser, and Sacerdote (2005) argue that cultural differences
Prescott (2004) studied how changes in tax rates affected between Europe and the United States may explain why
hours worked per adult in Canada, Germany, France, Italy, Europeans work so much less today than Americans. But
Japan, the United Kingdom, and the United States. He used there are some shortcomings with these different views. One
national income account data to construct tax rates and then is that they are either silent on why Europeans worked so
used a standard economic model to predict how observed tax much more than Americans in the 1950s or, alternatively,
rate changes between 1970–74 and 1993–96 changed hours why European immigrants to the United States do not appear
worked. He found that changes in tax rates accounted for to work systematically less than other American workers.
almost all the changes in hours worked across these countries. Moreover, these studies do not measure these potential
He summarizes his main findings: “In this article, I determine cultural differences, which precludes a formal analysis of
the importance of tax rates in accounting for these differences this alternative view.
in labor supply for the major advanced industrial countries
and find that tax rates alone account for most of them.” Economists have studied how other policies have affected
labor market performance, particularly unemployment. As
Ohanian, Raffo, and Rogerson (2008) also employ a standard discussed above, Europe has adopted political institutions and
model of labor supply and analyze a larger panel of countries, economic policies that have increased labor market rigidity
covering fifteen OECD countries, and over a longer time and reduced economic freedom within the labor market.
period, from 1956 to 2004. They use the McDaniel (2007,
2011) tax rate series, which was not available at the time of Blanchard and Wolfers (2000) analyzed panel data from
Prescott’s analysis. European countries to study how the level of unemployment
benefits, the duration of benefits, unionization, and employment
Table 3 summarizes their findings. The model predicts the protection laws affected European unemployment over time
significant decreases in labor supply for Austria, Belgium, and across countries.
Germany, Netherlands, and the United Kingdom. The
model’s prediction error is large for Spain, although that is Economists have focused on European data because
understandable. Despite higher taxes, Spain implemented unemployment in many European countries has been
many promarket economic reforms and a shift to more much higher than in the United States. Since 1985, French
democratic government after Francisco Franco left power. unemployment has averaged around 9 percent per year and
Those factors, which positively affect labor supply, likely German unemployment has averaged around 8 percent per
attenuated the impact of higher taxes. year.

The Netherlands is a particularly interesting case. After Blanchard and Wolfers found that labor market policies that
suffering a nearly one-third drop in hours worked per adult, have increased labor market rigidity and reduced economic
the nation implemented lower taxes in the 1980s. Following freedom have had very large effects on unemployment. They
this tax reform, hours subsequently rose by about 12 percent. find that the maximum benefit rate, which is the average
The model accurately generates the very large drop from the unemployment benefit measured as a percent of the average
1950s to the 1980s and the partial recovery in hours worked wage, has increased European unemployment on average by
afterward. 1.3 percentage points. They find that the duration of benefits,
which has been very high in Europe, increased unemployment

