V Wage Controls During IMF Arrangements in Central Europe

Adam Bennett, Louis Dicks-Mireaux, Miguel Savastano, María Carkovic S., Mauro Mecagni, Susan Schadler, and James John
Published Date:
September 1995
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James H.J. Morsink

Despite the general move to reliance on market mechanisms in Central Europe in 1990 and 1991, wage determination remained under official control. Wage controls were part of the 1990 standby arrangements with Hungary, Poland, and Yugoslavia, the 1991 stand-by arrangements with Bulgaria, Czechoslovakia, and Romania, and the 1991 extended arrangements with Hungary and Poland. The arrangements with Poland and Yugoslavia included quarterly ceilings on wages as performance criteria, and the implementation of wage controls was a prior action in the arrangements with Bulgaria and Romania. Though wage controls have been either eliminated or suspended in Hungary, Poland, and the Slovak Republic, they remain in place in Bulgaria and Romania, and after a brief interlude were reimposed in the Czech Republic.

While wage controls can help to secure macroeconomic objectives, such as nominal wage restraint and real wage adjustment, they also carry economic costs in terms of distorting the structure of wages and inculcating wage indexation. Thus, while incomes policies broadly conceived—especially efforts to reach a wide agreement on the required adjustment in the real wage—are not unusual in IMF-supported programs, IMF support for wage controls typically has been confined to their temporary use in a heterodox stabilization program, where a strong argument can be made that their benefits outweigh their costs. In Central Europe, besides the familiar supplementary nominal anchor role for temporary wage controls, the distinctive circumstances of transition provided a possible additional set of rationales for wage controls. In contrast to the stabilization rationale for wage controls, which applies just for the short run, these distinctive rationales could be relevant until enterprise governance was no longer a problem—a point likely to come late in the transformation process.

In this review four principal questions are addressed. First, what are the distinctive rationales for wage controls in transition economies? In other words, do the particular circumstances of the Central European countries argue for the use of wage controls beyond the stabilization phase? Second, to what extent did the design of wage controls mitigate the trade-off between wage restraint and labor market distortions? Third, what was the role of wage controls in restraining nominal and real wage increases? Finally, what kind of conditionality was attached to wage controls, and how were they monitored in IMF arrangements?

Rationales for Wage Controls in Transition Economies

Two types of arguments for wage controls in transition economies have been made. Besides the argument that is familiar from disinflation strategies in other countries—wage controls can be an important tool in a heterodox stabilization program—there are the arguments that are specific to transition economies—wage controls can address the “corporate governance problem” and can encourage labor shedding in a bloated state sector.

Experience with wage controls in other countries has produced a general view that wage controls can play an important temporary role in a strong disinflation program but tend to lose their effectiveness rapidly.1 Inflation stabilizations in Latin America and Israel suggest that wage controls can help break the inertia of inflation. Although fiscal correction is a sine qua non for low inflation, a disinflation strategy that focuses exclusively on the adjustment of aggregate demand may not be sufficient to bring down inflation quickly, because inflation is strongly affected by expectations and institutions. As long as wage setters are uncertain about the behavior of wages in other parts of the economy, they may hesitate to take the lead in halting wage increases in their sector. Thus, along with resolute fiscal consolidation and a firm primary nominal anchor—on money or the exchange rate—wage controls can help coordinate the adjustment of inflationary expectations.

The severity of the disruptions facing the Central European countries reinforced this argument for using wage controls. First, there were immense obstacles to stabilization: large monetary overhangs in Bulgaria and Romania, high inflation in Poland and Yugoslavia, and the threat of wage-price spirals as prices were liberalized in each of the countries. Second, there were enormous real shocks—the collapse of regional trade, sharp deteriorations in the terms of trade, and the need for strong investment to effect restructuring—all of which necessitated sizable reductions in real wages. Two other influences were also expected to reduce measured—though not actual—real wages: the shift from resource allocation through queuing and black markets to price mechanisms, and the potentially large improvement in the quality of the consumption basket as markets were opened to foreign goods.2 On all these scores, the IMF had seldom if ever been involved in situations of such profound macroeconomic adjustments.

