Optimal Minimum Wage in a Competitive Economy

Arantza Gorostiaga and Juan Francisco Rubio-Ramírez
Working Paper 2004-30
November 2004

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This paper studies the use of a minimum wage law to implement the optimal redistribution policy when a distorting tax-transfer scheme is also available. The authors build a static general equilibrium model with a Ramsey planner making decisions on taxes, transfers, and minimum wage levels. Workers are assumed to differ only in their productivity. The authors find that optimal redistribution may imply the use of only taxes and transfers, only a minimum wage, or the proper combination of both policies. The key factor driving their results is the reaction of the demand for low-skilled labor to the minimum wage law. Hence, an optimal minimum wage appears to be most likely when low-skilled households are scarce, the complementarity between the two types of workers is large, or the difference in productivity is small.

JEL classification: H21 and E62

Key words: minimum wage, optimal taxation, redistribution

The authors thank participants at 2004 SED Conference for useful comments. Financial support from Fundación Ramón Areces, Fundación BBVA (1/BBVA 00044.321-15466/2002) and 9/UPV 00035.321-13511/2001, is acknowledged. Beyond the usual disclaimer, the views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Arantza Gorostiaga, Departamento de Fundamentos del Análisis Económico II, Universidad del País Vasco, Avenida Lehendakari Aguirre, 83 48015 Bilbao, Spain, 34 94 601 38 14, jepgoala@bs.ehu.es, or Juan Francisco Rubio-Ramírez, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street N.E., Atlanta, Georgia 30309-4470, (404) 498-8057, juan.rubio@atl.frb.org.