Minimum Wages and the Informality Constraint

How does informality shape the impact of minimum wage policy? We study this question using evidence from Mexico’s 145% real increase in the minimum wage since 2016, together with a general equilibrium model featuring endogenous informality and household heterogeneity. Reduced-form estimates of the implemented increases indicate limited effects on employment and formalization, alongside modest wage gains at the bottom of the formal wage distribution that arguably reflect incomplete enforcement. The calibrated model reproduces these patterns but predicts that, under full enforcement, higher wage floors generate nonlinear effects: the share of firms reallocating toward informality rises sharply, lowering productivity and aggregate welfare. These losses fall disproportionately on low-skill households, who bear the brunt of the reduction in transfers caused by lower tax revenue yet, as predominantly informal workers, gain little directly from the minimum wage. The minimum wage’s effectiveness as a redistributive tool is therefore limited.