The task of addressing these problems was made all the more difficult because programs had to be formulated in conditions of institutional chaos. Particularly in Bulgaria, Czechoslovakia, Poland, and Romania, there was a real question whether existing and emerging institutions could exert the needed restraint on demand, prices, and wages. This suggested the need to secure several holds on the economy-through the conventional channels of credit and fiscal policy, but also the exchange rate (where possible), interest rates, and wages. In addition, discussions about wage controls between the government, labor unions, and employers could provide a forum for forging a social consensus on required adjustments.

While these problems argued for the use of wage controls in the initial stabilization phase, when macroeconomic conditions become more stable the justification for wage controls must rest on other considerations. Previous experience indicates that wage controls tend to be undermined over time by problems with enforcement, particularly increasing exemptions and noncompliance by would-be free riders. Also, real wage reductions achieved through wage controls are often reversed by a spurt in wages following the lifting of the controls (Flanagan (1992)). Therefore, the question for the medium term is whether the distinctive conditions of transition economies—specifically the dominance of the state sector in employment and production—justify wage controls on an ongoing basis.

It has been argued that transition economies require wage controls in order to address the “corporate governance problem” and to encourage labor shedding in the state sector.3 The corporate governance problem has two dimensions. First, given that budget constraints were “soft” under central planning—that is, credit policy was subjugated to the fulfillment of material targets—firms in transition economies do not face the same kind of budget constraints as firms in market economies. If the attempts to impose hard budget constraints are not credible, wages may escalate, since firms expect to be bailed out if they experience financial difficulties. Second, even if budget constraints are hard, poorly defined property rights mean that the objective functions of firms may differ from those of firms in market economies. With the collapse of communism, the control mechanisms of central planning no longer exist, but market institutions have not yet developed fully (“neither plan nor market”). In the absence of clearly defined property rights, the prospect of privatization may cause workers and managers to try to appropriate the firm’s assets—for example, by forgoing maintenance and replacement investment. With no advocate for capital, the combination of worker influence on management decisions and the anticipation of ownership transformation may lead firms to overpay labor.

The second distinctive rationale for wage controls in transition economies is that, by taxing the marginal labor input, they can provide an incentive to shed labor. Reducing employment in the state sector was a specific program objective in Poland in 1990 and in Bulgaria in 1991 and 1992. The idea is that labor shedding in the state sector promotes economic restructuring. These considerations conditioned the incorporation of wage controls in the initial programs, except in Yugoslavia, where they were meant to play a more conventional nominal anchor role (see Box 5-1).4 Yugoslavia will, therefore, not be included in the remainder of this review.

The case against wage controls is that they distort the structure of wages and inculcate wage indexation. In transition economies, the distortive effects are particularly important because the wage structure was highly distorted to begin with. Wage distortions result in a misallocation of resources that causes existing labor to be used inefficiently, though the static welfare costs due to these distortions are probably not large, as the analysis of deadweight losses indicates. Of greater concern is the effect of wage distortions on the accumulation of human capital and therefore on economic growth. Even a small effect on the growth rate can have a large impact on welfare over time.

Box 5-1.Yugoslavia

Wage controls were a key feature of the 1990 stand-by arrangement with Yugoslavia. Although Yugoslavia had previously been a centrally planned economy, important aspects of the economy had been liberalized from the 1960s on. For example, by 1990 most prices were freely determined. Thus, the 1990 program did not mark an important break with the past or the beginning of a transition to a market economy.

Wage controls took the form of an intervention law that froze wages in the entire socialized sector for six months. In principle, this provided a second nominal anchor in addition to the exchange rate. By preventing any adjustment of relative wages, the wage freeze would have ossified the wage structure.

