Minimum Wages and Firm Employment: Evidence from China Yi Huang Prakash Loungani Gewei Wang ¦ The Graduate Institute, IMF The Chinese University Geneva of Hong Kong September 2014 Abstract This paper provides the first systematic study of how minimum wage policies in China affect firm employment over the period 2001–07. Using a novel administrative dataset of minimum wage regulations across more than 2,800 counties matched with countrywide firm- level data, we investigate both the effect of the minimum wage and its regulation reform started from 2004. A dynamic panel estimator is combined with a neighbor-pairs approach to control for unobservable heterogeneity common to border counties. We show that minimum wage increases have a significant negative impact on employment on an annual basis, with an estimated employment elasticity of ¡0:116. By contrast, the employment response to minimum wage hikes was minuscule before 2004. In addition, we find a heterogeneous effect of the minimum wage on employment that depends on the firm’s wage level. Specifically, the minimum wage has a larger negative impact on employment in low-wage firms than in high-wage firms. We explore labor market competition as a potential explanation of this heterogeneity. Our results are robust for sample attrition checks and spillover tests. JEL classifications: J24; J31; 014, F10, F14 Keywords: China, Employment, Minimum Wages ¦ This is a revised version of an article previously circulated under the title Labor Market Shocks and Corporate Policies: Evidence from the Minimum-Wage Law Reform in China (IMF “Job & Growth” working group, November 2013). We thank Olivier Blanchard, Harald Hau, Elias Papaioannou, Richard Portes, Hélène Rey, and Qiren Zhou for invaluable guidance and generous support. We are indebted to Ministry of Human Resources and Social Security of China, Quheng Deng (Chinese Academy of Social Sciences), Shi Li (Beijing Normal University and IZA), Chong Liu (Tsinghua), Ming Lu (Fudan), Chunbin Xing (Beijing Normal University and IZA), and Tao Zhang (IMF) who provided us the data and helpful suggestions. We are grateful to Jean-Louis Arcand, Ying Bai, Kathleen Beegle, Nicolas Berman, Nick Bloom, David Card, Kim Sau Chong, Jeffrey Dickinson, Slobodan Djajic, Josef Falkinger, Tony Fang, John Giles, Corrado Giulietti, Mathias Hoffmann, Pravin Krishna, Carl Lin, Yang Lu, Ghazala Mansuri, Hong Ma, Jaime Marquez, David Neumark, David Locke Newhouse, Emily Oster, Jonathan Portes, Marco Pagano, Ugo Panizza, Albert Park, Michele Pellizzari, Jim Riedel, Liugang Sheng, Xinzheng Shi, Paolo Surico, Heiwai Tang, Cedric Tille, Hui Tong, Raymond Torres, Fabian Valencia, Pengfei Wang, Binzhen Wu, Zhiwei Xu, Dennis Tao Yang, Du Yang, Hongliang Zhang, Zhong Zhao, Klaus Zimmermann, and Josef Zweimuller for their helpful comments. We also thank seminar participants at the Chinese University of Hong Kong, CSEF-University of Naples Federico II, Fudan University, Geneva Graduate Institute, Hong Kong University of Science and Technology, International Labor Organization, IMF, IZA/CIER Annual Workshop on Research in Labor Economics (Bonn), London Business School, Ministry of Human Resources and Social Security-BNU “Minimum Wage” workshop (Beijing), UCL, Workshop on “Minimum Wages and Employment in China, Hong Kong, and the World”, World Bank “Labor and Poverty Practice Group” (2013), OFCE Sciences-Po, SAIS-Johns Hopkins University, Shanghai Jiaotong University, Swiss National Bank, Tsinghua University, University Zurich “Labor, Macro and Finance” seminar, and CEPR. We also benefited from the phenomenal research assistance from Pengtu Ni, Dmitriy Skugarevskiy, and Hang Zhang.The views in the paper are those of the authors and do not necessarily reflect those of the IMF. Corresponding author: Prakash Loungani, Research Department, International Monetary Fund, 700 19th Street NW, Washington, DC, 20431 USA . Email: [email protected]. 1 1 Introduction The impact of minimum wages on employment is the subject of challenging debates among economists and policy makers. While traditional research tells us that an increase in minimum wage reduces employment (Brown, 1999), substantial subsequent literature arrives at little con- sensus on its impact. Recent theoretical development introduces the possibility of a relationship between the minimum wage and firm employment in the context of bargaining and search models (Burdett and Mortensen, 1998; Acemoglu, 2001; Flinn, 2006), (dynamic) monopsony, and effi- ciency wage models (Lang and Kahn, 1998; Manning, 1995; Bhaskar, Manning, and To, 2002). The “New Minimum Wage Research” based on firm-level evidence also shows that employment responses are negligible or even positive (see Katz and Krueger, 1992; Card and Krueger, 1994; and also the studies cited in Neumark and Wascher, 2007). Our paper contributes to these ongoing debates. As China accounts for nearly 25 percent of the global labor force,1 the rising cost of labor in China is a topic discussed worldwide. During the period 1992–2007, the average real wage in urban China increased