Compliance with minimum wage laws in developing countries

Two models of enforcement: Penalizing non-compliance or encouraging compliance

Central to this literature is the idea that effective enforcement must take country-specific factors into account. One study identifies two models of minimum wage enforcement, describes the contexts in which they apply, and assesses their applicability, with a particular focus on developing countries [10]. The study distinguishes between an Anglo-American model and a Latin model of enforcement.

The Anglo-American approach to enforcement, seen most clearly in North America, views non-compliance as a result of rational, utility-maximizing calculations by individual firms and thus adopts a punitive approach to violations to encourage compliance. This is the model used by most economists in the literature described above, who view penalties and deterrence as the key policy levers. Within this model, labor inspectors generally have very little leeway in cases of non-compliance; they are expected to simply enforce the law. An employer that violates the minimum wage law is fined accordingly.

The appeal of this approach for policymakers is that it generally requires a less-skilled inspectorate, and it limits the potential for corruption and bribery. However, the concern is that a strict, punitive approach in developing countries risks driving emerging firms into the informal sector and could have strong disemployment effects.

In the Latin model of enforcement, applied in many Latin American countries, enforcement agencies tend to treat non-compliance as less of a calculated decision by firms than as an outcome of a range of possible factors, including limited capabilities of employers (see below). The response to non-compliance assumes a more “conciliatory and tutelary” attitude, aiming to assist non-compliant firms to become compliant over time [10]. In the Latin model, inspectors are generally charged with the broader mandate of improving compliance levels rather than simply penalizing non-compliance, and they have more latitude to approach each situation differently in order to achieve this. This approach requires skilled inspectors who have a comprehensive knowledge of labor law and can weigh infringements on a case-by-case basis. The approach also presents inspectors with more opportunities for bribery and corruption. Nonetheless, the Latin approach can achieve higher compliance over time by encouraging sustainable compliance that does not hurt employment or overburden new firms.

Enforcement in practice is generally a mix of both models

In practice, most countries apply a combination of the Anglo-American and Latin approaches to enforcement. While careful planning of enforcement strategies is necessary, it is often a lack of skills and resources that determines enforcement practice.

Disentangling the interactions between enforcement and compliance

There are two likely explanations for the dearth of work exploring this causal link.

• First, data on enforcement and compliance are scarce, and finding appropriate measures for both enforcement and compliance is problematic [11].

• Second, there is an endogeneity problem due to the potentially simultaneous relationship between enforcement and compliance, which makes any causal analysis difficult. Enforcement is likely to increase compliance, as firms are more likely to comply when the probability of their being caught is higher. At the same time, however, a government agency is likely to increase the number of inspectors or enforcement resources in response to low compliance levels. The difficulty of trying to disentangle the effect of enforcement on compliance is clear.

So far, the preferred proxy for measuring enforcement is the number of labor inspectors per country (or region), which is useful as an aggregate measure but struggles to overcome the problem of endogeneity. Doing that requires the use of appropriate instruments.

Factors that influence enforcement

The recent literature on minimum wage enforcement has focused on determining which factors influence compliance (or non-compliance) in developing countries and can thus be used to guide enforcement. This approach can be loosely designated the “determinants of non-compliance” approach. Several insights have emerged from studies that take this approach.

A study on Argentina is one of the first attempts to empirically estimate the effect of government enforcement on compliance in a developing country [8]. The study uses the number of labor inspectors working in provincial public enforcement agencies as a proxy for enforcement activity and finds that the intensity of enforcement is a significant determinant of adherence to the law. A higher concentration of inspectors is correlated with increased fines for non-compliance and suggests that this is one channel through which enforcement effectively influences compliance [8].

Another study in South Africa also uses the number of labor inspectors as a measure of the intensity of enforcement [12]. However, it finds an insignificant impact of the number of labor inspectors on compliance; the level at which the minimum wage was set had more marked effects. Despite this, in both the Argentinian and the South African studies, local labor market characteristics, most notably the unemployment rate, had a significant impact on enforcement: A higher unemployment rate was associated with lower levels of compliance.

A cross-country study presents a series of stylized facts on the incidence of enforcement. In addition to labor market characteristics, other factors such as firm size, the skill level of the workforce, and the degree of market power can all influence a firm’s likelihood of being inspected and, as a result, the firm’s incentive to comply with minimum wage regulations [13]. A program to increase compliance with minimum wages in Costa Rica increased average wages and compliance levels—with no significantly negative impact on employment [9]. In a sample of cities in Brazil, increased enforcement raised the level of formal employment, reduced self-employment levels, and reduced wage inequality. When stringently applied, other labor market regulations, such as those regulating firing, reduced average employment.

Factors that influence compliance

This strand of the literature suggests that there are four composite sets of variables that are important inputs for understanding the factors that shape and influence minimum wage outputs in developing countries:

• institutional factor;

• characteristics of inspectors;

• firm characteristics; and

• local labor market characteristics.

A template based on these inputs and outputs can help policymakers derive measures and formulate strategies to ensure an optimal environment for minimum wage enforcement and compliance.

Institutional factors include the penalty structure for failing to comply with minimum wage regulations, the number of minimum wages, the resources allocated to enforcement, and the conduct of awareness campaigns. All play a role in shaping the levels of non-compliance with minimum wage legislation, but their importance varies with the country and labor market context.

The individual characteristics of inspectors can influence how effective they are at achieving compliance. These individual characteristics include:

• education;

• experience; and

• gender.

Firm characteristics affect the observed levels of enforcement and non-compliance with minimum wage legislation in an economy. Important characteristics include the size of the firm, the distance from the enforcement agency, the number of previous violations, and foreign ownership share.

Finally, local labor market characteristics, such as the unemployment rate, the average wage rate relative to the minimum wage, and the levels of unionization, also play a crucial role.

Considerable work remains to be done to better understand these four sets of variables. Improved descriptive and econometric work is needed to generate a comprehensive set of stylized facts to explain the factors that influence firms’ compliance decisions and to understand their comparative importance. After that, the challenge is to gather these variables into a production function approach that estimates their effect on non-compliance levels within an economy.