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Sultan Mehmood
Friday, March 15, 2013
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On May 1, 2012, the then Prime Minister of Pakistan, Yousuf Raza Gilani, announced in front of a charged crowd that the minimum wage in Pakistan was to be raised from Rs7000 to Rs8000. On the same day the Chief Minister of Punjab, Shahbaz Sharif responded with a further Rs1000 increase. This resulted in the statutory minimum wage in Punjab adding up to an unrealistic Rs9000.

The PML-N has now – in its recently unveiled election manifesto 2013 – pledged that upon coming to power, the party will further raise the minimum wage to a whopping Rs15000!

At this point, one should point out that raising minimum wage based on mere political whims is not only unscientific but downright disastrous. Of course, it would be a good thing if incomes were to be increased. However, raising minimum wage introduces a host of negative ‘unintended consequences’.

Nobel Laureate Milton Friedman argues that increases in minimum wage have both positive and negative effects. One is the ‘intended’ poverty reduction effect of raising the wages for the poorest quartile of the population. The other more subtle effect is the resultant increase in cost of hiring for the employers.

When increases in minimum wages are introduced, not only current but future levels of unemployment tend to increase. In an effort to maintain the desired levels of profitability, employers tend to lay workers off and in turn compress the economy. Additionally, they cut back on future hires. This reduction in future hiring is particularly alarming for Pakistan – with most of its population below the age of 30 and a large number of youth entering the labour force every year.

Another approach employers have adopted in the past in response to steep increases in minimum wages is to increase prices. Hence, in a country where inflation consistently hits double digits the result is a further upward pressure on inflation.

The very people who are supposed to benefit from the increase in minimum wage end up spending more because of the increased prices of the goods they buy. This has an additional negative consequence of reducing the policy toolkit available to the government and the central bank. For example, in periods of low growth, the central bank can no longer rely on an (expansionary) monetary policy to spur growth.

The result of this drastic increase in minimum wage will be that there will be a large number of people living in extreme poverty and willing to work for lower wages, and employers who would like to hire them albeit at lower wages, which is no longer possible given the statutory minimum wage. Therefore, many transactions will not materialise.

There will be a further expansion in the already-bloated black market economy and a fall in tax revenues. The result is the classical ‘deadweight loss’ scenario elucidated in economics textbooks: mutually beneficial transactions are barred! Hence, drastic increases in minimum wages will compress employment and – consequently – GDP growth.

You might be wondering about the size of the aforementioned effects. If the effect is marginal, the increases in minimum wages might still be justified. However, careful econometric scrutiny reveals that a 10 percent increase in minimum wage decreases employment in the range of one to three percent.

Extrapolating this in the context of Pakistan, even considering the lower bound point estimate of one percent, the effects of increases in minimum wage leads to dire consequences.

If the PML-N is to go ahead with its proposed increase of minimum wage from Rs8000 to Rs15000, Pakistan’s economy will suffer a reduction of overall employment by about nine percent with a possible increase in prices. This is a possible loss of about five million jobs! Not only will it harm the very people it is intended to protect, it will also cause a distortionary effect on the economy and make the labour market more rigid.

Since the 1990s, more than 100 studies have been published on the effects of minimum wages on employment. An overwhelming majority of empirical research suggests the dominance of the negative impact of increase in minimum wage on employment. In fact, in the case of large raises as here, the positive effect is strongly outweighed by a large decrease in employment.

Whenever there was indeed a positive effect documented for raising minimum wage, these were modest increases in periods of high productivity growth. Unfortunately, both are missing in Pakistan.

Our politicians clearly need to refrain from political point scoring when deciding on national economic policy. If they are indeed to live up to their promises of over six percent GDP growth and poverty reduction, there is need for a concerted approach. They need to base their decisions on evidence rather than wish lists.

They need to think about the overall well-being of the national economy, and the possible unintended and long-term effects of their policies. One way is to focus on creating vibrant markets that will absorb the incoming labour force without the need to legislate a minimum wage hike.

In a vibrant market, competition among employers – and not increase in minimum wage – raises income levels. This has positive effects on innovation, productivity and entrepreneurship, the drivers of all modern growth. This can be facilitated with other concomitant reforms. For example, reforms in the areas of civil service, public health care, and universities, as well as a focus on honing school curricula that engenders dissent and critical thinking.

If we are to continue making our policies based on political expediency – this increase in minimum wage being just one example – it is mere wishful thinking that Pakistan will rise again.

The writer advises the Dutch government on macroeconomic policy. He tweets

@mrsultan713