by 202 percent (Ge and Yang, 2014).2 Among labor market policy tools, the minimum wage policy in China has been considered a major force driving increases in wages and putting pressure on firms.3 As employment hinges on business performance, the minimum wage can raise the income of poorly paid workers, but in the process cause some of them to lose their jobs. In this paper, we provide evidence of the effect of the minimum wage on firm employment using a novel administrative dataset of minimum wages across more than 2,800 counties in China.4 In contrast to most policy studies at China’s prefectural level, our paper benefits from significant variation in minimum wages at the county level. The geographic division based on China’s counties reduces the size of a geographic unit by 10 times compared to the division based on prefectural cities commonly seen in other research. Furthermore, the county minimum wage is more closely related to the market conditions of a local economy and thus more closely related to firm behavior. To our knowledge, this is the first study to show the effect of minimum wages on employ- ment using a comprehensive dataset that tracks firms across China. China’s Annual Survey of Industrial Firms provides a representative sample of firm data in the manufacturing sector. For example, in 2004 this survey covered more than 90 percent of China’s manufacturing output and 70 percent of manufacturing employment (Brandt, Van Biesebroeck, and Zhang, 2012). Considering its share in the national economy and employment, the manufacturing sector is of great significance in China’s labor market as the major concerns about the rising labor cost in China have been related to this sector. The overall wage rate of China’s manufacturing sector is also relatively low when compared to the average city wage, which makes this sector a pertinent target for policy debates on the minimum wage. The firm data enable us to explore how hetero- geneous firms show different responses to minimum wage changes. It is of interest to investigate 1This share is calculated from the data source of World DataBank: http://databank.worldbank.org. 2In the period from 1998–2010, the average growth rate of real wages was 13.8 percent, exceeding the real GDP growth rate as well as the growth of labor productivity (Li, Li, Wu, and Xiong, 2012). 3For example, see “China pushes minimum wage rises,” published in Financial Times, January 4, 2012. 4For more details about the spatial distribution of China’s minimum wages, see our interactive maps for every year at http://tinyurl.com/china-county-minimum-wage. These administrative data of minimum wages are provided and compiled by the Ministry of Human Resources and Social Security. 2 not only the firms heavily affected, but also other firms to see whether spillover and substitution effects exist. We also provide evidence on the effectiveness of China’s minimum wage regulations. Pre- vious studies have frequently documented imperfect compliance with minimum wage laws. For instance, Ashenfelter and Smith(1979) find an overall compliance rate of only 65%, as well as significant geographic heterogeneity, across the various states in the US. Based on empirical evidence from developing countries, Basu, Chau, and Kanbur(2010) argue that a legislated wage floor and the intensity of enforcement are two indispensable arms of a minimum wage pol- icy.5 Correspondingly, we study a minimum wage policy reform that raised the non-compliance penalty starting from 2004 to test whether and how this new regulation changed the impact of the minimum wage on employment. The endogenous nature of government policies poses a challenge in measuring the impact of the minimum wage. Freeman(2010) argues that governments could set minimum wages while considering the risk that they can cause more harm than good. In this regard, governments must maintain a balance in order not to draw opposition from local employers. It is necessary to explore and control for observable factors of the minimum wage in the employment estimation and exploit the sensitivity of additional control variables (Angrist and Krueger, 1999). Following the influential study of Sobel(1999) examining how minimum wages are set, our results show that among various indicators of the local economy, the setting of minimum wages in China is most closely related to local living costs, growth of GDP, and fixed asset investment (a proxy for future growth potential). This paper also aims to fill the gap in the literature by dealing with unobservable bias associated with minimum wage policy and employment. However, even with careful selection of appropriate controls as Angrist and Pischke(2010) suggest, there is still a risk that bias will remain. Following Altonji, Elder, and Taber(2005) and the method recently developed by Oster (2013), we also conduct a careful test of the possible range of unbiased estimates from selection on observables and unobservables. We also adopt an approach by matching county minimum wages with a hand-collected dataset of China’s neighbor county pairs.