In practice, the nominal wage freeze was not implemented, because the federal government was unable to prevent republican and provincial authorities from granting exceptions to the freeze. Lax fiscal and monetary policies led to nominal wage growth substantially in excess of its target. Thus, notwithstanding the dampening effect of the fixed exchange rate on inflation expectations, the performance criterion on the average wage was breached at the first test date (end-March), and wages were never brought back on track (Table 5-1).

Table 5-1.Yugoslavia: Performance Criterion on Wages1
Maximum limit2,6022,602
Source: IMF staff estimates.

Average monthly net personal income per worker in the socialized sector (new dinars per month).

Since wages were frozen for six months (only), neither performance criteria nor indicative ceilings beyond June were specified initially.

The constrained geographical mobility of labor in transition economies may amplify the costs of wage distortions. The unreformed housing markets, with largely state-owned apartments, subsidized rents, and allocation other than by price, make it difficult for workers to move and discourage housing investment. Since labor mobility is limited, it is even more important to allow relative wages to change to reflect the scarcity of labor in different parts of the country. If relative wages are not allowed to change, say, because of an implicit indexation rule, then there will be less of an incentive to invest in labor-abundant parts of the country (where investment is most needed) and more of an incentive to invest in labor-scarce parts of the country. To the extent that the short-run elasticity of investment with respect to the real wage is low, the short-run costs of wage controls are low, but medium-term effects are likely to be larger.

Design of Wage Controls

Wage controls during the arrangements were similar to those that had been in effect in the more reform-oriented centrally planned economies, namely, Poland and Hungary before 1990. Prior to the transition, wages had been either completely centrally determined or regulated by an excess wage tax. In Bulgaria, Czechoslovakia, and Romania, base wages were set according to predetermined schedules. Wage dispersion was minimal, returns to skills were low, and wages were biased toward manual workers (see Adam (1980)). In Hungary and Poland, with the relaxation of vertical controls and the increase in enterprise autonomy, wages were set by enterprises but were subject to a tax on payments in excess of a centrally determined norm. Although the wage norms were often related to enterprise productivity or profitability, the absence of market prices made these indicators difficult to measure. The experience with the excess wage tax was disappointing, because the tax was not applied consistently to all enterprises and the rules for setting the wage norm effectively amounted to the full indexation of wages to prices.

How Were the Costs of Wage Controls Minimized?

The central challenge in designing wage controls was to maximize their effectiveness while minimizing their costs. Transition economies addressed this trade-off by exempting the private sector to the degree possible, setting wage ceilings on firm-level variables, enforcing them with tax penalties, and limiting the coverage to easily observable types of compensation.

Because private firms were not expected to suffer from soft budget constraints or undue sensitivity to labor interests, each country exempted the private sector from wage controls in some way (Table 5-2).5 Thus, as the private sector expanded, the role of wage controls would diminish automatically. In Bulgaria, the wage controls applied only to the socialized sector. In Czechoslovakia and Hungary, small firms—the vast majority of private firms—were exempt. Although the private sector was covered in Poland in 1990, once inflation slowed markedly in 1991 wage controls applied only to the socialized sector. In Romania, majority private- or foreign-owned firms were not subject to controls. Exempting of the private sector reduced overall wage restraint but allowed expanding private firms to pay the wages needed to attract the right mix of workers.

