The Impact of Minimum Wages on Wage Inequality and Employment in the Formal and Informal Sector in Costa Rica

Abstract

Abstract:This paper tests the impact of the Costa Rican minimum wage policy on wage inequality and the level of employment in the formal sector (covered by minimum wage legislation) and the informal (uncovered) sector. We also examine the redistributive effects of the minimum wage, between the covered sector and the uncovered sector. Regression analysis using micro data from the Labour Force Surveys over 17 years reveals three important findings. At the median, a unit increase in the minimum wage relative to the average wage is associated with: a) a reduction in wage inequality in the covered sector of between 0.9 percent (using the Gini) and 1.7 percent (using the Theil mean logarithmic deviation) and there is no effect on earnings inequality among the self-employed (using all measures); b) an increase in the level of covered sector employment by 0.56 percent, but no effect on the number of self-employed over time; c) an increase in the average number of hours worked per week by 0.14 percent in the covered sector and 0.34 percent in the uncovered sector.From a theoretical perspective, these finds are counter to the traditional competitive two-sector models of the minimum wage. We interpret them as supporting the monopsonistic and efficiency wage models of the labour market in those industries where the ratio of the minimum wage to the average wage ("toughness") is low but supports the traditional models in those industries where toughness is high. Given that we found overall employment to have increased, minimum wages could be seen as assisting the reallocation of labour from the traditional to the more modern sectors.

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“…Evidence is also available for Costa Rica. Gindling and Terrell (2007) report a negative employment effect in the formal sector, but El Hamidi and Terrell (2002) find a positive employment effect for formal‐sector workers and no effect for the self‐employed on the basis of household survey data, although the authors do not control for other determinants of employment or the presence of interactions between formal‐ and informal‐sector employment.…”

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“…However, the impact on the uncovered sector has not been analyzed in other developing countries either. Aside from this paper's predecessors (El-Hamidi and Terrell, 2002;Gindling and Terrell, 1995), we are aware of only three other empirical studies in English that examine the impact on the uncovered sector in a developing country: Fajnzylber (2001), Lemos (2004) and Maloney and Nú ñez (2004).…”

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