Minimum Wage Spike and Income Underreporting

The labor markets of many transition countries are characterized by two features: a spike at the minimum wage level in the wage distribution and widespread use of so-called envelope wages, i.e. non-declared cash payments in addition to the official wage. In this brief, we present a body of suggestive evidence showing that tax evaders are overrepresented among minimum wage earners in Latvia. 

Introduction

Labor markets in many transition and post-transition countries are characterized by the prevalence of payroll tax evasion in the form of envelope wages, i.e. non-declared cash in addition to the official wage (see for instance Putnins and Sauka (2015) for Latvia, Paulus (2015) and Kukk and Staehr (2014) for Estonia and  Bíró et al. (2022) and Elek et al. (2012) for Hungary).

Another defining characteristic of these transition economies is a very large peak at exactly the minimum wage in the wage distribution. To explain this phenomenon, Tonin (2011) argues that the mass of individuals at the minimum wage level is composed to a large extent of workers receiving envelope wages, where employers and employees collude and agree on reporting only the minimum wage to minimize tax liabilities while remaining under the radar of the tax authorities. In such a setup, the minimum wage policy becomes an enforcement tool for the fiscal administration, as it pushes non-compliant firms to convert part of the envelope wage into an official wage so that it reaches the new minimum wage.

However, only scarce concrete evidence shows that payroll tax evaders are overrepresented among minimum wage earners. Considering the regular minimum wage hikes in the region (e.g., a 95 percent increase in Latvia in 2010-2022 and a planned increase by another 24 percent in 2023), understanding the interaction between minimum wage policy and labor tax evasion is crucial.

In this brief, we present a body of suggestive evidence highlighting the prevalence of wage underreporting at exactly the minimum wage level in Latvia.

Data and Methodology

We use Latvian administrative employer-employee data for 2011 to 2015, covering the full Latvian employed population at a monthly rate. To identify tax evasion, we rely on the comparison between small and large firms. The literature studying tax evasion provides considerable evidence showing that small firms tend to evade more taxes than large firms. Kleven et al. (2016) provide a theoretical foundation for this result, showing that collusive evasion is more difficult to sustain in firms with more employees. Empirically, this effect has been documented in many countries (see for instance Putnins and Sauka (2015), Gavoille and Zasova (2021), and Benkovskis and Fadejeva (2022) for the results on Latvia, Bíró et al. (2022) for Hungary, Paulus (2015) for Estonia, and Kumler et al. (2020) for Mexico).

In this brief, we use a very broad definition for firm size categories and divide firms into firms employing 30 or fewer employees as small and firms with more than 30 employees as large. With such a crude definition, it is inevitable that firms below and above the threshold are highly heterogeneous, implying that some firms below the threshold are tax-compliant, while some firms above the threshold are tax-evading. For our purposes though, it is sufficient to assume that the share of evading employees in small firms is larger than that in the sample of large firms.

Results

We begin by plotting the distribution of wages in the private sector. Figure 1 plots monthly wages in the range of 0–1000 Euros in 2011. The right most dashed vertical line in the figure marks the minimum wage (284.57 Euros per month in 2011) and the left most dashed line marks 50 percent of the minimum wage. There are clear spikes at the minimum wage (and at half of the minimum wage). The minimum level wage spike in small firms (top graph) is much more pronounced than in large firms (bottom graph), which is consistent with the idea that the spike is driven by income underreporting.

Figure 1. Gross wage distribution in the private sector in small (< 30 empl.) and large (> 30 empl.) firms in 2011.

Note: Micro enterprises are excluded. Vertical lines depict the minimum wage (284.57 Euro) and half of the minimum wage (142.29 Euro) in 2011. Source: Authors’ calculations.

This explanation implies that employers and employees choose to declare employment and underdeclare earnings instead of staying completely informal, which is consistent with the available evidence. Staying completely informal involves much higher risks of detection if authorities perform regular inspections of workplaces, and in many Central European countries with prevalent income underreporting, completely informal employment is not very common (OECD, 2008). In Latvia, firms have to register employees in the electronic system of the State Revenue Service before they start to work, hence the probability that an unofficially employed person is detected during a workplace inspection is very high (State Labor Inspectorate, 2010). Existing empirical evidence on Latvia also suggests that income underreporting is much more widespread than completely informal employment, which is estimated at only 2–3.5 percent (European Commission, 2014; Hazans, 2012). Hence, we interpret the spikes as indicative of tax evaders bunching at the minimum wage.

Wage Growth Among Minimum Wage Earners

Wages are expected to grow with tenure, but if minimum wage earners receive part of their income in cash, their reported wage can remain unchanged even after years of employment within a firm (as any increase would arguably go through the non-declared cash). To examine if this is the case, we exploit a period when there were no changes in the Latvian minimum wage (January 2011–December 2013). We select employees who were employed by the same firm in all months of 2011–2013, assign them to wage bins according to their wage in 2011, and in each wage bin calculate the share of workers whose wage in 2013 was the same as in 2011. We assign workers to 10-Euro bins, with the exception of minimum wage earners, whom we assign to a bin of 1 Euro.

