Posted by Gustavo Silva Cano on Dec 14, 2009 Leave a comment

Why lowering the minimum wage is a good idea

Colombia news- Minimum

In Colombia, the end of the year always marks the beginning of an interesting event. No, it is not Christmas. If you thought it was el día de los inocentes (equivalent to April Fools’ Day), which Colombians celebrate on December 28, you did not guess right either. The event I am referring to, which occurs every single year in an almost ritualistic fashion, is the minimum wage negotiation.

The event proceeds as follows: In order to define the minimum wage for the following year, government officials meet with members of Colombia’s labor unions and representatives of business groups, say, in the presidential palace. The leaders of the labor unions start by demanding a rise of 10% (plus or minus a few percentage points) to the minimum wage. To this, the business leaders respond that the workers’ demands are simply unfeasible. A 10% rise in labor costs would mean that they would have to lay off some people. The negotiations go on for a while and no side is willing to give up. With no consensus in sight, the government proceeds to set the new minimum wage by decree. The increase is usually closer to what the business leaders propose, although a few points higher just for the government to save face.

The ritual repeats itself on and on, and this year is no exception. The first disagreements between the parties in the negotiations have appeared already. An added complication to the description above is that the Constitutional Court ruled in 1999 that the increase to the minimum wage could never be below inflation. This year, the economic downturn has brought prices down in Colombia, so inflation is expected to be about 2.5%. With this in mind, the business leaders argue that an increase of 3.5% in the minimum wage is fair, whereas the workers will accept no less than 8%. The labor unions argue that increasing the wage above inflation will boost aggregate demand, which will help get the economy back on its feet, as the workers will have more money to spend. The businessmen reply that such a suggestion is nonsense, arguing that the last thing that industries need right now is a hike in their payrolls, especially considering the deterioration in commercial relations with Venezuela.

What to do? Who is right? Indeed, this is class warfare at its best. The poor against the rich. The needy workers fighting the greedy capitalists, demanding what is rightfully theirs. To be honest, the corporatism involved in the whole process makes me rather uncomfortable. The government sitting together with the unions and the businesses trying to find a harmonious way to allocate resources is definitely something very far from the free market economy I want Colombia to become.

But as we have to work with what we have, let us go for the second-best solution. The government should decree a rise for the minimum wage of no more than 4%. Anything else beyond that would increase unemployment and enlarge the already immense informal economy. However, as the government should be mainly concerned with reducing both unemployment and the informal economy (not merely with preventing their expansion), there is something much braver that the government must do: create a parallel, flexible, cheaper version of the minimum wage, totally different from today’s stiff and expensive scheme.

Confused? Let me elaborate. For 2009, Colombia’s minimum wage was about COP496,000 per month (US$247). In addition to that, employers must pay their employees a subsidy for transportation of 59,300 pesos (US$ 29). That is the money that the worker receives in cash every payday. Backstage, however, employers are required by law to pay 12% of the salary to the worker’s retirement fund, 8.5% for his healthcare, 10.4% towards a severance pay fund (known in Colombia as cesantía), 9% for other welfare benefits and funds that go to two state agencies (this pay is called cobros parafiscales), and the list goes on. As a result, one worker in Colombia ends up costing 872,000 pesos (US$ 435) in total, although the employee only sees a fraction of that sum.

If you think there is no problem with this, and that it is really okay for employers to pay this much for each one of their workers, think again. In Colombia around 4.5 million people earn the minimum wage, according to some calculations. Yet, the same estimates put the number of people who earn less than the minimum wage at 8 million! These are the people who work in the informal sector, those without formal contracts and social security. By making their labor too expensive by decree, the minimum wage has shut off millions of Colombians from the formal sector. It is simply not profitable for employers to spend COP872,000 a month on some workers, especially in a country where labor is as abundant as it is in Colombia. By increasing the price of labor, the minimum wage ends up benefitting the few who earn it, at the expense of the rest of the workers who are made unemployable due to the high price tag the government has put on their skills.

But before you call me a snob for saying that Colombia’s US$435-per-month minimum wage is high, listen to this: Colombia has South America’s most expensive minimum wage relative to its income per capita, as shown by the graph above. This means that it is relatively more expensive to hire people in Colombia than in any of the other South American nations. It is no coincidence that Colombia has South America’s highest unemployment rate. Take another example: if in the United States the ratio of minimum wage to income per head were equal to Colombia’s, minimum wage workers would earn about US$2,500 a month, and not the US$1392 they earn today (working 8 hours a day, 6 days a week for the US$7.25 an hour mandated by the federal government). So yes, the minimum wage in Colombia is too high for the size of the economy.

Indeed, US$435 per month is an insufficient amount of money to provide a good living – on that I agree with the labor unions. But increasing the minimum wage to ever higher levels is only going to produce more unemployment and put more people in lower paid informal jobs. Seriously, if poverty could be eradicated simply by ordering businesses to pay higher wages, there would be no mystery to economic development, and all nations would have done it already. So what the Colombian government must do now is to bring people from the informal economy into the formal sector by creating a special, lower minimum wage for them. Perhaps this new wage won’t be very high, but it will certainly be better than the US$5 a day that some Colombians earn (and they are not the poorest ones). By liberalizing the labor market and by making the minimum wage more flexible, new formal jobs for the poor and the unskilled will appear. In time, the unemployment rate will go down to normal South American levels (which are still terribly high).

Nonetheless, it is not very likely that anybody in the minimum wage negotiations considers this option in any way whatsoever. The ritual of the negotiations will carry on as usual. And unfortunately, so will unemployment.