The effects of minimum wage increases on the macro economy, income distribution, and informal wages

Abstract

This paper examines how changes in the minimum wage influence an economy with a substantial informal sector. To achieve this, we simulate the recent minimum wage increase in Latvia, providing a comprehensive assessment of its macroeconomic, sectoral, and distributional effects. This panoptic assessment was made possible by the linked system of the CGE model and the EUROMOD tax-benefit microsimulation model. Notably, the framework incorporates unreported wage payments into both the CGE and EUROMOD components to account for Latvia's significant labour tax non-compliance. Our findings reveal that the minimum wage increase leads to a reduction in unreported payments and an increase in reported gross wages. The model further indicates positive spillover effects on private consumption but identifies adverse outcomes for employment and GDP. In the fiscal sector, budget revenues rise, primarily driven by increased personal income tax revenues linked to higher reported wages. While the analysis suggests a decline in income inequality when considering only officially reported income, this effect is mitigated when the formalization of unreported payments is considered.