As evident from Figure 2 minimum wage earners clearly stand out from other employees. In small firms, almost 45 percent of employees earning the minimum wage in 2011 had the same reported wage in 2013. There is also a spike at the minimum wage in large firms (28 percent), but it is less pronounced than in small firms.

Figure 2. Proportion of continuously employed workers facing no wage growth between 2011 and 2013, by wage bins, in small (< 30 empl.) and large (> 30 empl.) firms.

Note: Micro enterprises and public sector firms are excluded. Source: Authors’ calculations.

An alternative explanation for the large share of minimum wage earners who experience no wage growth could be that, for many of them, the minimum wage is binding. To rule this out, we perform the same calculations on a sample of young employees (24 or younger in 2011). Workers in the early stages of their careers tend to have higher returns to experience and tenure; thus, young workers are less likely to have no wage growth after three years of employment with the same firm. Figure 3 plots the results for young workers. In large firms, the spike at the minimum wage is more than twice as small as for the full sample of workers (12 percent vs. 28 percent), but in small firms it remains very high (33 percent).

Figure 3. Proportion of continuously employed young workers (aged 24 or less in 2011) facing no wage growth between 2011 and 2013, by wage bins, in small (< 30 empl.) and large (> 30 empl.) firms.

Note: Micro enterprises and public sector firms are excluded. Source: Authors’ calculations.

Conclusion

This brief documents highly prevalent tax evasion among minimum wage earners in Latvia. In such a context, the minimum wage is a powerful fiscal instrument as a higher minimum wage pushes non-compliant firms to disclose a larger share of their employees’ true earnings. In addition, wage underreporting among minimum wage earners can act as a shock absorber and cushion the negative employment effects of a minimum wage hike in countries where a large share of workers officially receive the minimum wage.

These upsides however come at a cost. The results presented in this brief by no means imply that all minimum wage earners are tax evaders; a notable share of employees receiving the minimum wage on paper do honestly earn only the minimum wage. In our paper (Gavoille and Zasova, 2022), we show that the flip side of the positive fiscal effect of a minimum wage hike is job losses among genuine low-wage earners and closures of tax-compliant firms that are affected by the hikes.

Acknowledgement

This brief is based on a recent article published in the Journal of Comparative Economics (Gavoille and Zasova, 2022). The authors gratefully acknowledge funding from LZP FLPP research grant No.LZP-2018/2-0067 InTEL (Institutions and Tax Enforcement in Latvia).

References

• Benkovskis, Konstantins; and Ludmila Fedejeva, 2022. “Chasing the Shadow: the Evaluation of Unreported Wage Payments in Latvia“. Latvijas Banka, Working Paper Nr. 1/2022.
• Bíró , Anikó; Dániel Prinz, and László Sándor, 2022. “The minimum wage, informal pay, and tax enforcement“. Journal of Public Economics, 215, 104728.
• Elek, Péter; János Köllő, Balázs Reizer, and Péter A. Szabó, 2012. “Chapter 4 Detecting Wage Under-Reporting Using a Double-Hurdle Model“. Emerald Group Publishing Limited, Rochester, NY, pp. 135–166.
• European Commission, 2014. “Undeclared Work in the European Union“, Special EUROBAROMETER 284.
• Gavoille, Nicolas; and Anna Zasova, 2022. “Minimum wage spike and income underreporting: A back-of-the-envelope-wage analysis“, Journal of Comparative Economics, forthcoming.
• Gavoille, Nicolas; and Anna Zasova, 2021. “What we pay in the shadow: Labor tax evasion, minimum wage hike and employment“. SSE Riga/BICEPS Research paper No.6.
• Hazans, Mihails, 2012. “How many people are working without a contract in Latvia and neighboring countries?”. Technical Report, University of Latvia.
• Kumler, Todd; Eric Verhoogen, and Judith Frías, 2020. “Enlisting Employees in Improving Payroll Tax Compliance: Evidence from Mexico“. The Review of Economics and Statistics, 102 (5), 881–896.
• Kukk, Merike; and Karsten Staehr, 2014. “Income underreporting by households with business income: evidence from Estonia“. Post-Communist Economies, 26(2), 257-276.
• OECD, 2008. “Declaring Work or Staying Underground“. OECD employment outlook 2008.
• Paulus, Alari, 2015. “Tax Evasion and Measurement Error: an Econometric Analysis of Survey Data Linked with Tax Records“. Working Paper 2015-10. ISER Working Paper Series.
• Putnins, Talis; and Arnis Sauka, 2015. “Measuring the shadow economy using company managers“, Journal of Comparative Economics, 43(2), 471-490.
• State Labor Inspectorate, 2010. “Latvia: Annual Report 2010”
• Tonin, Mirco, 2011. “Minimum wage and tax evasion: Theory and evidence“. Journal of Public Economics, 95(11-12), 1635-1651.

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