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 7
by about 0.75 percentage points. Employment protection will result in lower demand. In the labor market, this means
policies, which raise the cost of dismissing redundant workers, that any worker who does not deliver enough value to offset
raised unemployment by about 1 percentage point and an artificially high minimum wage will be unemployed.
unionization raised unemployment by about 0.6 percentage
point. Youth unemployment statistics highlight the impact of
minimum wages. In mid-2012, more than two years after
Taken together, the findings of Blanchard and Wolfers the end of the last recession, teenage unemployment (ages
indicate that observed policies could have potentially increased sixteen to nineteen) was 25 percent, compared to a 6.7 percent
European unemployment by as much as 4.6 percentage points unemployment rate for prime age workers (ages twenty-five
per year. Note that this is the difference between a very healthy to fifty-four). Even in 2019, with the strongest job market in
labor market and one that is perpetually in a severe recession. the last fifty years, teenage unemployment was 12.6 percent,
compared to a prime age worker unemployment rate of 2.9
In another influential study, Ljungqvist and Sargent percent (US Bureau of Labor Statistics 2020a, 2020b).
(1998) assess how labor market policies affect European
unemployment with a focus on long-term unemployment, Despite the simple economic logic described above, and the
which is very prevalent in Europe. They hypothesize that observed large difference in unemployment rates by age, some
European policies tend to increase long-term unemployment commentators today hold the view that raising the minimum
because worker skills deteriorate as unemployment duration wage will have little, if any, effect on unemployment and
rises. In particular, their hypothesis is that some workers instead will substantially raise the standard of living among
ultimately become chronically unemployed as their skills nearly all low-wage workers.
deteriorate so much that unemployment benefits, which have
been quite high in Europe, become higher than their market Perhaps the major factor driving this change in opinion was
wage. They find that well-intentioned policies account for research by David Card and Alan Krueger (1994, 2015). In an
much of the rise in long-term European unemployment and influential paper, Card and Krueger (1994) compared changes
long-lasting benefits trap European workers in a persistent in employment in fast-food restaurants between New Jersey,
cycle of unemployment. which increased its hourly wage from $4.25 to $5.05 in 1992,
and Pennsylvania, which kept its minimum wage at $4.25.
These findings have been confirmed for emerging economies. They surveyed about four hundred fast-food restaurants near
Bernal-Verdugo, Furceri, and Guillaume (2012) study a panel of the New Jersey-Eastern Pennsylvania border by phone and
eighty-five countries, many of which are developing countries, asked restaurant managers about employment levels before
and find that “after controlling for other macroeconomic and after the New Jersey minimum wage change.
and demographic variables, increases in the flexibility of
labor market regulations and institutions have a statistically They reported that the New Jersey restaurants had expanded
significant negative impact both on the level and the change employment by nearly three full-time equivalent workers
of unemployment outcomes (i.e., total, youth, and long-term relative to Pennsylvania restaurants. This result was extremely
unemployment). Among the different labor market flexibility surprising, as it defies the most basic economic argument that
indicators analyzed, hiring and firing regulations and hiring artificially raising wages of low-skilled labor depresses the
costs are found to have the strongest effect.” demand for that labor.

Botero et al. (2004) report similar findings from an eighty-five- However, there are problems with Card and Krueger’s analysis,
country study. They find that highly regulated labor markets including data collection and their research design. In terms of
reduce labor force participation and raise unemployment, data collection, Card and Krueger (1994) relied on telephone
particularly for young workers. surveys with the restaurants. Subsequent research based on
better data collection showed very different results.
Minimum Wages: Theory and Evidence
In a series of papers and a book, David Neumark and William
At one time, there was nearly universal agreement among Wascher (2000, 2008) review many minimum wage studies,
economists and policy makers that high minimum wages including that of Card and Krueger (1994). In contrast to
depressed employment, particularly for young people who Card and Krueger (1994), Neumark and Wascher redo the
were still in the process of accumulating skills and experience. New Jersey and Pennsylvania fast-food restaurant study by
using administrative payroll data from fast-food restaurants
The economic logic behind this once-standard view is simple: rather than telephone interviews. Payroll data are more reliable
fixing the price of any good or service above its market price than the telephone interview responses obtained by Card and

8 Hoover Institution
Krueger (1994) because restaurants have a legal obligation to between short- and long-run effects is incredibly important
report taxable income and costs. but rarely is documented by empirical studies.

