Regulation And Labour Market Performance.pdf

REGULATION AND LABOUR MARKET PERFORMANCE 1

Tito Boeri (Università Bocconi-IGIER and CEPR)

Giuseppe Nicoletti (OECD)

Stefano Scarpetta (OECD)

Abstract

The increasing literature on the interactions between liberalisation-integration of product

markets and labour market reforms is often highly speculative and draws on a rather weak

empirical basis. Cross-country indicators of regulatory frameworks are often lacking, making

it difficult to identify the linkages with observed outcomes in the labour and product markets.

Moreover, empirical studies have often focused exclusively on the impact of certain labour

market regulations, largely ignoring the role of product market regulations and the

interactions between regulatory interventions in the two markets. As a result, while there are

convincing theoretical arguments pointing to a potentially positive effect of product market

liberalisation on labour market performance, empirical investigations of this issue are lacking.

This paper aims at providing some preliminary evidence on these issues. In particular, the

cross-country patterns and changing profile of product and labour market regulations are

identified. Evidence on the relationships between product and labour market regulations is

discussed in the context of other policies and institutional factors affecting the labour market;

and the clustering and convergence of institutions across countries are characterised. More

importantly, the paper reports evidence of a potentially significant impact of product and

labour market regulations on employment and its composition. The evidence presented draws

heavily on a novel set of cross-country indicators of regulation in the product and labour

markets assembled at the OECD. It should be stressed at the outset that these indicators are

preliminary estimates and should be taken only as rough approximations of the regulatory

stance across OECD countries. 2

1. We thank Giampaolo Galli, Jaques Pelkman and Paolo Sestito as well as participants in

the Workshop on “Regulatory Reform, Competitiveness and Market Functioning” for

helpful comments on a previous draft of the paper. The views expressed in this paper are

our own and should not be held to represent those of the OECD or its Member

governments.

2. The indicators are used in this paper under the exclusive responsibility of the authors

and do not engage the OECD or its Member countries.

The plan of the paper is as follows. Section 1 reviews the theoretical and empirical

evidence concerning the effects of regulations in the product and labour markets on the labour

market. This section also sheds some light on the possible interactions between regulatory

regimes in the two markets. Section 2 presents the quantitative indicators of the strictness of

the labour market and product market regulations, while Section 3 discusses the cross-country

co-variations between indicators of labour and product market regulations. This section also

identifies some clusters of countries that share similar features in these two domains. Section

4 analyses the interactions between, on the one hand, PM and LM regulations, and, on the

other hand, labour market performance with particular emphasis on the level and composition

of employment. Finally, Section 5 evaluates the convergence of labour market institutions

within and across the clusters identified in Section 3, which provides a preliminary test of the

convergence and/or race-to-the-bottom hypothesis.

Labour and product market regulations and their effects on the labour market

Economic regulation can be broadly defined as the use of the coercive power of the

government to restrict the decisions of economic agents. 3 It may include restrictions on firm

decisions over entry, exit, the use of inputs, the quantities and the types of output produced as

well as prices. These restrictions are likely to affect significantly (in intended or unintended

ways) the functioning of labour and product markets. Moreover, since market forces will

continue to act even under the most stringent regulatory conditions, outcomes in the labour

and product markets will generally be driven by the interplay of those forces with the existing

regulatory framework. As a result, regulation can be expected to have important repercussions

on overall allocative and productive efficiency. 4

In the following, the focus is set on a subset of government-imposed restrictions that

may affect the level and composition of employment. These include (i) labour market

regulations disciplining hiring and firing decisions of firms; (ii) product market regulations

restricting firm decisions over entry and output; and (iii) direct interventions of the state in

resource allocation, especially through public ownership and control of business enterprises.

Conceptually, these regulatory interventions may all have both direct and indirect effects on

labour market equilibrium, either in isolation or interacting among them and with other public

policies.

1.1 The employment protection legislation: rationale and effects on the level and the

dynamics of employment

1.1.1

The rationale and potential effects of employment protection legislation

In all OECD countries, there are rules and regulations that govern the employment

relationship between workers and firms. Those referring to hiring and firing practices are

often referred to as "employment protection" legislation (EPL). These rules and regulations

govern unfair dismissals, restrictions on lay-offs for economic reasons, compulsory severance

payments, minimum notice periods and administrative authorisations.

