Whenever lawmakers float a minimum wage increase, the same worry surfaces: small, independent businesses will struggle to absorb higher labor costs, lay off workers, or close their doors. Owners have slim margins, the argument goes, and customers won’t tolerate higher prices. But until recently, economists had limited ability to trace exactly where the money moves when a state raises its wage floor, because doing so requires linking individual firms to their workers, their owners, and their full financial statements over time.
A new article in The Quarterly Journal of Economics takes on that question using the full universe of U.S. tax returns. The researchers find that independent firms in industries heavily reliant on low-wage labor largely absorb minimum wage increases by raising new revenue, leaving owners’ profits essentially unchanged. Workers see higher earnings without losing jobs, and the industries themselves become populated by fewer but more productive firms.
A question that required a new dataset
Nirupama Rao of the University of Michigan’s Ross School of Business and Max Risch of Carnegie Mellon’s Tepper School of Business built a linked firm-worker-owner panel drawn from IRS records spanning 2010 to 2019. They focused on “pass-through” businesses, a legal category that includes S-corporations, partnerships, and LLCs. These are the privately owned firms that make up the bulk of independent businesses in the country, accounting for roughly half of private-sector employment.
Pass-through firms are harder to study than large public corporations because there’s no standard financial reporting. But their tax returns contain detailed income statements, and each firm can be linked to the W-2 forms it issues to workers. That connection let the researchers track not just how many people worked at a firm, but who those workers were, what they earned, and where they went if they left.
The analysis centered on 19 state-level minimum wage increases that took effect between 2013 and 2016, including hikes in 17 states, Washington D.C., and Chicago. The average increase amounted to $2.59, or about 34 percent, when phased in over four years. The researchers compared firms in these treated states to similar firms in 22 states that left their wage floors unchanged during the period, focusing on the four-digit industries where minimum wage workers are concentrated. Restaurants alone account for 42 percent of workers paid at or below the prevailing minimum wage.
What happened to jobs
The first finding concerns employment. On average, independent firms in highly exposed industries did not lay off existing workers after the minimum wage rose. They did, however, pull back modestly on hiring, ending up with about 1.5 fewer employment relationships per firm per year, roughly a 2 percent reduction.
That decline was concentrated almost entirely in part-time positions paying less than $4,000 a year, and mostly in jobs held by teenagers. Workers earning between about $3,900 and $35,000 annually saw their compensation rise, with the largest gains going to those working full-time at the new wage floor. There was no evidence that firms clawed back pay from higher earners to offset the new costs.
Where the money came from
If firms weren’t cutting staff and weren’t reducing pay elsewhere, how did they cover the higher wage bills? The tax data offered a direct answer. Wage costs rose by about 1.43 percent of baseline revenue four years after the increase. Non-labor costs (things like materials and supplies) rose by about 1.66 percent of baseline revenue. Together, that’s roughly a 3 percent jump in total variable costs per dollar of prior revenue.
Revenue, meanwhile, rose by about 3.31 percent. The math worked out almost exactly: owner profits showed no detectable change, with the estimate ruling out losses larger than 0.37 percent of baseline revenue with 95 percent confidence. Rao and Risch interpret this as evidence that consumers, rather than owners, finance the higher pay to low-wage workers through some combination of price pass-through and demand shifting toward surviving firms.
The pattern held across industries, though the composition of the cost increases differed. For restaurants, where wages are a bigger share of revenue, the wage bill rose by about 2 percent of baseline revenue and materials costs barely moved. For retail and other exposed industries, materials costs rose more while wage bills rose less.
The entry effect
Minimum wage increases did leave a mark somewhere: on new firm formation. Four years after a state raised its wage floor, the number of independent firms operating in highly exposed industries was about 2 percent lower than it would have been otherwise, driven entirely by reduced entry rather than increased exit. Existing firms stayed in business, but potential entrepreneurs appeared to think twice.
The firms that did enter were different from those that might have entered before. They showed higher productivity, measured as value added per worker, and lower spending on non-labor inputs relative to revenue. The researchers describe this as “positive selection”: the cost shock filtered out would-be entrants who couldn’t operate efficiently at the new wage floor, leaving behind leaner, more productive newcomers.
Despite the slower entry, aggregate revenue across independent firms in these industries rose by about 2.63 percent, and aggregate profits held steady. Workers collectively received a larger share of a larger pie.
Following the workers
The firm-level results raised a separate question: if independent businesses were hiring fewer part-time workers and fewer new firms were opening, did vulnerable workers end up worse off? To check, Rao and Risch built two worker-level panels, one tracking low-earning workers and another tracking young individuals ages 15 to 26, across all industries and firm types, including large C-corporations not covered in the firm analysis.
Average annual earnings for low-earning workers rose by about 18.9 percent four years after a minimum wage increase, compared to similar workers in untreated states. Young workers saw earnings rise by about 21.8 percent. Employment rates stayed essentially flat for both groups. Retention rates at exposed firms actually rose, with low-earning workers about 1.87 percent less likely to separate from their employer.
The worker panels also revealed a reallocation pattern that helps reconcile the firm-level and worker-level findings. Low-earning workers and teenagers became more likely to work at large C-corporations in exposed industries and less likely to work at independent businesses. As independent firms hired fewer part-time workers and fewer new independents opened, displaced and churning workers landed at larger corporations instead. The net effect on whether a worker was employed at all was close to zero.
Caveats and what the study doesn’t address
The authors are explicit that their findings describe short- to medium-run effects of phased-in increases, covering a window of up to four years after a state’s initial hike. Longer-run responses could differ if firms eventually reconfigure production to rely less on low-wage labor, or if incumbents cut back on amenities or equipment maintenance in ways that tax data don’t capture. The study also can’t separate price increases from shifts in consumer demand toward surviving firms, since tax records report revenue but not the prices and quantities behind it.
The wage increases studied came during a period of economic expansion. Research focused on minimum wage increases during recessions has found somewhat larger effects on employment and firm finances, suggesting the economic context matters. And the analysis covers minimum wage increases that did not exempt small firms, so the results speak to policies that apply uniformly rather than those with small-business carve-outs.
For the independent business owners who worry loudest about minimum wage policy, the tax records tell a specific story: their profits, on average, weren’t the casualty. The costs landed on customers and on the entrepreneurs who never got started.