In contrast to the Card and Krueger study, Neumark and Minimum wage research has important implications for
Wascher found that the higher minimum wage in New Jersey current policy discussions. In particular, there are a number
had reduced New Jersey employment by about 4 percent of proposals to raise the federal minimum wage from its
relative to Pennsylvania, in which the minimum wage was current level of $7.25 per hour to $15 per hour.
not changed. This finding is in line with standard economic
logic and with the majority of previous empirical estimates At its current level, the minimum wage affects very few
of the impact of a minimum wage. workers, just 0.28 percent of the labor force. According to
the Labor Department, almost half of minimum wage workers
Neumark’s most recent review (2019, 321) of many short- are workers younger than twenty-five, who account for only
run minimum wage studies concludes as follows: “The about 20 percent of the overall labor force (US Bureau of
preponderance of evidence indicates that minimum wages Labor Statistics 2019). However, if the minimum wage were
reduce employment of the least‐skilled workers. Earlier raised to $15 per hour, then it would affect over 40 percent
estimates suggested an ‘elasticity’ of about −0.1 to −0.2. Many of American workers (Rodgers and Novello 2019). Alan
estimates are still in this range … More definitively, though, Krueger, one of the authors of the New Jersey–Pennsylvania
it is indisputable that there is a body of evidence pointing to study cited above and a former economic adviser to President
job losses from higher minimum wages. Characterizations of Obama, warned of job loss if the minimum wage were raised
the literature as providing no evidence of job loss are simply to $15 per hour (Kreuger 2015).
inaccurate.”
An important risk of a $15 federal minimum wage is that
More recently, economists have begun to study the long-run low earners in relatively poor states would be particularly hard
effects of minimum wages on employment. This is important, hit. For example, the average hourly wage in Mississippi is
as the short-run responses to a higher minimum wage, which under $15 per hour.3
are the focus of much of the literature, may be very different
from long-run responses. This is because it takes time for There are policies that will improve the efficiency of the labor
employers to make adjustments in response to minimum wage market while promoting compensation growth for those who
changes, including installation of new capital investments and may be adversely affected by the minimum wage. These policies
adoption of new technologies, both of which can substitute include expanding the earned income tax credit, increasing
for workers. the scope and scale of enterprise zones which incentivize
businesses to locate in poor neighborhoods, improving our
Research by Isaac Sorkin (2015) shows that the difference K-12 education system, and expanding preschool programs.
between the short-run and long-run effects of minimum
wage legislation can be enormous. Sorkin measures the The Impact of Unions on Labor Market Performance
responsiveness of employment to a wage change using the This section summarizes how unions have historically
economic concept of demand elasticity, which is the percentage affected labor market efficiency and opportunities. In the
change in labor demand in response to a given percentage late nineteenth and early twentieth centuries, unions focused
change in the wage. on increasing worker safety, protecting worker civil rights,
supporting education, and limiting the use of child labor
He shows that the contemporaneous elasticity of labor demand (Ohanian 2009).
can be virtually zero upon impact of a minimum wage change,
in which he estimates that a 10 percent change in the wage These efforts were important because labor markets were
generates an immediate .02 percent drop in employment. much less competitive at that time than they are now. In the
However, he finds that this sensitivity rises to -.252, meaning nineteenth and early twentieth centuries, there were often just
that a 10 percent change in the wage generates a 2.5 percent a few large employers in a community, which gave employers
drop in employment after six years, which is roughly one much more market power than employers have today.
hundred times larger than the immediate effect.
Because worker safety, human rights, and child labor
This large difference reflects the fact that as labor costs rise, regulations are now well established at the federal, state, and
businesses economize on labor by substituting capital and new local levels, unions have shifted their focus to increasing
technologies for workers and also by offshoring some tasks compensation and increasing employment, the latter through
to lower-cost providers of labor services. This large difference a process known as featherbedding. A large body of research

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 9
finds that these aspects of unionization have benefited union Their most striking conclusion is that in the absence of labor
members, particularly in the short run, but at the expense of market conflict with unions, the Rust Belt’s manufacturing
others by depressing economic growth, particularly in heavily employment share would have held steady at about 51 percent,
unionized industries. Moreover, research shows that unions even with stronger foreign competition. This is because
depress long-run compensation for their members by reducing globalization doesn’t just replace domestic sales with imports
firm innovation and investments. but provides opportunities for competitive domestic producers
to sell abroad, thus creating new markets.
Unions have considerable market power in collective
bargaining agreements since they are the sole supplier of labor Galdón-Sánchez and Schmitz (2002) and Schmitz (2005)
services to the firm. There are hundreds of studies estimating study how union work rules that severely limit the tasks that
union wage premia. Lewis’s survey (1986) finds estimated employees can perform in order to increase employment can
premia around 15–20 percent, meaning that union market depress worker productivity by 50 percent or more. These
power drives up compensation by 15–20 percent over the work rules can be as restrictive as not allowing a worker to
estimated free market compensation level. More recently, perform minor maintenance on a machine or change a light
Farber et al. (2018), with many references, also report similar bulb. They show that when iron-ore producers were subjected
union premia estimates. to increased competition, union work rules were reformed to
permit workers to perform more tasks, which doubled worker
One way this wage premium depresses economic activity is by productivity.
raising employer costs. This in turn raises prices and reduces
customer demand. Moreover, some of the methods by which Similarly, Holmes (1998) studies job creation and economic
unions have generated wage premia, which include strikes, performance right at state borders, in which one state is
independently depress economic activity. This is because a relatively heavily unionized and the state just across the border
strike is a tax on investment. By idling a firm’s capital stock, a is a “right to work” state which outlaws the union shop. He
strike, or even the threat of a strike, lowers the expected return finds that employment growth over time is much higher in
to investment, which in turn lowers investment, innovation, manufacturing plants in the right-to-work states very close
and productivity growth. This has very negative consequences to the border than in manufacturing plants that are close to
for the long-run health of the firm and, ironically, for the the border in the heavily unionized states.
long-run health of the union.
Union representation among private-sector workers has
Alder, Lagakos, and Ohanian (2014) analyze the impact of declined from a high of about 35 percent in the early 1950s
strike behavior and provide both theoretical arguments and to only around 6 percent today. This likely reflects several
empirical evidence that the frequent use of strikes and strike economic shifts since World War II that have led today’s
threats in major Rust Belt industries, such as autos and steel, workers to find union representation less attractive.
is the main factor responsible for the Rust Belt’s long-run Perhaps the most important factor is changes in competition.
economic decline. As described above, yesteryear’s unions imposed significant
economic inefficiencies within bargaining at a time when
The Rust Belt is typically defined as states bordering the many American producers faced little competition, either
Great Lakes, including Ohio, Pennsylvania, Michigan, Illinois, domestically or internationally. But in today’s increasingly
and New York. It accounted for more than 50 percent of competitive marketplace, any form of inefficiency threatens
the nation’s manufacturing employment in 1950. That share firm survival. The fact that public-sector unions have fared
declined chronically throughout the 1950s, 1960s, and 1970s, much more successfully than private-sector unions supports
falling to about 38 percent by 1980. This decline preceded this competition view. In the public sector, there rarely is any
the large shift to globalization that began around the mid- competition among producers and providers of government
1980s and that is widely believed to have negatively affected services. Not surprisingly, union membership among public-
US manufacturing. However, the timing of the Rust Belt’s sector workers is about 45 percent among local government
decline means that Alder, Lagakos, and Ohanian (2014) find employees (Ohanian 2011).
that the historical use of the strike threat by Rust Belt unions
accounts for about two-thirds of the decline of the Rust A second reason why union organization is much less popular
Belt’s manufacturing employment share. They also find that today is that collective bargaining agreements invariably offer
it accounts for much of the Rust Belt’s failure to innovate at a “one-size-fits-all” compensation package for its members.
the same rate as non-Rust Belt producers. But as workers have become increasingly skilled, and as job
responsibilities have become much more specialized, collective
bargaining has become outdated.