Table 5-2.Design of Wage Controls, 1990–92
Change in Wage NormControl VariablePenalty Tax RatesExemptionsCompensation Coverage
BulgariaCeilings based on projected inflation, with compensation if forecast error exceeded 10 percentWage bill adjusted for productivity11991: 100–800 percent
1992: 50–400 percent
Private sectorWages and bonuses
Czechoslovakia1991 Q1: Ceilings based on projected inflation
1991 Q2–4: Full indexation
1992: Ceilings based on projected inflation, later adjusted
Average wage, adjusted for profitability in 1992200–750 percent1991: Fewer than 25 employees
1992: Fewer than 150 employees or more than 30 percent foreign ownership
Wages. Bonuses covered in 1991, but exempt in 1992
Hungary2In 1990, ceilings allowed to increase in line with value added. In 1991, ceilings raised by 18 percent over the year, No automatic ex post indexation1990: Wage bill adjusted for value added
1991: Wage bill3
Corporate tax rate (40 percent)Less than 20 million forint wage costs or more than 20 percent foreign ownershipWages
PolandFormal ex post partial indexation. Frequent and widespread exceptions result in de facto full indexation as of 19911990: Wage bill
As of 1991: Average wage adjusted for profitability
100–500 percent41990: None
1991: Private sector, i.e., more than 50 percent private ownership
Wages. Bonuses covered separately as of 1991
RomaniaImplicit backward-looking partial indexationAverage wage and individual wagesAverage wage: 500 percent
Individual wages: 40–80 percent
Less than 50 percent private or foreign ownershipWages and bonuses
Source: IMF staff reports

In budgetary institutions, ceilings applied to average monthly wages.

In 1992, Hungary had a conditional excess wage tax (EWT): if the average wage in the economy increased by more than 23 percent (which did not occur), the EWT was applied to those firms whose wage bill increased by more than 28 percent.

If employment rose by more than 5 percent, firms were allowed to increase their wage norms proportionately.

In the first half of 1990, the lowest marginal rate was 200 percent.

Ceilings were put on either firms’ wage bills (Bulgaria, Hungary, Poland in 1990) or firms’ average wages (Czechoslovakia, Poland after 1990, Romania). Although some of the flavor of rules that governed the wage ceilings is provided in Table 5-2, the rules were complicated, and it is impossible to infer what they meant for the wage ceiling of the “typical” firm. This situation contrasts with an economy-wide norm on wage increases (for example, a wage freeze), common in heterodox stabilization programs in which the nominal anchor role is dominant. Firm-level ceilings introduced some flexibility into wage setting by allowing the wages of individual workers within a firm to be adjusted without penalty. However, they did entail distortions at the level of the firm by interfering with firms’ employment decisions. The wage-bill ceiling gave firms the incentive to shed labor and to subcontract work, enabling them to increase the average wage, but constrained their exploitation of new, profitable opportunities. (In an attempt to compensate for this effect, wage ceilings in Bulgaria could be adjusted to take into account new lines of production.) Poland switched to ceilings on average wages in 1991 in order to remove this disincentive.

Ceilings on the average wage provided an incentive to hire low-paid workers or fire high-paid workers, and discouraged the payment of higher wages for greater effort or the acquisition of skills. Tax penalties allowed some flexibility in interfirm relative wages or wage bills, in that firms could break the wage-setting rule as long as they were willing to pay the penalties. Bulgaria. Czechoslovakia. Poland, and Romania adopted “prohibitive” penalty tax rates, while Hungary taxed excess wage increases at the corporate tax rate. Tax rates of several hundred percent provided a strong incentive for wage restraint (although after mid-1990 many firms in Poland were willing either to pay the excess wage tax or to accumulate large tax arrears), but severely limited the scope for firms to expand or to reward skills or effort. Of course, to the extent that firms were willing to pay wages that exceeded the wage ceilings, this flexibility came at the price of less wage restraint.

The trade-off between wage restraint and administrative cost was reflected in the fact that not all types of compensation were covered. While bonuses were covered in every country except Hungary, nonpecu-niary compensation—an important part of compensation but notoriously difficult to measure—was not covered anywhere.6 The experience in Hungary illustrates how compensation that was covered—wages—grew much more slowly than compensation that was not—assimilated incomes, which consisted of payments-in-kind (for example, vacations and use of automobiles) and untaxed side payments (for example, meals and clothing). Assimilated incomes, which constituted 12 percent of the total in 1990 and 17 percent in 1991, grew by 65 percent and 76 percent in those years, versus 19 percent and 22 percent for wages. Comprehensive coverage of compensation would have removed the incentive for such substitution but would have involved far greater administrative cost.

