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The Impact of Minimum Wages on Demand-Driven Development

Development Challenge

Developing countries often have low levels of formal sector employment, which, because it is more productive and efficient, is more likely to bolster economic growth than informal employment.  However, workers may prefer informal sector employment due to real or perceived difference in working conditions or hours, keeping informal employment high and thus stifling growth.

There is little evidence on successful policies for encouraging a shift to formal sector employment. One approach is to increase formal sector wages to make formal sector jobs relatively more attractive to prospective employees. However, economic theory posits that artificially raising wages results in higher marginal costs for producers, leading to lower labor demand, lower profits, and stalled development. This study tests whether increased minimum wages can actually increase demand-driven development. 

Context

The first half of the 1990s witnessed rapid economic expansion and massive foreign investment in Indonesia. From 1990 to 1997, minimum wages doubled in real terms before falling during the Asian financial crisis. This rapid rise in minimum wage was motivated by a convergence of factors: the national government’s desire to enforce a wage which would enhance consumption, pressure from the US Government, and concurrent anti-sweatshop activism.

Local councils, not the national government, determined minimum wage rates. This led to 32 different minimum wage regimes throughout the country. The heterogeneity of the wages created natural comparison groups to observe the effect of minimum wage on growth and formal employment. From 1997 to 2000, full time wage employment grew in areas with higher minimum wages.  

Evaluation Strategy

The “big push” model predicts that an increase in the minimum wage would cause an increase in formal sector employment, but only for firms that produce non-tradable goods and products.  Non–tradable goods are especially important in local markets because they 1) have the potential to feed industrialization, and 2) rely on local consumption. At the same time a reduction in informal employment should occur, as the informal sector is crowded out by the more efficient formal sector. For industries that are tradable or not able to industrialize, however, increases in minimum wage should have no positive impact.

To test this model, the study:

1.Examined the average trends in formalization and employment,

2.Verified the increase in local expenditures in response to minimum wages, and

3.Explored industry heterogeneity to see if it followed the model.

Data on these outcomes of interest are regressed on real minimum wages (normalized by a national price index).  The study utilized three estimation strategies to verify trends: difference in difference (DD), spatial difference (SD, comparing effects across small regions in space), and difference in spatial differences (DSD).  DSD analyses require strictly weaker assumptions than DD or SD analyses, and so are valid when either the DD or SD approach would be (as well as some contexts where neither would be).

The study utilizes two primary data sources. The first is the Indonesia Family Life Survey (IFLS), which captured levels of informal economic activity and personal consumption in 1993, 1997, and 2000. The second, Statistics Industry (SI), is an annual census of all manufacturing firms in Indonesia with at least 20 employees from 1990 to 2000. It provides information on formal sector employment, as well as detailed firm-specific data, which is used to distinguish tradable and non-tradable industries. 

Results and Policy Implications

Increased minimum wages were associated with higher formal sector employment and household expenditures. A one hundred percent increase in real minimum wage led to:

  • A ten percent increase in full-time waged employment and a ten to twenty percent reduction in self-employment.
  • An eighty to one hundred percent increase in total expenditures, primarily in nonfood products.

This supports the demand-driven development theory that increased minimum wage leads to an expansion of markets for industries producing non-food goods for sale locally.

Industry Results

Overall, manufacturing employment in districts with higher minimum wages increased, but impacts varied with to firm characteristics. Formal, non-exporting firms saw an increase in employment as a result of higher minimum wages, while informal firms (ie. no legal status) saw a decrease in employment. Exporting firms showed no impact. Conversely, the service industry, which is largely unindustrialized and dominated by non-tradable goods, showed an increase in informal employment and no increase in wages. Regulated wage standards do not impact informal employment, but increased consumer spending benefits the industry.

This study demonstrates that a “big push” strategy can be effective in stimulating industrial growth by raising minimum wages in situations where production is dependent on local consumption. Developing countries that lack investment in high productivity industrialization technologies and seek to grow their economy can benefit from a well-designed minimum wage law. This can move economies away from low wage, low consumption, informal labor markets to a high wage, high consumption, formal labor market, spurring increased productivity while improving standards of living. Policymakers should be cautioned, however, that is only effective in economies where firms depend primarily upon local consumption of goods, and would not hold true for an export-oriented economy.

Timeline

2011-2012

Photo Credit: J-PAL, Indonesia, 2008.