Published on Jobs and Development

Preventing distortions in minimum wages

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The minimum wage is a basic labor policy for workers and used in most countries around the world. But can we prevent the distorted use of the minimum wage? In theory yes. It is difficult although not impossible.
The function of the minimum wage as a labor tool is to correct imperfections in labor markets, which can lead to misalignments between wages and productivity levels in the economy. In some countries, the minimum wage is used as a tool to protect workers from lower incomes by establishing an effective wage floor. But its effectiveness differs greatly around the world, mainly because of various adjustment designs and schemes used, and the fact that in several cases their management is not aligned with the desired target.
In countries as diverse as the United States and Peru, minimum wages have become one of the protagonists in the electoral drama. In the US for example, some candidates propose specific minimum wage levels, while others refute their need to be increased altogether. In Peru, despite the socio-economic situation of the country—weak economic growth, low labor productivity and high incidence of informality— electoral candidates have made a number of campaign promises to raise the level - significantly in some cases. In both countries, the candidates make promises without offering a valid technical justification for the proposed levels, and do so without evaluating the consequences that such an increase (or lack thereof) could generate on the economy.
Why is such an essential labor market tool and policy so prone to such levels of politicization? The main reason is the lack of an institutional framework to regulate the process of coordination of minimum wage levels. The absence of such institutions threatens the objectivity in the adjustment process and facilitates manipulation by political agents. Thus, economists and others try to find ways to prevent misuse of this labor policy.
We have identified three institutional models for fixing / adjusting the minimum wage; and only some of these models use technical tools to adjust the level. In the first model, the executive body sets the minimum wage unilaterally. In the second model, the minimum wage is determined through collective bargaining (which can be bipartite, tripartite or quadripartite). In the third model, the government, usually through the Ministry of Labor, sets the minimum wage after receiving a recommendation from a council for negotiating the minimum wage.
In all three models technical tools based on statistical information and socioeconomic indicators are used to set the new level. However, the use of these tools and factors and the methods of measurement differ greatly.
There is a fourth, less common, model based on technical tools to determine the level objectively and maintain closer links with the socio-economic context. This type of model has been mainly adopted by Asian countries (for example in Malaysia, Hong Kong and Korea). It makes use of objective methods based on economic tools by designing formulas that link specific parameters and criteria to socio-economic context. This determines optimal levels and discards suboptimal levels. The parameters that are used for measurement typically include general economic conditions, labor market conditions, competitiveness / productivity and social inclusion. Through this method, it is possible to derive minimum wage ranges that prevent exacerbating unemployment and informality and which do not impair the performance of the economy. These ranges are subject to a process of consultation with the various parties responsible for making the final decision to validate the results and decide an appropriate level. In this way, the negotiating process becomes a process in which the parties have technical information to decide the level of adjustment.
Source: Eric Garcetti/Flickr

This approach can improve the transparency of the deliberation process and the quality of discussion for agents involved in making this decision. However, it is not possible to avoid manipulation of the minimum wage entirely by using these technical tools. United States, Peru and other countries where the minimum wage is a central protagonist in the political soap opera, might consider changing their institutional model for fixing and adjusting the minimum wage from the first three models mentioned above to the fourth model. This would create and implement a process of deliberation based on results derived from a formula that takes into account factors such as those included in other countries using technical tools.
Depending on the country context, such factors can include economic growth, productivity, competitiveness, industrial composition, labor market indicators such as employment, unemployment, and informality, cost of living, wage inequality and qualifications of the workforce. It is important to note that the use of these technical tools should be supplemented with other technical inputs such as assessments, sector studies, and qualitative analysis to help improve the quality of the deliberation process. But in 2016, given the quality of the data and methods available, and the quality of experts in labor matters that exist in these countries, this change is not only possible but necessary to prevent this tool from being used for purposes that ultimately may end up generating undesirable effects on the economy


Ximena Del Carpio

Practice Manager, World Bank

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