10 Hoover Institution
The fact that private-sector workers are not choosing union Most research analyzing occupational licensing has concluded
representation is the strongest evidence in supporting the view that much of this licensing is not in the interest of protecting
that the union model of yesteryear is not sufficiently valued consumers, but rather exists to insulate incumbent producers
by today’s private-sector workers. This is also reflected in the from competition at the expense of consumers.
fact that former union stronghold states, including Indiana,
Michigan, and Wisconsin, have voted to become right-to- Licensing limits entry of new professionals, which in turn
work states in the last few years. reduces competition in the industry. Licensing fees also raise
the cost of doing business. Both these factors drive up prices,
Private-sector unions have responded to these long-run trends thus reducing demand and harming consumers. Kleiner (2000)
driven by substantially changing bargaining practices to focus finds wage premia as high as 30 percent due to restricting entry.
on forming cooperative relationships with management
and enhancing firm efficiency and performance to increase Ironically, licensing can also harm incumbent licensees once
competitiveness. As an example of this change in union political and social pressure builds to force regulators to allow
practices, former United Auto Workers (UAW) president reforms. For example, in New York, livery drivers, particularly
Robert King summarized the very significant changes in taxi drivers, required a taxi medallion, which simply gave a
UAW practices as quoted on a website: “The 20th-century driver the legal right to operate (Williams 2019). Before the
UAW fell into a pattern with our employers where we saw popularity of ridesharing, including Uber and Lyft, the market
each other as adversaries rather than partners. Mistrust became price of these medallions was as high as $1 million.
embedded in our relations . . . [which] hindered the full use
of the talents of our members and promoted a litigious and However, this price has now fallen to about $100,000, given the
time-consuming grievance culture” (Walsh 2010). introduction of competition from Uber and Lyft. This decline
in the price of medallions has led to the loss of virtually all of
These long-run changes in private-sector unionization density the wealth of some drivers who purchased their medallions
and bargaining practices are natural reactions to increasingly at very high prices.
competitive markets and they are generally improving labor
market function by reducing inefficiencies. Occupational licensing has also been found to negatively
impact historically disadvantaged groups by imposing long
The Inefficiency of Occupational Licensing training or internship periods (Gittleman, Klee, and Kleiner
2018). For example, more than 1,700 hours of training are
Licensing occupational practices by a professional bureau required to become a licensed cosmetologist in California while
has been employed for many years in skilled professions 4,000 hours of training are required to work with electrical
where there is potential for substantial consumer harm. These signs in Michigan. Note that this latter requirement may
practices include medicine, law, and dentistry. Licensing is exceed the number of hours used by law students in taking
intended to protect consumers by providing objective, third- classes, studying, and preparing for the bar exam.
party confirmation that a provider is professionally qualified
to perform a trade. The negative impacts of occupational licensing led then
president Obama to commission a special study (US Treasury
More recently, professional licensing has spread to many Department 2015) of this issue by his Council of Economic
other occupations, particularly occupations where potential Advisers and the Treasury Department. They concluded:
consumer damage is extremely modest, such as tour guides,
cashiers, card dealers, florists, interior decorators, and hair The current licensing regime in the United States also
shampooers. Licensing even extends to professions that are as creates substantial costs, and often the requirements
much or more about providing entertainment as providing a for obtaining a license are not in sync with the skills
service, such as Maryland, which requires licenses for fortune needed for the job. There is evidence that licensing
tellers, and Arizona, which requires licenses for rainmakers requirements raise the price of goods and services,
(Kleiner 2000). restrict employment opportunities, and make it more
difficult for workers to take their skills across State
Today, 29 percent of workers require a professional license, lines. Too often, policymakers do not carefully weigh
up from 18 percent in 2000 and about 5 percent in the 1950s. these costs and benefits when making decisions about
Put differently, this means that nearly one of every three whether or how to regulate a profession through
workers must have government approval to work in his or licensing.
her chosen profession.

