California Gov. Arnold Schwarzenegger and state lawmakers reached a deal late Monday to hike the minimum wage to the highest level in the nation, aides said on Tuesday.

The agreement between the Republican governor and the Democrat-led legislature's leaders would increase California's minimum wage by $1.25 over the next year and a half to $8 an hour. The deal calls for an increase of 75 cents an hour next January and a rise of 50 cents an hour the following January.

The new wage would be 25 cents more than initially offered by Schwarzenegger, who vetoed previous bills to hike the state's minimum wage. In exchange, Democrats dropped demands the wage automatically adjust upward with inflation changes.

Schwarzenegger, a fiscal conservative and ally of business groups concerned about the cost of doing business in California, said the state economy had recovered and companies could afford to pay minimum-wage workers more.

I have always said that when the economy was ready, we should reward the efforts of California's hard-working families by raising our minimum wage, he said in statement.

The agreement would benefit low-paid workers, said Assembly Member Sally Lieber, a Democrat who had advanced a minimum wage bill earlier this year. We have a moral obligation to ensure that the minimum wage keeps pace with federal poverty guidelines. This bill does that, she said.

Business groups and labor unions were not pleased by the agreement, which Democratic lawmakers can pass without votes from minority Republicans.

We appreciate the governor's opposition to indexing the minimum wage and not walking into automatic increases, but we still oppose increasing the minimum wage, said Michael Shaw, an officer of the National Federation of Independent Business, a small-business advocacy group. It takes away resources from business owners, who are in the best position to decide how to invest in their companies.

Art Pulaski, secretary-treasurer of the California Labor Federation, said the state's AFL-CIO could live without an inflation-adjusted minimum wage over the near term.

We realize that from a Republican governor who is so close to big corporations ... that we would never get him there, Pulaski said. Fortunately, it's an election year, so we leveraged that to push him to do something.

Schwarzenegger is running for re-election against Democratic challenger and state Treasurer Phil Angelides, who is favored by unions, and is moving to improve his standing with Democrats and independent voters who turned against him in a controversial special election he called last year.

The Hollywood icon signed a bill on Monday that aims to make California one of the world's biggest producers of solar energy and is in talks with lawmakers on a bill to cap industrial emissions of greenhouse gas, popular ideas in a Democrat-leaning state where environmental issues rank high with voters.

Angelides said in a statement he would back an inflation-adjusted minimum wage.

After three years of denying Californians the minimum wage increase they deserve, Governor Schwarzenegger is now trying to save his own job by giving minimum support to the minimum wage, Angelides added.