The Effects of China's Minimum Wage Hikes on Firms' Capital-labor Ratio
WANG Wenchun, YIN Hua, GONG Rukai
School of Finance, TaiLong Finance School, Zhejiang Gongshang University; Research Institute for the Development of Shanghai, Shanghai University of Finance and Economics; Glorious Sun School of Business and Management, Donghua University
Summary:
China's labor cost advantage is gradually weakening, and the population is aging rapidly. The minimum wage standard since 2004 has strengthened the rising labor cost trend. Theoretically, increasing capital input and the capital-labor ratio are important measures to help firms cope with rising labor costs and an important way to improve firms' productivity. However, rising labor costs also reduce corporate profits and free cash flow, squeezing investment incentives and curbing capital investment. Therefore, do rising labor costs force firms to increase their capital investment and capital-labor ratio？ Do these activities mitigate the negative effects of rising labor costs？ Answering these two questions requires a careful examination of both labor and investment inputs. In the face of rising labor costs, whether firms reduce employment and increase investment depends on their ability to transfer the increased wage costs. Thus, the direction of change in the capital-labor ratio depends on the respective directions of change in the labor and investment inputs. Therefore, the impact of rising labor costs on the capital-labor ratio is an open empirical question. Using the annual surveys of industrial firms collected by the National Bureau of Statistics of China and manually collected urban minimum wage data from 2002 to 2011, this paper empirically examines the relationship between labor costs and the capital-labor ratio and the mechanism of this relationship. The results show that an increase in the minimum wage has a significant positive effect on the capital-labor ratio of manufacturing firms. For each 10% increase in the minimum wage, firms' capital-labor ratio increases by 2.0%, and this effect is more significant for firms with wage levels near the minimum wage. Second, inspired by the natural experiment of Card and Krueger (1994), this study exploits the minimum wage increase in Fujian province as a quasi-natural experiment, with firms affected by the increase as the treatment group and firms in geographically adjacent Guangdong province but unaffected by the increase as the control group. The robustness of the conclusions are verified using a difference-in-differences approach. The mechanism analysis shows that the minimum wage increase increases capital input and reduces labor input, providing strong evidence that firms replace labor with capital. Heterogeneity analysis shows that the impact of the minimum wage increase on the capital-labor ratio is concentrated in non-state-owned firms, low-wage firms and labor-intensive firms. Finally, this paper finds that with the minimum wage increase, the productivity and profit of firms also increase significantly. The reduction in production costs is the main factor in the increased profits, verifying the positive effect of replacing labor with capital. This study makes several important contributions. First, it adds to the literature on the effects of minimum wage changes. Studies on the effects of minimum wage changes focus on firms' labor input and output, such as the number of employees, profit, export, productivity and innovation. From the factor substitution perspective, this paper differs from those studies by revealing that faced with rising labor costs, firms change their production and business activities. Second, by investigating firms' capital input, employment and performance, this paper provides strong evidence that enterprises replace labor with capital. This insight deepens understanding of firms' technological upgrades, innovation improvements and industrial structure transformation. This paper also has important policy implications. First, although increasing labor costs decrease firms' employment and exports in the short term, they encourage firms to replace labor with capital, improving labor productivity. Hence, in the long run, increasing labor costs will eliminate Chinese firms' and industries' over reliance on cheap labor and improve firms' innovation ability and the upgrading of the industrial production structure. Second, the findings regarding the mechanism help clarify the trade-off between the minimum wage, capital-labor ratio and employment. The government should take relevant measures, such as reducing corporate taxes and fees, to alleviate firms' burdens, encouraging firms to increase capital input and realize technological upgrading.
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