This unexpected shock allows for a “laboratory experiment” on microeconomic factors, such as labor demand and supply, job loss and gain, and efficient – or “fair” – wages. But the drastic measure also had repercussions for macroeconomic aggregates, such as output and prices, government expenditures and tax revenues. This brings us back to the insurance broker. While the majority of low-wage earners are unskilled workers at small firms in depressed regions, many professionals are also paid the minimum wage, because taxes and mandatory social security contributions levied on wages are much higher than those levied on entrepreneurial income. Many firms complement a low- (often minimum-) wage contract, which carries social security benefits (healthcare, pension, etc.), with low-tax compensation schemes. For an average experienced skilled worker, this can cut total labor costs by a whopping 43%.
The minimum wage increase was hence an attempt by the government to counter this tax avoidance. The government also aimed to compress wage distribution: by 2007, the fraction of workers paid the minimum wage rose to 35% from just 10% in 2006. Such significant changes in relative wages tend, however, to bring about turmoil in labor markets. In Albania, the steady upward trend in employment broke sharply in early 2005, coinciding with the first minimum wage hike. Obviously, myriad factors other than the minimum wage, such as the global recession, may influence employment.
Labor Market Effects In analyzing labor market effects, we’ll find that the direct result of the minimum wage increase was the drop in demand for unskilled workers by between 1% and 3%, especially among small enterprises in depressed regions. Lower labor demand, in turn, increased the probability that low-wage workers would be let go. Workers earning 30%-60% of the new minimum wage were twice as likely to lose their jobs as workers in the control group, with just slightly higher wages (110%-125% of the minimum wage).
The probability that the unemployed will find employment may theoretically go either way after a minimum wage rise. On the one hand, better wage prospects for the low-skilled unemployed may increase the intensity of their job search or their willingness to leave unemployment – a supply-side effect much emphasized by the government. On the other hand, the destruction of low-wage jobs lowers the demand for entry in employment. The negative demand effect outweighed the positive supply effect: low-wage workers were 14 percentage points less likely to find a job after unemployment than low-skill workers. Overall, the minimum wage increase significantly deteriorated the employment chances of people at the lower end of the wage distribution.
Macroeconomic Effects To examine the indirect macroeconomic effects of the minimum wage rise on labor tax revenues, prices, GDP and the budget deficit, let’s build a multi sector general equilibrium model of the Albanian economy. To model firms’ tax-avoiding behavior, I assume that a fraction of firms only pay taxes and social security contributions based on the minimum wage. Since they have no direct measures or reliable estimates of the importance of this phenomenon, they vary this fraction between 60% and 90%.
The impact of the 2007 minimum wage rise is such that, as the demand for low-skill workers falls, aggregate employment drops by 0.6%-1.1%. The more tax avoidance in the economy, the farther the fall, because the minimum wage increase means an increase in effective labor taxes. Even though companies are able to pass on some of their labor cost increase to customers, corporate profitability and hence investment plummets. This has a negative impact on real GDP, which declines by 0.5% – 1%. At the same time, because of the increase in labor costs, consumer prices rise by 0.5% – 1%.
As for the government budget, revenues from labor taxes and social security contributions rise by 0.1%-0.3% of GDP (2005-2006), depending largely on how much of the economy is engaged in tax avoidance. This is a small sum compared to the magnitude of the rise and the government’s hopes that it could substantially “whiten” the grey sector. The rise could only have had a bigger effect on tax revenues if one is willing to assume that more than 90% of firms were playing the minimum wage game, which is an unreasonably large proportion.
Overall, because value added taxes comprise 35% of tax revenues and both corporate and value added tax receipts decline in real terms, total tax revenues are unchanged or decline slightly (by 0.3%). Since the structure of government expenditure is assumed to remain fixed, the budget deficit is largely unchanged. This probably underestimates the budgetary costs of the minimum wage increase, as many social security benefits are indexed to the minimum wage. Who benefited from this policy in the end? Even though low-wage workers face a mix of better wage prospects and deteriorated job security, those lucky enough to keep their jobs must surely have welcomed the sizeable rise in their real wages. However, contrary to the hopes of the government and popular belief, tax revenues and the budget deficit have not been significantly affected.