Reducing inequality with the minimum wage

Debate over raising the minimum wage often focuses on whether jobs will disappear. But economists have become increasingly interested in how an increase to the minimum might affect other outcomes as well, such as output and inequality.

A higher minimum wage will obviously raise pay for those who remain employed at the new minimum. But in a working paper for the Minneapolis Fed’s Opportunity & Inclusive Growth Institute, economists Niklas Engbom and Christian Moser find that a hike in the minimum in fact increases wages for other workers, too, including relatively high earners.

The lowest earners enjoy a substantial increase when the minimum wage goes up, the economists find; middle earners receive a moderate increase, and top earners experience little or no rise. The result, therefore, is that “the policy change induced a notable decline in earnings inequality,” write Engbom and Moser, in “Earnings Inequality and the Minimum Wage: Evidence from Brazil” (IWP7). “At the same time, employment and output fall only modestly as workers relocate to more productive firms.”

Engbom, a Princeton economist, and Institute visiting scholar Moser of Columbia University analyze the consequences of minimum wage changes in Brazil, specifically, to see if its 119 percent increase in inflation-adjusted minimum wage between 1996 and 2012 can explain a substantial decline in wage inequality that occurred over the same time. The data display a remarkable inverse pattern (see figure). Did the rise in minimum wage cause the decline in inequality? And if so, how?

Modeling job search

That the minimum wage and wage inequality are (inversely) correlated does not prove causality, of course. So Engbom and Moser build a labor market model to determine how the two might be related. The model’s workers, searching for jobs, have different skill levels. Firms, which vary in productivity, choose the wage for each job and decide how often to post vacancies. Setting a lower wage will increase the firm’s per-worker profit, but a higher wage means finding a worker more quickly. This trade-off leads more productive firms to offer higher wages. Thus Engbom and Moser are able to re-create the real-world observation that wages vary across firms even for workers with the same skills.

They then use data from the Brazilian Ministry of Labor and Employment to fit their model to Brazil’s labor market by matching features such as the rate at which employed workers find new jobs and the wages that workers are willing to accept.

Next, the researchers simulate the effects of a minimum wage hike like that experienced in Brazil. The result is wage increases for workers from the 1st through the 80th percentile of the earnings distribution. The increase is largest for low-skill workers and gradually declines for higher-earnings groups. The result: The gap between top and bottom earners shrinks, thereby reducing earnings inequality.

Why does this happen? When low-productivity firms increase their wages to meet the new minimum, high-productivity firms increase wages, too, because they want to attract workers quickly. They need to outbid low-productivity firms with better offers than they made before the wage hike.

“Such competitive pressure leads the minimum wage to spill over to higher-paying firms,” Engbom and Moser write. Firms are able to offer higher wages because the labor market was not fully competitive to begin with: Workers were being paid less than their marginal product, with firms capturing the extra profit.

Big change to inequality, small change to employment

Engbom and Moser also use their model to evaluate other macroeconomic consequences of an increase in the minimum wage. Notably, nonemployment (in Brazil, this includes unemployment and informal employment) increases by 0.4 percentage points, while gross output declines by a modest 0.1 percent. These macroeconomic effects are muted, the economists explain, because in a labor market that is not fully competitive, the minimum wage increase leads to “efficient reallocation of workers toward more productive firms.” In other words, increasing the Brazilian minimum wage actually led to small efficiency gains as well as a large reduction in earnings inequality.

One takeaway is that a policy that nominally affects only a small share of workers—those who were making less than the new minimum wage—in fact influences wages for most workers. Engbom and Moser suggest that future research might examine whether other labor market policies that in theory affect just a subset of the labor force (such as unemployment benefits and antidiscrimination laws) also have more far-reaching impact. It would also be interesting to extend the model to the United States, where recent significant increases to the minimum wage have been enacted or proposed at the local level in a number of major cities, including San Francisco, Chicago, New York and Minneapolis.