The Effect of Economic Freedom on Labor Market Efficiency and Performance | Ohanian 11
Policies to Safely Restore Work During the COVID-19 Alesina, Alberto, Edward Glaeser, and Bruce Sacerdote. 2005.
Crisis “Work and Leisure in the U.S. and Europe: Why So
Different?” NBER Macroeconomics Annual.
Without safe and effective vaccines available, all economies
will need to contend with the novel coronavirus for the near Bernal-Verdugo, Lorenzo E., Davide Furceri, and Dominique
term. Policies should be focused on incentivizing low-risk Guillaume. 2012. “Labor Market Flexibility and
workers— those who are young and middle-aged and without Unemployment: New Empirical Evidence of Static
the risk factors of significant hypertension, diabetes, and and Dynamic Effects.”  Comparative Economic
cardiopulmonary disease—to return to work. Studies 54, no. 2 (May): 251–73.

One policy shift is to convert existing unemployment benefits Blanchard, Olivier. 2004. “The Economic Future of Europe.”
to unconditional cash transfers. We want low-risk workers to Journal of Economic Perspectives 18, no. 4 (Fall): 3–26.
return to work and we do not want social support to be tied to
Blanchard, Olivier, and Justin Wolfers. 2000. “The Role of
them remaining unemployed. We also can directly subsidize
Shocks and Institutions in the Rise of European
health insurance for workers who do not receive insurance
Unemployment: The Aggregate Evidence.” Economic
that is not provided by their employers. Businesses should
Journal 110, no. 462 (March): C1–33.
be incentivized to take precautions to protect their workers
from the virus. They could receive tax credits if few of their Botero, Juan, Simeon Djankov, Rafael LaPorta, Florencio
workers test positive after returning to work. This is in the López-de-Silanes, and Andrei Shleifer. 2004.
same spirit as unemployment insurance ratings for businesses, “The Regulation of Labor.”  Quarterly Journal of
in which the insurance premium paid by a business depends Economics 119, no. 4: 1339–82.
on the frequency that its workers are laid off. This is needed
because workers need to feel safe in returning to their places Card, David, and Alan B. Krueger. 1994. “Minimum Wages
of employment. and Employment: A Case Study of the Fast-Food
Industry in New Jersey and Pennsylvania.” American
Summary and Conclusion Economic Review 84, no. 4 (September): 772–93.

This study has summarized research on how economic freedom ———. 2015. Myth and Measurement: The New Economics of
affects the labor market. Research shows that high tax rates, the Minimum Wage, 20th anniversary ed. Princeton,
high regulations (including occupational licensing), inefficient NJ: Princeton University Press.
unionization bargaining practices, and high minimum wages
depress the efficient functioning of the labor market. It also Cociuba, Simona E., Edward C. Prescott, and Alexander
shows that many of these policies have benefits for very few Ueberfeldt. 2018. “US Hours at Work.” Economics
while imposing significant costs on the rest of society. Letters 169: 87–90.

