Chapter 7: Monitoring the effects of minimum wages

7.5 Effects on formal and informal employment

Developing countries are frequently characterized by the co-existence of a formal and an informal employment. According to the definitions adopted in 2013 at the 17th International Conference of Labour Statisticians, jobs in small or unregistered enterprises as well as non-declared jobs in registered enterprises are included in the definition of informal employment.

Based on the ICLS definition, figure 1 below shows that the percentage of wage-earners in informal employment ranges from about 20 per cent in urban areas of Uruguay to more than 80 per cent in India, where an estimated 135 million casual workers in 2009-10 far outnumbered salaried workers.1

Figure 1. Percentage of employees in informal employment, latest year available
Source: ILO, 2013. Women and Men in the Informal Economy: A Statistical Picture, Second Edition, Geneva
In most countries, minimum wage laws in principle do apply to small or unregistered enterprises or non-declared jobs (see chapter 4 on who is covered). Almost by definition, however, enforcement of legal or regulatory frameworks is much more of a challenge when wage employment is not registered or takes place in un-registered enterprises.

Taking this reality of developing countries into account, economists have long hypothesized that instead of causing lower employment, minimum wages that are too high and effectively enforced may cause employees to be displaced or shifted from the formal to the informal economy – thereby leading to higher rates of non-compliance and downward pressure on wages in the informal economy.2

Empirical findings

While several studies have documented reduced formal employment, a review of employment effects in Latin America shows that effects are frequently more complex. One study in Argentina found for example that minimum wage increases have had only little effect on the formal sector, but have increased wages in the informal economy3 – pointing to the fact that non-compliance with one legislation (like registration or social security) does not necessarily mean that minimum wages have no influence.

One explanation for the effect of minimum wages on wages in the informal economy, where only few labour inspections take place, has been the “lighthouse effect” – i.e. a signal given by the minimum wage to workers and employers in the informal sector about socially acceptable minimum levels of pay.4

County-specific research is required to determine whether the displacement or lighthouse effect dominates. To understand overall effects, such research into the effect of the minimum wage on the uncovered/informal economy should include estimates of wage as well as employment effects.

More work is currently under way at the ILO on transition from the informal to the formal economy.

1 On India, see Rani U. and P. Belser, 2012. “The effectiveness of minimum wages in developing countries: the case of India”, International Journal of Labour Research, Vol 4, Issue 1.
2 Nataraj, S., Perez-Arce, F. Srinivasan, S. V. and Kumar, K. B. 2014. The impact of labor market regulation on employment in low-income countries: A meta- analysis. Journal of Economic Surveys 28(3): 551-572.
3 Khamis, M. 2008. “Does the Minimum wage Have a Higher Impact on the Informal than on the Formal Labor Market? Evidence from Quasi-Experiments”, Discussion Paper Series IZA DP No3911, Institute for the Study of Labor. Bonn, Germany.
4 See, for example: Souza, P.; Baltar, P. 1979. “Salario minimo e taxa de salaries no Brasil” in Pesquisa e Planejamento Economico, 9, pp. 629-60; Bell, L. A. 1997. The impact of minimum wages in Mexico and Colombia. Journal of Labor Economics 15 (3): 103–35.