Designing Wage Controls as Nominal Anchors

An important role of wage controls, particularly in the stabilization phase of an adjustment program, is to ensure that wage increases do not add to or perpetuate inflationary pressures. However, if wage norms are fully indexed to past inflation, they cannot play a nominal anchor role and in fact create a situation in which supply shocks lead to increases in the inflation rate. In order for wage controls to provide a nominal anchor, wage norms need to be predetermined for a reasonably long period on the basis of projected inflation, and adjustments for past inflation should occur only in extreme circumstances. In principle, a predetermined path of wages constitutes a nominal anchor because of the central role of wages in setting the path of prices. In practice, the political need to limit any decline in real wages weakens the effectiveness of wage controls as a nominal anchor. Even so, appropriately designed forward-looking wage controls linked to an exchange rate or money anchor can help to keep wage growth in line with the projected increase in other nominal variables.

In principle, if the authorities announce a credible inflation forecast, partial backward-looking indexation can be equivalent to forward-looking indexation. In either case, economic agents know what to expect of inflation and nominal wage growth. In practice, partial backward-looking indexation, even if intended to be “strict,” is often hard to distinguish from full backward-looking indexation. In Poland, where the announced indexation coefficient was 0.6 after 1991, the de facto coefficient was very close to 1.0. In Romania, where the announced indexation coefficient was 0.5, the de facto coefficient was 0.9.

A related argument is that wage controls may help to reduce the inflation cost of inevitable real wage declines. Here the idea is that the equilibrium real wage will be reached one way or another. In principle, by lowering the de facto indexation coefficient, strictly enforced wage norms can reduce the amount of inflation that is needed to reach that real wage. Conversely, wage norms may come to be viewed by managers and workers as targets, as in Bulgaria during 1993, and thus push the system toward de facto indexation. In practice, it is impossible to say whether wage controls increased or decreased the de facto indexation coefficient.

The degree to which wage controls fitted the description of an ideal nominal anchor varied both across countries and over time (Appendix 5-1).7 Wage controls provided more of a nominal anchor in Bulgaria in 1991 and 1992 and in Hungary in 1991, because wage norms were based on projected inflation and were not adjusted during the year (although in Bulgaria, the wage ceilings were adjusted in 1992 when actual inflation exceeded projected inflation by more than a threshold amount). In Czechoslovakia, wage norms were based on projected inflation in early 1991 and in mid-1992, but not at other times. Backward-looking indexation, explicit in Poland and implicit in Romania, provided less of a nominal anchor. To a large extent, these differences were a function of how countries responded to larger-than-expecied declines in real wages when prices rose more than anticipated. For example, in Czechoslovakia the shift to full indexation in April 1991 was a response to the far larger than expected drop in real wages in the first two months of the year. The need to adjust to such developments underscores the weakness of wage controls as a nominal anchor.

Role of Wage Controls in Restraining Nominal Wage Growth

Even though the price increases following price liberalization were generally larger than expected, nominal wage growth in Central Europe did not explode, and wage-price spirals did not develop. In fact, nominal wage increases lagged price inflation in every country, even when inflation significantly overshot initial forecasts. Although real wage declines were warranted in each of the countries, this is not a picture suggestive of wage-driven inflation. What roles did wage controls play in these outcomes?8

The best technique for isolating the independent effect of wage controls on nominal wage growth is to control for all the other factors that affect wage growth. In practice, given just a few years of data for each country and several explanatory variables, there are not enough degrees of freedom for such an investigation. Thus, the role of wage controls must be considered with second-best techniques—examining actual wage behavior relative to projections and comparing wage behavior when controls were in place to that when controls were not in place. Data on projected and actual nominal wage growth are available for nine program years. There are even fewer experiences where wage controls were not in place—Hungary (from the beginning of 1992), the Slovak Republic (1993), and the Czech Republic (first half of 1993).9 The effect of wage controls on nominal wage growth may be assessed by analyzing three distinct time frames: the period of price liberalization, the period after price liberalization, and the period after the removal of wage controls.

