Minimum Wages and Consumer Credit: Impacts on Access to ...

Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs

Federal Reserve Board, Washington, D.C.

Minimum Wages and Consumer Credit: Impacts on Access to Credit and Traditional and High-Cost Borrowing

Lisa J. Dettling and Joanne W. Hsu

2017-010

Please cite this paper as: Dettling, Lisa J., and Joanne W. Hsu (2017). "Minimum Wages and Consumer Credit: Impacts on Access to Credit and Traditional and High-Cost Borrowing," Finance and Economics Discussion Series 2017-010. Washington: Board of Governors of the Federal Reserve System, . NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers.

Minimum Wages and Consumer Credit: Impacts on Access to Credit and Traditional and High-Cost

Borrowing

Lisa J. Dettling Federal Reserve Board

Joanne W. Hsu Federal Reserve Board

This version: January 15, 2017*

Click here for current version

Abstract

Proponents of minimum wage legislation point to its potential to raise earnings and lift families out of poverty, while opponents argue that disemployment effects lead to net welfare losses. But these arguments typically ignore the possibility that minimum wage policy has spillover effects on other aspects of households' financial circumstances. This paper examines how state-level minimum wage changes affect the decisions of lenders and low-income borrowers. Using data derived from direct mailings of credit offers, debt recorded in credit reports, and survey-reported usage of alternative credit products, we broadly find that when minimum wages rise, access to credit expands for lower-income households, who in turn, use more traditional credit and less high-cost alternatives. Specifically, for each $1 increase in the minimum wage, lower-income households receive 7 percent more credit card offers, with higher limits and improved terms. Further, there is a drop in usage of high-cost borrowing: payday borrowing falls 40 percent. Finally, we find that borrowers are also better able to manage their debt: delinquency rates fall by 5 percent. Overall, our results suggest that minimum wage policy has positive spillover effects by relaxing borrowing constraints among lower income households.

Keywords: consumer debt, minimum wages, credit limit, delinquency, payday loans, credit constraints

* Contact e-mails: lisa.j.dettling@, joanne.w.hsu@. We thank Neil Bhutta, Melissa Kearney, Kevin Moore, John Sabelhaus, Jeff Thompson, and seminar participants at the Federal Reserve Board and George Mason University for comments. Elizabeth Llanes and Peter Hansen provided excellent research assistance. The analysis and conclusions set forth are those of the authors and do not indicate concurrence with other members of the research staff or the Board of Governors.

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1. Introduction

Minimum wages policies are enacted to raise incomes for low skill workers, with the intended goal of lifting households out of poverty, reducing inequality, and stimulating the economy by increasing aggregate consumption. But labor market outcomes are only one piece of a household's finances, and any changes in income stemming from changes in the minimum wage may also affect a household's ability to borrow and their interactions with credit markets. Whether and how the minimum wage passes through to credit markets may weaken or amplify the effects of the policy. If low-income households face binding borrowing constraints, expanded access to credit could enable households to leverage small increases in income to finance lumpy durable or human capital investments, which could help further lift them out of poverty. But if potential borrowers are sufficiently present-biased, financially illiterate or face self-control problems, over-borrowing and large debt-service burdens could worsen household's financial circumstances, mitigating any income gains. If low-income households do not face binding borrowing constraints, or if lenders do not expand access to credit after a minimum wage change, than neither of these would occur.

Our paper examines the impacts of state-level minimum wage changes on lender and borrower behavior in traditional credit markets, like credit cards and auto loans, as well as highcost alternative credit products, like payday loans. We use data on direct mailings of credit offers, panel data derived from credit reports, and survey data on high-cost credit usage, combined with changes in state minimum wage policy, to document several novel empirical facts. First, that lenders send more offers, with better terms, to low-income borrowers when the minimum wage rises in their state. Second, we confirm the findings from previous research

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(e.g., Aaronson, Agarwal and French 2012): borrowing increases among low skill workers after the minimum wage rises, and that borrowers do not default on these new loans in the medium term. We also find evidence of pay-down of existing debts. As a result, borrowers' credit scores rise. And third, we document a substantial drop in usage of payday loans and other high-cost alternative to formal credit. We find no corresponding changes among higher income or higher skill workers.

We interpret our empirical results as supportive of the existence of borrowing constraints among low-income households. In particular, the fact that lenders increase access to traditional credit to low-income borrowers, and borrowers take up such low-cost credit and substitute away from payday borrowing after a minimum wage hike, suggests that credit constraints faced by low-income borrowers are at least partially relaxed when minimum wages increase. This view is consistent with recent work by Aaronson, Agarwal and French (2012) who found that their estimated consumption response to minimum wage hikes are consistent with a buffer stock model with widespread borrowing constraints. We expand upon their analyses by empirically documenting an expansion in credit supply and a reduction in payday borrowing.

We find that defaults fall by 5 percent following a minimum wage hike. For new borrowers, the reduction in defaults suggests these households are not over-borrowing, and for existing borrowers, it suggests households save some of their new income via debt pay-down. As a result, we find that credit scores rise by 8 points following a minimum wage change. Because payment behavior and credit scores are used in future credit applications, this suggests the minimum wage could have persistent effects on household's ability to access affordable liquidity. These changes may better enable those households' to weather future expenditure

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shocks and finance lumpy investments, further improving their economic well-being. To our knowledge, this potentially important --and persistent-- spillover effect of minimum wage policies on households' financial lives has not previously been explored.

We find evidence of a 40 percent drop in payday and other high-cost borrowing following minimum wage hikes. This is particularly notable in light of the fact that targeted payday loan bans have had limited success in reducing borrowing costs for low-income families (Bhutta, Goldin, and Homonoff, forthcoming). A common explanation for payday loan usage among low-income borrowers is cognitive biases (Bertrand and Morse, 2011). Our paper suggests borrowing constraints in traditional credit markets are an important explanation, and that policies that target income support and/or credit constraints may be more effective in reducing usage of these products than targeted bans.

Broadly, our paper indicates social insurance programs can have spillover effects on lender and borrower behavior in consumer credit markets, and these spillovers can amplify the effects of policy. This is consistent with Hsu, Matsa and Meltzer (2014) who find that more generous unemployment insurance acts as housing market stabilizer by averting mortgage default and foreclosures. Minimum wages target a lower income segment of the population, but we similarly see amplification effects via expanded access to lower cost credit. This speaks the potential interaction between social policy and financial stability.

The rest of the paper is organized as follows. Section II describes our conceptual framework for understanding how minimum wages affects how low-income households interact with credit markets, along with the relevant literature. Section III presents our empirical analysis, including a description of minimum wages in the US, our data and empirical strategy, and

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