3. For a discussion of the concept of economic regulation, see Viscusi et al. (1997).

4. For instance, the cost of US Federal regulations were estimated to range from 4 to 10 per

cent of GDP (Office of Management and Budget, 1998), while the costs of regulation

for the Dutch economy were estimated to range from 11 to 14 per cent of Net National

Income (Bergeijk and Haffner, 1996).

The EPL regulations may affect the equilibrium level of employment -- as well as

its dynamics over the business cycle -- in different ways:

By reinforcing job security, EPL may enhance productivity performance, as workers will

be more willing to co-operate with employers in the development of the production

process (Akerlof, 1984).

To the extent that EPL leads to long-lasting work relationships, it may encourage

employers to provide training to workers with potentially beneficial effects on human

capital and labour productivity. A better skilled workforce may also increase internal

flexibility and thus lead to a better functioning of production activity (Piore, 1986).

EPL may also be a way to internalise the social costs of dismissals by moving the social

burden of re-allocating a worker to another job closer to the firm’s profitability criteria

(Lindbeck and Snower, 1988).

However, if these regulations are very strict, as in many European countries, firms may

become more cautious about adjusting their workforce with the ultimate effect of

reducing labour turnover, e.g. movements from employment to unemployment and from

unemployment back to employment (Bertola, 1992).

In addition, if hiring and firing costs are not transferred into lower wages, total labour

costs for the firms increase and this may lead to a lower level of employment, other

things being equal.

The effective coverage or implementation of standard employment protection provisions

influences the overall strictness of EPL regulations. For example, in many countries

employment protection provisions for workers with regular contracts are often extended

to those with fixed-term contracts after a given tenure or number of renewals has been

reached. In addition, in some countries, the judicial system appears to have interpreted

legislation more strictly than was intended by the law.

A different degree of strictness of regulation governing permanent versus temporary

employment (fixed-term contracts and contracts through temporary work agencies) may

affect the structure of employment. Stricter regulations for permanent contracts relative

to those for temporary contracts are likely to promote a shift from permanent to

temporary employment (as it is occurring in a number of European countries). This has

the potential effect of distorting the optimal composition of employment between

temporary and permanent contracts. Moreover, those who are able to maintain a

permanent contract (often the insiders) will enjoy an even higher level of job security,

bringing about an increase in wage pressure (Bentolila and Dolado, 1994). In contrast,

those under temporary contracts (often youths and other workers with little work

experience or low skills) will bear the brunt of employment adjustment (Saint Paul,

1996).

market?

What do previous empirical studies suggest about the impact of EPL on the labour

Empirical evidence on the impact of employment protection legislation is mixed,

not least because of the lack of suitable data on the enforcement and evolutions of regulations

over time (Bertola et al., 1999). A clear distinction exists between the potential effects of

EPL on employment turnover as distinguished from the equilibrium level of employment

(unemployment) and its compositions (temporary/permanent; youths/prime-age workers etc.).

1.1.2

Employment turnover : There is consistent empirical evidence that strict employment

protection legislation reduces unemployment turnover. Under strict EPL provisions, the

unemployment pool is more stagnant, with fewer people being laid off, but also fewer

unemployed people getting a new job. (Bentolila and Bertola, 1990; and Nickell and

Layard, 1998). The effects on employment turnover are less clear cut: Bertola and

Rogerson (1997) and Boeri (1999) found similar job creation and job destruction rates

across countries with different EPL regimes but lower unemployment inflows in flexible

labour markets). As stressed in Boeri (1999) and OECD (1999), a possible explanation

is that strict EPL may foster job-to-job shifts rather than overall employment turnover

because insofar employers and workers will seek direct shifts from one job to another

without intervening unemployment spells, in order to avoid the associated dismissal and

search costs.

The level of employment : Some studies (e.g. Scarpetta, 1996) suggest a detrimental effect

of strict EPL on the level of employment to working-age population ratios. Nickell and

Layard (1998) indicate that this may be partially due to the low participation rates in

Southern European countries, which also have strict EPL. However, participation rates

may be low, especially amongst the youths, precisely because employment prospects are

lower the stricter the EPL system.

Overall unemployment rate : There is also no consensus as to the overall impact of EPL

on unemployment. Part of the disagreement stems from the use of different models.

