# enforcement in the formal sector.

The second possible explanation involves the level at which minimum wages are usually set. Where significant negative employment effects have been observed, the minimum wage tends to be quite high or out of line with economic conditions. In Nicaragua, for example, formal sector employment suffered when the minimum wage was set at 86% of the median wage (Alaniz et al. 2011). Colombia experienced negative employment effects after a substantial minimum wage increase in the late 1990s when labor demand was weak (Kucera and Roncolato 2008). Examples such as these notwithstanding, it is more typical, as Freeman (2010) noted, that policy-makers are aware of the potential harm of very high minimum wages, so they tend to set them at a reasonable level, roughly in line with prevailing market wages for unskilled workers.

# _Impacts on earnings_

Virtually all studies that estimate the wage effect find, not surprisingly, that formal-sector wages rise with higher minimums. As expected, the positive impact is strongest around the minimum wage, persisting somewhat above the minimum because wage relativities are maintained and diminishing as one moves further up the wage distribution (e.g., Gindling and Terrell 1995; Fajnzylber 2001; Maloney and Nunez Mendes 2004).<sup>9</sup> More surprising is the observation that increases in the minimum wage often raise, rather than depress, wages in the informal sector. This finding is most common in studies of Latin American countries (e.g., Foguel et al. 2001 for Brazil; Fajnzylber 2001; Maloney and Nunez Mendes 2004; Banaante 2004 for Peru; Gindling and Terrell 2004; Lemos 2004 and 2009). It has usually been attributed to the _"Efeito Farol"_ , or "lighthouse effect", whereby the minimum wage is seen as a benchmark wage for unskilled labor throughout the economy, including the informal sector where it is not binding.

The empirical research is also consistent in demonstrating that the minimum wage compresses wage distributions and reduces earnings inequality. For example, Lemos (2004, 2009) and Fajnzylber (2001) find wage compression in Brazil as a result of minimum wage increases. Gindling and Terrell (1995) and Banaante (2004) report similar findings for Costa Rica and Peru because positive wage impacts are strongest for low-wage workers. However, in their review of minimum wages in the Latin America and Caribbean region, Kristensen and Cunningham (2006) note that the effects of the minimum wage on the distribution of wages depends on where the minimum wage is set. When it set at a relatively low level, it compresses the distribution. When it is set at a higher level, it can widen distributions by primarily benefiting higher-wage workers.

An important question concerns the role of minimum wages in the long-run increases in earnings inequality that have been observed in many countries. In a recent cross-country analysis of inequality, the OECD (2011) has estimated that policies and institutions accounted for the largest share in the increase in the 9<sup>th</sup> /1<sup>st</sup> earnings decile ratio, more than technological change and much more than globalization. Declining real minimum wages are one of the institutional changes driving this inequality. This finding has been established for developed countries for a number of years (e.g., DiNardo, Fortin, and Lemieux 1996 for the U.S.). This is 9