Chapter 5: Setting and adjusting minimum wage levels

5.4 Economic factors

When setting the level of the minimum wage, policy makers should take into account economic factors. If the minimum wage is set too high or increased too much, this may have unexpectedly large impacts on the labour costs that employers must pay. This, in turn, could trigger price inflation, hurt exports, and reduce the level of employment. Wages that are too low, by contrast, constrain domestic household consumption.   

According to ILO Convention No.131, economic factors to take into account include, "the requirement of economic development, levels of productivity, and the desirability of attaining and maintaining a high level of employment". Other economic factors that can be considered include issues related to competitiveness, investment, prices, and economic growth.1

Labour productivity - sharing the fruits of progress

In setting and adjusting minimum wages, policy makers frequently make reference to labour productivity. Labour productivity provides contextual information on the market value of what is produced by an average worker in a country, given existing levels of capital and technology.2 Taking into account labour productivity in regular adjustments also ensures that workers receive a share of the fruits of progress.

Average labour productivity in a country is usually measured as GDP per worker, or GDP per hour worked. Data on sector-level productivity is also useful when minimum wages are set at different levels in different industries. However, in some sectors, measuring labour productivity is problematic. For example, quantifying the value added in the education sector or in domestic work are particular challenges.3

In practice, in their periodic adjustments, many countries use some proxy indicators, like GDP growth or GDP per capita growth. In Brazil, the legislation places price inflation and GDP growth in a mathematical formula for minimum wage adjustment. Other countries, such as Costa Rica, increase the minimum wage by inflation plus a share of past economic growth.

Proportion of workers affected and impact on total wage bill

Another statistical indicator to consider is the proportion of employees who will likely be affected by the introduction of a minimum wage or an uprating of an existing minimum wage. This indicator captures the impact that the minimum wage will likely have on the overall wage structure and the total wage bill.

If the minimum wage is set too high, it will likely affect a large number of workers and this could have unexpectedly large impacts on average labour costs and on the total wage bill that employers must pay. This, in turn, could trigger price inflation and/or reduce the level of employment. Since compliance is partly dependent on the level of the minimum wage, there is also a high probability that a minimum wage set too high would result in a low level of compliance.

The proportion of workers affected can be calculated at the national, regional or industry level. It can also be calculated for certain groups of workers (such as by sex, race, and so on). These disaggregated analyses enable a richer understanding of the wage distributions unique to each part or group of workers in the economy. They also allow a better understanding of the individuals, regions or industries that will be most likely or disproportionately affected by the minimum wage.

Managing aggregate demand - finding the right balance

For some individual enterprises, increasing wages can be very problematic. At the same time, even during periods of economic difficulty, there are strong economic and social reasons why governments may want to encourage wage increases in line with average productivity growth. One such reason is that higher wages for low-paid workers can increase their consumption levels and in some circumstances lead to higher aggregate demand. When wages are pushed too high, however, exports and investment may decline, and aggregate demand may fall.  

From a macroeconomic perspective, wages which increase roughly at the rate of medium-term productivity growth plus the Central Bank’s target rate of inflation (or some other low inflation rate if there is no explicit inflation target) should guarantee price stability, ensuring that wage developments do not cause deflation or excessive inflation.

1 IOE. The Minimum Wage, Guidance paper of the International Organisation of Employers
2 OECD. 2001. Measuring Productivity: OECD Manual, Measurement of aggregate and industry-level productivity growth (Paris, OECD).
3Atkinson. 2005. Atkinson Review: Final Report. Measurement of Government Output and Productivity and the National Accounts (New York, Palgrave Macmillan).