The Effect of Increasing the Minimum Wage on Employment in Indonesia An Analysis of Manufacturing Firms in West Java from 1994 to 2015.

AuthorHigashikata, Takayuki
  1. Introduction

    After Indonesia introduced its sweeping decentralization reforms in 2001, a host of responsibilities was devolved to provincial and local governments (Hofman and Kaiser 2006). Along with these changes, the authority to decide minimum wages was transferred from the centre to the provincial level. Since 2001, provincial governors have set the minimum wages in their territory on an annual basis. This is done upon receipt of a proposal from provincial tripartite councils consisting of employers' association members, labour union representatives, and local government officials. In some municipalities or districts (kota/kabupaten), local tripartite councils have recommended to the mayors or regents (walikota/bupati) how much the minimum wage in their territories should be increased. These, in turn, are reflected in the provincial decrees on the minimum wage. As of 2019, we find that almost one-third of local governments effectively set their minimum wages. Using this change in establishing the minimum wage, this paper investigates its effects on employment in Indonesia before and after the decentralization reforms.

    There is a huge volume of literature analysing the effect of increasing the minimum wage on employment. Although the results are often mixed, there are two broad schools of thought (Neumark and Wascher 2008). One, as predicted by the neoclassical approach, has reported that increasing the minimum wage has a detrimental impact on employment. The other, based on the monopsony model, suggests that a minimum wage hike may not harm employment at all. Most of the literature comes from research in developed countries, especially the United States, though the evidence from developing countries has increased recently. According to the literature review of cases from developing economies, minimum wage hikes have little, if any, impact on employment (Betcherman 2014; Broecke, Forti and Vandeweyer 2017).

    The studies on the impact of raising the minimum wage on employment in Indonesia have also reported mixed results. Comola and De Mello (2011), mainly using the National Labour Force Survey (Sakernas) aggregated by local government areas such as municipalities and districts (kota/kabupateri), showed that an increase in the ratio of the provincial minimum to the mean wage (Kaitz Index) is associated with a net increase in employment. (2) Magruder (2013) presented evidence that the hike in the minimum wage in the 1990s brought about an increase in formal sector employment and a decrease in informal employment as predicted by the "Big Push" model. (3)

    In contrast, using a panel data set of medium and large manufacturing establishments (IBS) in Jakarta and the surrounding area of Bogor, Tangerang, and Bekasi (Botabek), where the minimum wage had been brought closer to that of Jakarta by 1994, Alatas and Cameron (2008) estimated the effects on employment of production workers with a matched difference-in-difference (DID) approach. They found a negative impact on employment for small factories with between twenty and 150 workers, although no clear negative impact for large establishments. Regarding the provincial minimum wage hikes in the early 1990s as exogenous, Rama (2001) reported negative effects of a provincial minimum wage hike on waged workers only for small manufacturing firms. Del Carpio et al. (2015) also utilized the same manufacturing panel data set to investigate the effects of changes in the provincial minimum wage on employment and wages between 1993 and 2006. They found negative effects on employment among small firms with 150 workers or fewer.

    From the perspective of the labour supply side, Suryahadi et al. (2003) used the National Labour Force Survey from 1988 to 2000 and estimated the minimum wage effects on employment. They found negative effects for female, young, and less-educated workers. However, they found a positive effect for white-collar workers. Constructing a province-level panel data set from the Labour Force Survey, Siregar (2020) estimated the effects of a change in the provincial minimum wage on employment from 2001 to 2015. He found that the effects were negative on formal sector employment, but positive for informal sector employment.

    Using plant-level panel data from 1994 to 2015, this paper will shed some light on the increase of Indonesia's minimum wage following the 2001 decentralization reforms. Our main contribution to the literature is twofold. Firstly, we use local government-level minimum wage information for our analysis. As shown above, most of the literature utilized the provincial-level minimum wage. However, this could result in a (negatively) biased estimator because, especially after the 2001 reforms, many local governments began to set their own minimum wages which were significantly higher than the provincial level--as will be shown in the next section.