First, the available evidence suggests that wage controls on average were not binding during the initial price liberalization. In Czechoslovakia (first quarter of 1991) and Poland (first quarter of 1990), despite price jumps that were larger than programmed, wages rose less than programmed.10 This is not to say that wage controls did not play any role during this very uncertain period, but rather that it is difficult to attribute a major role, particularly in the aggregate, to them.

Second, during the period when wage controls were in effect, the behavior of wages relative to projections suggests (i) that wage controls alone were insufficient to restrain wages and (ii) that there is a close association between meeting credit targets and meeting wage projections. Wage controls were in effect in all nine program years for which data are available, but wage projections were exceeded by large amounts in two (Poland (1990) and Romania (1991)) and by smaller margins in four (Bulgaria (1992), Czechoslovakia (1992), Hungary (1990), and Poland (1991)) (Table 5-4). In these nine program years, there is close to a one-to-one association between the adherence to programmed credit restraint and the adherence to initial wage projections (Table 5-5). (The extension of credit to nonfinancial enterprises was compared with the program projection in order to control for, among other things, periods of high expected inflation.)

Box 5-2.Wage Bill Versus Average Wage as a Nominal Anchor

Even though the choice between the average wage and the wage bill for the control variable was driven by the different incentives for labor shedding, it is interesting to consider whether they were equally effective as a nominal anchor. The price that wage controls aim to stabilize is unit labor costs (ULC), which can be expressed either as the ratio of the average wage (AW) to productivity (P), or as the ratio of the wage bill (WB) to output (Y):

where L is employment. If the forecast for output is more certain than the forecast for productivity, then unit labor costs will be more certain if the wage bill is controlled. However, if the forecast for productivity is more certain than the forecast for output, then unit labor costs will be more certain if the average wage is controlled.

In Central Europe at the outset of the programs, there was a great deal of uncertainty about the future course of all economic variables. In Bulgaria, productivity was viewed as more uncertain than output, since productivity depended on difficult-to-predict decisions about whether to hoard or to shed labor with zero marginal productivity in the hugely overstaffed state sector. Controls on wage bills, therefore, provided a better nominal anchor. In the other countries, there was little to suggest whether output or productivity was more uncertain. Consequently, there was no reason to prefer either the average wage or the wage bill as the better supplementary nominal anchor.

With the benefit of hindsight, the relative accuracy of the IMF staff’s output and productivity forecasts can be compared. Given that forecast and actual data on output and productivity in the state sector are not available, forecast and actual data for real GDP and overall productivity—the latter inferred from the output and unemployment forecasts, assuming a constant labor force—are used.1 Comparable data on both the forecast and the outcome are available for nine program years (Table 5-3). The forecast errors are sometimes large, but on only one occasion was the error larger than 15 percentage points (in Romania in 1992). On the basis of these nine program years, the root mean squared error (RMSE) of the output and productivity forecasts is similar. Ex post it therefore appears that the average wage and the wage bill were equally desirable as a nominal anchor.

Table 5-3.Forecast Accuracy in Central Europe(Percentage change)
Real GDPProductivity
Root mean squared error of forecast7.28.7
Root mean squared error of forecast excluding Romania7.07.3
Source: IMF staff estimates.
1Forecasts for labor force participation are unavailable. In Bulgaria, state sector employment was forecast.
Table 5-4.Comparison of Projected and Actual Nominal Wages1(Period average; percentage change)
Bulgaria (wage bill)Projection13964
Czechoslovakia (average wage)Projection28122
Hungary (average wage)3Projection20304
Poland (average wage)5Projection240684
Romania (average wage)Projection604
Source: IMF staff estimates.