However, disagreement persists even amongst papers using the same indicator (the

OECD summary index, see OECD Jobs Study, 1994). While a recent study (Elmeskov,

Martin and Scarpetta, 1998) suggests a somewhat more robust effect on unemployment

if changes in EPL over the past two decades are taken into account, OECD (1999) could

not find a statistically significant effect of EPL on aggregate employment.

Composition of employment and unemployment: Nickell and Layard (1998), Scarpetta

(1996) and OECD (1999) suggest a stronger effect of strict EPL on youth

unemployment. Moreover, Grubb and Wells (1993) indicated that strict EPL for

permanent workers may encourage firms to shift to temporary workers and more

generally foster self employment.

Persistence of unemployment . By reducing unemployment turnover, strict EPL is also

found to slow down the labour market adjustment after an exogenous shock (Jackman et

al., 1996; Scarpetta, 1996). Unemployed workers may loose human capital over time

and they may exert a lower moderating impact on wages (Blanchard, 1998; Bertola,

1990).

Dualism . Countries with stronger employment protection for regular contracts tend to

display a bimodal tenure distribution with either very short or very long tenures (Boeri,

1999). In countries where fixed-term contracts are liberalised, a large share of

employees with fixed-term contracts tend to insulate permanent workers from

adjustment (Bentolila and Dolado, 1994), thereby increasing their bargaining power and

the corresponding wage pressures.

1.2

Product market regulation and the labour market

In the product market too, regulatory provisions are generally motivated on public

interest grounds. The main rationales for product market regulations include natural

monopoly conditions, externalities, asymmetric information and other types of market

failures. However, economic theory also suggests that regulations are generally implemented

as a response to pressures of interest groups acting to maximise their (broadly defined)

incomes. As a result, regulation may be biased towards benefiting interest groups that are

better organised and gain more from regulatory interventions. A detailed analysis of these

issues is outside the scope of this paper. 5 It should be noticed, however, that existing

regulatory frameworks may be flawed by several (possibly concurring) factors:

the effects of some regulatory provisions often drift away from the original public

interest aims, resulting in the protection of special interest groups; 6

regulations and their implementation are sometimes likely to involve costs that exceed

their expected benefits; 7

technical progress and the evolution of demand can render obsolete in a number of

instances the design of existing regulations;

the progress in regulatory techniques may make it easier than in the past to fine tune

regulation, e.g. by separating potentially competitive and inherently imperfect markets.

As a result, in the absence of regulatory reform, existing regulations are likely to be

often ineffective and unnecessarily restrictive of market mechanisms in both the product and

labour markets, potentially bringing about static and dynamic inefficiencies and losses in

social welfare. 8

The effects of product market regulations on labour market outcomes are complex

because they are mediated by market behaviour, industry structure, governance issues and

labour market institutions. In general, entry restrictions may originate from explicit legal

impediments or limitations on the number of competitors allowed in certain markets as well

as from the lack of administrative transparency and/or heavy administrative burdens (so-

called administrative regulation). Entry restrictions are also associated with international trade

and investment policies that deter competition by non-resident firms either through explicit

measures (such as tariffs and legal limitations on foreign ownership) or implicit measures

(such as non-tariff barriers and administrative obstacles to the establishment and operation of

foreign firms in the domestic market).

Entry restrictions in (otherwise) competitive markets cause production inefficiencies

by reducing equilibrium output, moving firm size away from the minimum efficient scale of

operation and sheltering inefficient firms from competition by new entrants. Ill-designed

entry regulations may cause similar inefficiencies in imperfectly competitive markets by

reducing or eliminating actual or potential competition. In addition, entry restrictions

constrain the supply of a particular type of capital, entrepreneurial ability (Krueger and

Pischke, 1998). Finally, by reducing product market competition and international technology

5. For a discussion of theories of regulation and the related empirical evidence see, for

instance, Noll (1989a,b), Winston (1993) and Winston and Crandall (1994).

6. Special interest groups are usually composed of a relatively small number of producers

whose individual marginal gains from regulatory interventions are large as opposed to

the large audience of consumers, who are typically dispersed and ill-organised and

whose marginal gains are individually small. See Peltzman (1989).

7. On the balance of costs and benefits of regulation, see Office of Management and

Budget (1998).

8. For a review of the rationale, the status and the potential effects of regulatory reform in

OECD countries, see OECD (1997b).

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