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Well-meaning distortions

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Last year India made historic changes to its minimum wage laws by amending the Minimum Wages Act of 1948, which increased the wages of unskilled non-agricultural workers by 42 per cent. Additionally, the Delhi government increased the local minimum wage by 37 per cent. Such changes garnered praise in India as a historic move that will benefit the poor. However, in a country where the vast majority of workers are employed in the informal sector, the minimum wage hikes are likely to create further distortions that will only serve to harm those it intends to help. In India roughly 90 per cent of India’s 470 plus million workers are in the informal sector (defined as enterprises outside the public and private corporate sectors which employ five or less workers) meaning the vast majority of India’s workers do not have privileges like social security and workplace benefits. Despite policymakers’ goal of reducing the size of the informal sector, higher minimum wages will disproportionately hurt the poor by making it harder to gain formal employment.

Needs improvement Inflexible labour

Distortions in India’s labour market are at the root of its struggles to increase manufacturing employment. Famously rigged laws make it very difficult for firms to fire employees. Firms that employ 100 or more workers need to comply with onerous regulations and require multiple approvals before laying off workers. In effect firms are prevented from growing because they are incentivised to stay small and informal in order to avoid regulations. Although Prime Minister Narendra Modi hails plans to increase the share of the manufacturing sector to 25 per cent of GDP, the latest adjustment to the non-agricultural minimum wage will likely make these goals more difficult to achieve (see Chart 10). Raising the minimum wage will make it more difficult to find formal employment and could increase the size of the informal sector by pushing more workers out of formal employment. In a study of minimum wages in Indonesia, researchers found negative employment effects of minimum wages among small firms and less-educated employees. Evidence showed that in areas where higher minimum wages could be enforced, job losses were significant and affected low-skilled and less educated workers disproportionately.

Proponents of India’s higher minimum wage claim that higher levels of labour productivity can make up for higher wages. However, productivity gains would more likely come from formal employment, where training and high-quality management can improve the skills of workers. India already struggles from relatively weak levels of productivity which is one of the reasons it has struggled to boost manufacturing growth. India’s neighbour Bangladesh has roughly the same level of productivity as India, but its wages are much lower and laws allow for more labour flexibility. For these reasons, although its population is a fraction of India’s, it exports roughly the same amount of textiles as India (see chart 11). Policymakers’ intentions are well-meaning to raise the income of the poorest members of society, but a better understanding of the labour market would provide better outcomes. Reducing restrictions in the labour market would allow more workers to gain formal employment, which could boost labour productivity and eventually bring higher wages; however laws imposing artificially higher wages are not the answer.

Alex Wolf, Senior EM Economist