See Appendix 5-2 for full definitions. The projection is taken from the initial program document.

End-1992 over end-1991.

Data on wage bills are unavailable.

No projection made.

In 1990, the control variable was the wage bill, but no annual projection for this variable was made.

The direction of causality between credit and wages is somewhat ambiguous. That is, did meeting credit targets restrain wages, or did well-enforced wage controls reduce the pressure on the monetary authorities to relax credit policy so as to limit the adverse effects on output and employment? The conventional view that credit is more under the control of the government than are wages (that is, credit is “more” exogenous) is not necessarily accurate in Central Europe, because of the history of credit policy being subjugated to enterprises’ credit needs. The possibility that wage controls may have helped to restrain wages and credit underscores the importance of setting wage norms on the basis of projected inflation. The degree to which wage controls were set exogenously varied across countries, and even within countries over time, but the strongest examples are Bulgaria (1991 and 1992), Czechoslovakia (1991), and Hungary (1991). However, even in these countries, the catch-up provisions in case of projection errors meant that wage norms were not completely exogenous.

Table 5-5.Adherence to Wage and Credit Projections
Wage Projection2
Credit Projection1Met3Almost met4Largely exceeded5
Met3Bulgaria, 1991, 1992
Czechoslovakia, 1991
Hungary, 1991
Poland, 1991None
Almost met4NoneCzechoslovakia, 1992
Hungary, 1990
Largely exceeded5NoneNonePoland, 1990
Romania, 1991
Source: IMF staff estimates.

Projected credit to enterprises (or nongovernment) (see Charts 5-1 to 5-7) from initial program document, except for first year of transition, when the midyear projection was used (because of the effect of unexpectedly high inflation on nominal credit targets).

Nominal wage projection from initial program document (see Table 5-4).

Actual minus projection was less than or equal to 1 percent.

Actual minus projection was between 1 and 15 percent.

Actual minus projection was greater than 50 percent.

Chart 5-1.Bulgaria: Inflation, Wages, and Credit

Sources: IMF staff estimates, and International Financial Statistics, various issues; and national authorities.

1Credit to nonfinancial public enterprises.

The leads and lags in credit growth and wage growth provide some indication of changes in credit preceding changes in wages. (Given the range of factors that affect wage growth, including expectations about wage policy and inflation, and labor market conditions, the fact that there is any appearance of credit leading wages is remarkable.) In Bulgaria in 1991 and 1992, there is no distinct pattern in the relationship between changes in wage growth and in credit growth, but in the first half of 1993 both growth rates increased at the same time (Chart 5-1). In Czechoslovakia, credit and wages appear to move mostly together, but in early 1991 and late 1992 accelerations in credit seem to have led accelerations in wages (Chart 5-2); the subsequent acceleration of wages in the Czech Republic (in the second quarter of 1993) might also have reflected expectations that wage controls would be reintroduced. In Hungary, there seems to have been a rather regular one or two quarter lag in the response of wage growth to credit growth (Chart 5-3). In Poland in 1990, a distinct shift towards more expansionary financial policies preceded an acceleration in wages: the credit projection was exceeded as of the second quarter, while the performance criterion on wages was breached from the third quarter onward (Chart 5-4 and Table 5-6). In 1991 and 1992, a deceleration of credit growth appears to have led the deceleration of wages. In Romania, there also appears to be a one or two quarter lag in the effect of credit on wages (Chart 5-5).

Chart 5-2.Czechoslovakia: Inflation, Wages, and Credit

Sources: IMF, staff estimates, and International Financial Statistics, various issues; and national authorities.

1Beginning in 1993, credit to Arms and households.

