Minimum wage increase: Bread crumbs for the poor

Peter Gardiner, Social Researcher, Technical Advisor, Insan Hitawasana Sejahtera, Jakarta

Minimum wages are widely seen as a form of protection for the workers, at least for those employed as wage labor in the formal sector. Companies are obligated to pay their employees at least this amount as basic wage plus any overtime or other benefits according to the law. But there are also dangers in falling prey to populist sentiment and in setting minimum wages at arbitrarily high levels. At some point this can work in a perverse fashion against the interests of workers and particularly the lower income workers they are designed to protect.

What is important to remember that in an open market economy, it is the market that is the primary determinant of wage rates. If wages are set (by regulation) above levels acceptable to the market then it will respond by such things as non-compliance, shedding jobs, raising prices or, most likely, a combination of all of these.

None of these are particularly good for workers or for the economy as a whole. Minimum wages do serve a purpose, but for those who accept these principles, the purpose is not to drive the market, but more to send appropriate signals to employers and to mitigate against exploitation at the bottom end.

Unfortunately, this seems to have been largely lost in the current situation of essentially arbitrary and generally unjustified increases in minimum wages in Indonesia that, contrary to their intended purpose, may actually hurt, more than help, the poor.

First of all, minimum wages only directly benefit those with access to wage employment. Less than 40 percent of the Indonesian labor force falls in this category (the rest are self-employed or unpaid family workers). Among the poor, the share is even lower, less than 30 percent for the bottom two expenditure quintiles. And many of these are laborers (employees) in agriculture for whom, outside of more organized food and estate crop operations, wages are largely outside the purview of minimum wage legislation in any case. Higher minimum wages only benefit workers outside the formal sector to the degree that they influence overall wage rates (including returns to informal sector activity) in the same direction.

And those benefits can be quite short-lived. One logical response to a higher wage bill is to raise prices for outputs. This simply adds to inflation that, in turn, erodes the benefits of higher incomes. In practice, higher prices will usually result in reduced demand, which, in turn, will mean some jobs will be lost and some companies will go out of business until a new equilibrium is achieved at the higher price regime.

Workers who are lucky enough to keep their jobs will probably not be worse off, but the same cannot be said for those who are laid off or for the much larger number of workers who were outside of the wage sector to begin with.

Second, there are potentially damaging impacts on the macro- economy that are likely to be particularly perverse for the poor. We should keep in mind that what is most important for the poor in Indonesia is an expanding labor market (job creation) under a regime of low to moderate inflation.

Lack of employment opportunity makes the price of labor largely irrelevant to those who are unemployed or severely underemployed. And high inflation is by far the single biggest threat to an ability to maintain a basic, lifeline, level of consumption. Artificially high minimum wages tend to work against both these interests constraining job creation though reduced investment and lower economic growth and stimulating inflation through increased prices.

In addition, inflationary pressures will further exacerbate servicing problems for the large domestic debt and reduce government capacity to undertake positive development expenditure as it will be that much more difficult for Bank Indonesia to reduce interest rates to more manageable levels.

And even if some companies can escape the wage requirements by asking for special exemptions (due to their precarious economic state), it is likely that the only people who will benefit financially will the bureaucrats responsible for issuing these exemptions -- it will simply be another "cost" of doing business in Indonesia.

None of these arguments are new. They are well understood by economists, including those that are supposed to leading Indonesia out of the current crisis. So why are they silent? Why are they letting government practice what is dangerously bad economics at a time such as this? Why aren't they actively trying to deal with the false proposition that artificially high minimum wages are pro-poor when, in fact, they are exactly the opposite?

All stakeholders should understand that in a market economy, the market should be the prime determinant of wage rates. Minimum wages can be used for guidance and a degree of social protection, but in no case should they be allowed to distort markets by being set close to or above average wages. Even if they represent what is essentially a "poverty wage rate" in the eyes of many beholders they should be held substantially below average wages at any point in time. This is the same principle guiding social safety net wage rate in public works programs. It is no different for minimum wages in the context of the economy as a whole.

Minimum wages can rise, but they should rise in line with inflation and, most importantly with trends in real wages for various forms of unskilled labor, not on the basis of populist whim that sees political advantage in simply passing out money at what, on the surface, appears to be at little or no cost to the public purse. To do otherwise, as indicated above, will only create greater problems further down the road.

Minimum wage policy seemed to work fairly well during the period leading up to the crisis for precisely these reasons. Minimum wages were generally well below average wages and, while they did rise, they stayed largely in line with real wage increases in the market -- particularly for unskilled and semi- skilled workers in the more modern manufacturing and service sectors outside agriculture.

It is not clear if this was a conscious policy even then. But even if it was fortuitous, it did no harm and probably some good in terms of signaling employers on what was reasonable and fair under the prevailing economic conditions. Unfortunately, that is not what is being practiced today where the substantial increases in minimum wages being implemented in many areas are way out of line with either underlying inflation or with trends in average wages in what is an increasingly depressed overall economy in the country.

Let us hope that government officials and politicians wake up soon. What Indonesia's poor need are jobs -- not higher incomes emanating from a much-reduced number of job opportunities. What the poor need is as much price stability as possible, not a wage- price inflationary spiral that will inevitably erode what limited gains they may make from higher wages and that will increase destitution among the great majority of the poor who are outside of the formal wage sector.

If the country's leaders can keep these basic priorities in mind, then the chances of a more balanced recovery benefiting all Indonesians will be that much greater.