# **e. Minimum Wages**<sup>**27**</sup>

Theoretically, the minimum wage offers a trade off between raising the incomes of poorer workers to provide a “living” wage and the possible negative employment effects that, taken as a group, may leave the poor potentially less well off.

**_Minimum wages affect the distribution of wages... especially in the informal sector._** Despite concern about enforcement, kernel density plots suggest that the minimum wage is often binding and sometimes strongly, as in the case of Colombia.<sup>28</sup> Both studies also confirm as a general rule in the region, the existence of what Neri and others term the “efeito farol” or lighthouse effect, that the minimum wage is _more binding in the informal than the formal sector_ . This adds support to the idea that the informal sector is not completely unprotected by social norms, but in fact is covered by notions of fair wages.

**_Further, the wage is used as numeraire for wage gains throughout the distribution_** thus leveraging the effect even up to middle income workers.<sup>29</sup> This contrasts with the OECD where only youth whose wages are clustered around the minimum wage are affected.

**_The minimum wage can be a tool for poverty and inequality reduction but it can be set too high and lead to greater income inequality_** _._ The recent LAC regional study “Minimum Wages: Employment, Wages and Poverty”<sup>30</sup> commissioned studies of several countries and concluded that in countries with relatively low minimum wage levels,  the minimum wage increases the wages of poorer workers, has minimal effects on unemployment, and leads to an aggregate net increase in household labor income for the poor households.  It also reduces income inequality because the numeraire effects diminish to zero in higher earning households.<sup>31</sup> However, in Colombia, a country with relatively high minimum wages, Arango (2003) finds that the lost employment effect dominated the wage effect and led to an increase increased poverty and  an increase in household labor income inequality.  Thus, while a high minimum wage may serve a social justice objective, by setting it “too high,” it can have the opposite effect.

**_Further, the most “vulnerable” workers are the first to be hurt by excessively high minimum wages._** Even where minimum wages are relatively low, the wages of young, low-skilled, and female workers benefit from a higher minimum wage – as do those of prime-aged, skilled, and male workers –, but the unemployment effects are also concentrated on them. Montenegro and Pages (2004) for example, find that, as with job security provisions, minimum wages reduce the employment probabilities of the young and unskilled.  In essence, their income as a group is redistributed to less vulnerable segments of the labor force.

**_The unemployment effects imply a need to combine the minimum wage  with other social welfare tools._** While a well-targeted direct policy of tax and redistribute would most efficiently achieve the redistribution goals, the minimum wage may be a more realistic means for achieving this goal.  It avoids many of the pitfalls of other social policies: self targeting, market (rather than government) income redistribution, minimal public administration, no perverse labor supply incentives (receipt of benefit is contingent on being in the labor force), and it does not ring of paternalism

> 27 See background document by Cunningham.

> 28 See Maloney and Nuñez (2004) Cunningham (2004). See also Gindling and Terrel for Costa Rica who  nonetheless find no impact in the informal sector.

> 29 See Maloney and Nunez (2004), Fajnzylber (2002), Cunningham et al (2004), Garcia Verdu (2003).. 30 Cunningham (2004)

> 31 See Cunningham, Neumark and Siga 2004 for Brazil, Maloney and Nunez(2004) for Colombia

15