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Minimum wages aren’t always the best way to improve social welfare

May 4, 2016

For most countries, raising the minimum wage has long been considered a way to protect poor workers and their families. In fact, this active labour market intervention is a common social protection policy in many Latin American countries. But how effective are minimum wages in protecting the poor? It’s a timely question as the debate heats up over whether minimum wages help avoid “the race to the bottom” or serve as a major impediment to greater labour market flexibility and competitiveness. 

To shed light on this issue, International Development Research Centre research partners, led by FUSADES in El Salvador, examined how minimum wage legislation affects the welfare of workers and their families in Costa Rica, El Salvador, and Nicaragua. They produced new multi-year panel data sets (from 1998 to 2007) for households and individuals, and state-of-the-art econometric methodologies to assess the impact of minimum wage changes on wages, employment, the movement of workers into and out of the formal sector, and transitions into or out of poverty.

A blunt tool for poverty reduction

The results show that minimum wages boost the wages of some workers and that higher minimum wages can reduce poverty rates. However, the evidence also suggests that minimum wages are a blunt and inefficient way to reduce poverty and income inequality. Key findings include:

  • Minimum wages affect only a sub-set of workers, mostly full-time formal sector workers in large firms in urban areas who earn near the middle of the distribution of wages. That is, legal minimum wages in these countries do not affect the wages of the lowest-paid workers and thus have little effect on those in extreme poverty. ​
  • Enforcement is limited. Unsurprisingly, enforcement of legal minimum wages in Central America is limited because of the complex structure, limited capacity of enforcement institutions, and the existence of large sectors of workers not legally covered by minimum wage laws. However, even in the private formal sector a large percentage of workers earn below the minimum wage.
  • Rising minimum wages hurt workers in the private formal sector. Changes in minimum wages deter firms from hiring new workers and trigger layoffs in jobs that usually offer other benefits such as social security coverage. A 10% increase in the real minimum wage leads employment to fall by approximately 1% in Costa Rica, 3% in Nicaragua, and 10% in El Salvador.

Better policy tools

While pursuing complex minimum wage legislation may provide quick political gains, a more effective way to protect workers would involve the following:

Simplify legislation.

Fewer and simpler minimum wages should boost compliance, including “self-enforcement” by workers and employers. The complex system of minimum wages – which is costly and resource intensive – makes it difficult for workers, employers, and labour ministry officials to know which specific minimum wage applies to a specific worker.

Introduce short-term programs to help workers who lose their jobs because of higher minimum wages.

Minimum wages will better help low-paid workers and social goals if programs are in place to support the low-paid workers who lose their jobs. These programs include emergency employment programs (workfare or guaranteed employment programs for the poor), unemployment insurance, placement programs, and job training.

Introduce long-term programs to improve income earning capabilities of low-paid workers.

Most workers see their incomes rise not because of higher minimum wages, but because they have the skills and ability to command higher wages. This suggests that policies should focus on increasing the ability of low-paid workers to earn more – whether through better access to formal education or training, especially for vulnerable workers. Conditional cash transfers could help by providing incentives for poor families to invest in health and education for their children. Finally, to reach out to those now unaffected by minimum wages, there is a role for policies that enhance business skills and credit availability for the self-employed and microenterprises. 

For more information on these findings, visit IDRC program officer Edgard Rodriguez’ blog. ​