The research cited here has important implications for Farber, Henry S., Daniel Herbst, Ilyana Kuziemko, and
economic policies. It shows that policy reforms that reduce Suresh Naidu. 2018. “Unions and Inequality over
tax rates, eliminate burdensome regulations, and enhance the Twentieth Century: New Evidence from Survey
competition can significantly increase economic growth Data.”  National Bureau of Economic Research
and job creation. Moreover, the increased economic growth working paper 24587.
would dwarf the costs to those who currently benefit from
the inefficient policies. This means that those who would lose Galdón-Sánchez, José E., and James Schmitz Jr. 2002.
from such reforms could in principle be easily compensated “Competitive Pressure and Labor Productivity: World
for their losses. Iron-Ore Markets in the 1980’s.” American Economic
Review 92, no. 4 (September): 1222–35.

Gittleman, Maury, Mark A. Klee, and Morris M. Kleiner.

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Endnotes
1
Labor income taxes and sales taxes on consumption have fairly
similar effects on labor supply, as labor taxes reduce take-home
pay, which reduces the amount of consumption workers can
purchase, while consumption taxes raise the cost of the goods,
which also reduces the amount of consumption workers can
purchase.

2
Canada, New Zealand, and Australia were the other countries in
the dataset that had small changes in tax rates. All had relatively
constant labor supplies. These countries are omitted from the table
because of space considerations.

3
PayScale, “Average Hourly Rate for State: Mississippi,” https://
www.payscale.com/research/US/State=Mississippi/Salary.

Lee Ohanian
Senior Fellow, Hoover Institution
Lee E. Ohanian is a senior fellow at the Hoover
Institution and a professor of economics and
director of the Ettinger Family Program in
Macroeconomic Research at the University of
California, Los Angeles (UCLA).

14 Hoover Institution
 SOCIALISM AND FREE-MARKET CAPITALISM:

THE HUMAN PROSPERITY PROJECT

A N E S S AY S E R I E S F R O M T H E H O O V E R I N S T I T U T I O N

Over the last century, free-market capitalism and socialism have provided the dominant interpretations, and conflicting visions, of political
and economic freedom.

Free-market capitalism is characterized by private ownership of the means of production, where investment is governed by private decisions
and where prices, production, and the distribution of goods and services are determined mainly by competition in a free market. Socialism
is an economic and political system in which collective or governmental ownership and control plays a major role in the production and
distribution of goods and services, and in which governments frequently intervene in or substitute for markets. Proponents of capitalism
generally extoll the economic growth that is created by private enterprise and the individual freedom that the system allows. Advocates of
socialism emphasize the egalitarian nature of the system and argue that socialism is more compassionate in outcomes than is the free market.
The Hoover Institution’s Socialism and Free-Market Capitalism: The Human Prosperity Project is designed to evaluate free-market capitalism,
socialism, and hybrid systems in order to determine how well their governmental and economic forms promote well-being and prosperity.

CO-CHAIRS John F. Cogan Bjorn Lomborg

Scott W. Atlas Leonard and Shirley Ely Senior Fellow Visiting Fellow
Robert Wesson Senior Fellow
Larry Diamond Michael McConnell
Edward Paul Lazear Senior Fellow Senior Fellow
Morris Arnold and Nona Jean Cox Senior Fellow
Elizabeth Economy H. R. McMaster
PARTICIPANTS Distinguished Visiting Fellow Fouad and Michelle Ajami Senior Fellow

Ayaan Hirsi Ali Niall Ferguson Lee Ohanian

Research Fellow Milbank Family Senior Fellow Senior Fellow

Terry Anderson Stephen Haber Condoleezza Rice

John and Jean De Nault Senior Fellow Peter and Helen Bing Senior Fellow Thomas and Barbara Stephenson Senior Fellow

Peter Berkowitz Robert E. Hall Amit Seru

Tad and Dianne Taube Senior Fellow Robert and Carole McNeil Senior Fellow Senior Fellow

Russell A. Berman Victor Davis Hanson John B. Taylor

Senior Fellow Martin and Illie Anderson Senior Fellow George P. Shultz Senior Fellow in Economics

Michael J. Boskin Caroline M. Hoxby John Yoo

Wohlford Family Senior Fellow Senior Fellow Visiting Fellow

John H. Cochrane David L. Leal

Rose-Marie and Jack Anderson Senior Fellow Senior Fellow

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