Minimum Wages, Inequality, and the Informal Sector

IMF Working Papers, July 19, 2024

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Research question: How do minimum wages affect earnings inequality in countries with large informal sectors?
Empirical finding (reduced-form): The 2000s minimum wage hike in Brazil raised overall inequality by increasing inequality inside the informal sector.
Model contribution: A model where heterogeneous firms select into informality is developed to investigate when and how raising the minimum wage can increase inequality.
Calibration result: Calibrated to Brazil, the model finds that, by generating substantial informality, the increase in the minimum wage raised overall inequality by 6.4%.

The 2000s minimum wage hike in Brazil is associated with:
- An increase in overall earnings inequality.
- An increase in inequality inside the informal sector.
Quantified impact from model calibration:
- Overall inequality increased by 6.4 percent due to the minimum wage increase, with informality playing a central role.

Model structure:
- Firms are heterogeneous and choose whether to operate formally or informally (selection into informality).
- The model is used to analyze the mechanisms through which minimum wage increases can affect inequality.
Empirical approach:
- Reduced-form evidence is provided linking the 2000s minimum wage hike in Brazil to distributional outcomes, particularly within the informal sector.
Calibration:
- The model is calibrated to Brazil to quantify the contribution of informality to the observed increase in inequality.

Mechanism emphasized:
- Movements into and out of the informal sector modulate the effects of formal labor legislation, such as minimum wage hikes.
Implication for policy design:
- Policymakers aiming to affect inequality through minimum wage policy should account for the size and dynamics of the informal sector, as standard formal-sector effects may be offset or reversed when informality responds to wage regulation.