Minimum Wages and the Fight Against Inequality

Financial Economics
Macroeconomics - Economic growth - Monetary Policy

This article was previously published in the Ideas Matters Blog, on March 21, 2018.

Many policymakers say minimum wage hikes are crucial to reducing inequality. They look at Latin America and see abundant evidence, including the fact that in various countries large minimum wage increases during the commodity boom of the 2000s coincided with large inequality declines.

There is certainly some truth to the idea. Minimum wage increases during times of strong economic growth can make a significant difference. That appears to have been the case in numerous countries during the boom, including Brazil, Argentina, and Chile.

Minimum wage increases do not always work

But a minimum wage increase during a recession can be harmful. It may squeeze companies that can’t afford it, forcing them to fire employees or to hire them under the table at lower wages than the minimum and without labor protections. The result: more people in the informal sector and higher rather than lower inequality.

It is all a question of gauging the circumstances and timing.

Take the case of Brazil. During 1995-2002, a time of low growth in Brazil, minimum wage hikes above mean and median wages led to falling compliance with the law. As a result, the number of workers earning less than the minimum wage increased by a full 6 percentage points of the labor force. But during the boom years of 2003-2012, rising minimum wages provided a significant lever for pulling low-wage workers closer to middle-wage ones in income. Indeed, according to a studydone by Chico Ferreira, Sergio Firpo and I, minimum wage hikes accounted for around 20% of the dramatic decline inequality in the country during that period.

Still minimum wages are far from the whole story in Latin America. Countries like Peru and Paraguay showed strong declines in inequality during the 2000s without raising the minimum wage very much. And, as mentioned, minimum wage increases even in Brazil accounted for only around 20% of the fall in inequality. The rest was due to numerous factors, as discussed in a recent blog. They included, among others, strong demand for unskilled workers; reductions in pay differences between those in the formal and informal sector; and smaller premiums (or extra pay), both for highly educated people – as education levels rose — and for older, experienced workers, perhaps because of technological changes to which they could not adapt.

A high minimum wage can lead to low compliance

Minimum wage increases, in short, can help. But they aren’t everything and will only work in the right contexts. Getting it right is difficult as Joana Silva and I discuss in a recent book. In Colombia, for example, the minimum wage is so high that it has provoked significant avoidance of the law, with many people even in the formal sector working at wages below the minimum. It is doubtful, given that mismatch with real conditions, that raising the minimum wage there would positively affect either poverty or inequality. In Mexico and Uruguay, by contrast, the minimum wage was so low during the boom relative to the median wage, that it failed to deliver much of a kick, it impacts limited to roughly the bottom 10% of workers.

The key is placing the minimum wage at the right distance from the median wage and then finding the right moment to increase it. Some countries make the mistake of failing to raise it when the median wages are moving up, thus missing an opportunity to help workers on the bottom. Then, they make an even worse mistake and try to catch up during a recession when workers are hurting. Since firms can’t afford the hike at that time, those workers may end up being pushed into informality. Brazil has worked to avoid that mistake. It has been using a formula in recent years to synchronize minimum wage growth with inflation and economic growth.

The conclusion seems clear: the commodity boom has indeed provided evidence of minimum wages’ virtues. They are a valuable tool for ensuring that growth is inclusive, that everybody shares in its benefits. But, like any tool, they must be used at the right time and in the right way if they are to help fight rather than exacerbate inequality.

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