    Secondly, we focus on neighbouring local government units that belong to the same urban area and, before the 2001 reforms, used to be under a uniform minimum wage. This could reduce biases caused by unobserved local government-specific characteristics affecting both minimum wages and employment (an endogeneity problem). Although the causal impact is not identified in the paper, adopting an analytical framework similar to DID, we find that, in local government areas where higher minimum wage levels have been set since 2002, there has been a statistically significant decrease in employment compared to local governments with a lower minimum wage.

    In our baseline analysis, we found that a 1 per cent increase in the minimum wage in real terms reduced the number of workers employed by manufacturing plants the following year by 0.35 to 0.51 per cent. As, following the 2001 reforms, the average minimum wage in Bekasi municipality was 10.5 per cent higher than that of Bogor municipality, this result suggests that the number of workers employed in factories in the former was 3.7 (= -0.35 x 10.5) to 5.4 per cent (= -0.51 x 10.5) lower than in the latter. In addition, we also found that the negative effects were mainly observed in large firms with 100 or more employees as of 1994.

    The rest of the paper is organized as follows. The next section describes the historical background of the minimum wage system in Indonesia. We present our empirical strategy and data in the third and fourth section, respectively, and show results of our baseline analysis in the fifth section. In the following section, we check the robustness of our findings, and the final section concludes the paper.

  2. Setting the Minimum Wage in Indonesia

    In Indonesia, the central government established the minimum wage throughout the country up until the end of 2000. Under the country's centralized decision-making system, the Ministry of Manpower determined the minimum wage levels after consulting with the National Wage Research Council (DPPN) as well as governors who took advice from provincial tripartite councils. These bodies consisted of the provincial counterparts of the Ministry of Manpower, representatives of employees, and employers. Provincial minimum wages were fixed by taking into account minimum subsistence needs (Kebutuhan Hidup Minimum or KHM), (4) the Consumer Price Index, provincial wage level in general, level of economic development, inter alia (Ministerial Decree of Manpower No. PER-03/MEN/1997 on Minimum Wage). Some provinces had sectoral minimum wages that were set at higher levels than the general provincial ones. In addition, the provinces of Riau, South Sumatra, West Java, East Java and Bali, set different minimum wages within each province during the periods that we analysed (Caraway and Ford 2020; Dhanani and Islam 2004; Manning 1998; Suryahadi et al. 2003).

    After the fall of the Soeharto regime in 1998, the central government under the newly inaugurated president Jusuf Habibie passed two landmark pieces of legislation, namely Law No. 22/1999 on Regional Governance and Law No. 25/1999 on Fiscal Balance between the Central and the Local Government. In order to prepare for the enactment of these far-reaching reforms, the central government issued a regulation in 2000 to devolve the authority to set the minimum wage to provincial governments (Government Regulation No. 25/2000 on Authority of the Central and the Provincial Government as Autonomous Regions).

    In 2003, the government passed Law No. 13/2003 on Manpower, which stipulated that the minimum wage level should be based on decent living standards (Kebutuhan Hidup Lay ok or KHL), productivity, and economic growth. It also required that wage councils advise local government leaders (bupatilwalikota) and provincial governors on the minimum wage. The wage councils, consisting of representatives from employer associations, labour unions, and local governments, hold annual meetings to negotiate and set minimum wages in each district/municipality (kabupaten/kota) and province. (5) These recommendations are then forwarded to local government leaders and provincial governors. With regard to local governments, regents and mayors have the authority to agree on or amend the recommendations, before submitting them to their respective provincial governors who, in turn, have the final say. (6) After that, governors are to announce the provincial minimum wages on the first day of November each year. Following the recommendations from local government leaders in their province, governors may set minimum wages for districts or municipalities that should be higher than the provincial minimum wage and make them...

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