Third, the behavior of wages following the (sometimes temporary) removal of wage controls in the Czech Republic, Hungary, and the Slovak Republic provides mixed evidence about the restraining effect of wage controls. In Hungary, wage controls were removed permanently at the beginning of 1992. While the spurt in wage growth in the first quarter of 1992 may point to wage controls having had a restraining effect, the acceleration was short-lived, and wage growth declined for the year as a whole. The fact that the labor share rose sharply in 1991, when wage controls were in effect, and leveled off in 1992, after wage controls were removed, does not provide prima facie evidence of wage controls having had a critical restraining effect (Table 5-7). In the former Czechoslovakia, after wage controls were formally eliminated at the beginning of 1993, wage growth rose in the Czech Republic but fell in the Slovak Republic. In the second half of 1993, wage growth slowed in the Czech Republic following the reimposition of wage controls at midyear, but wage growth slowed in the Slovak Republic also, where wage controls were not reimposed. In other words, the with-and-without comparison of wage growth is consistent with wage controls having a restraining effect in the Czech Republic, but not in the Slovak Republic.

Chart 5-3.Hungary: Inflation, Wages, and Credit

Sources: IMF, staff estimates, and International Financial Statistics, various issues: and national authorities.

Chart 5-4.Poland: Inflation, Wages, and Credit

Sources: IMF, staff estimates, and International Financial Statistics, various issues; and national authorities.

1Credit to nonfinancial public enterprises.

2Including capitalization of interest due but not paid.

Evidence on the Distinctive Rationales for Wage Controls

Thus far, the discussion has focused on the role of wage controls as a nominal anchor—a role familiar from stabilization efforts in some market economies. Beyond this role, however, there were three rationales for wage controls distinctive to transition economies: that wage controls would help constrain the excesses of firms with soft budget constraints; that wage controls would prevent labor from exerting undue influence in wage setting; and that limits on wage bills would promote needed reductions in state sector employment.

Chart 5-5.Romania: Inflation, Wages, and Credit

Sources: IMF. staff estimates, and nternational Financial Statistics, various issues; and national authorities.

Did wage controls help to mitigate the effects of soft budget constraints? The preceding discussion about the relative endogeneity of wages and credit points to a possible role for wage controls in helping to strengthen the authorities’ hand in enforcing hard budget constraints. However, the fact that changes in financial policies, and the extension of credit in particular, appear frequently to have preceded changes in wages raises questions about the importance of this role.

This section addresses the other two distinctive rationales for wage controls. To determine the effectiveness of wage controls in preventing excessive labor influence in wage setting, the behavior of real wages and microeconomic evidence are reviewed. Next, to investigate the role of controls on the wage bill in reducing state sector employment, data on the latter are compared across countries.

Table 5-6.Poland: Performance Criterion on Wages(Percentage change)
Source: IMF staff estimates.

Performance criterion on the wage bill.

Three-month change.

Six-month change.

Performance criterion on the average wage.

No projection made.

Initial projection of January–June average compared with December 1990.

Initial projection of January–September average compared with December 1990.

Role of Wage Controls in the Decline in Real Wages

In each of the transition economies, wage ceilings were set exclusively on nominal wages; appropriately, in light of the scope for destabilization, real wages were never formally targeted. Nevertheless, either explicitly or implicitly there was an “objective” for real wages, which in each country, except Hungary, amounted to a large drop in the level. What considerations entered into the formulation of these objectives? There was invariably a high degree of uncertainty about the level of the equilibrium real wage. The deterioration in the terms of trade, the collapse of traditional markets, the large change in the composition of the consumption basket as imports were liberalized (which rendered base measures of consumption wages irrelevant), and changes in labor productivity all pointed to the need for a substantial decline in the real wage, but the precise amount was unknown. A consideration raised in Czechoslovakia was how the real wage would affect the speed of enterprise restructuring. An intermediate balance was sought between a low real wage, which would tend to slow down the demise of old enterprises but promote investment in new industries, and a high real wage, which would tend to produce the reverse.

Table 5-7.Hungary: Comparison of Projected and Actual Nominal Wages(Period average; percentage change unless otherwise noted)
Projections (state sector)
Average wage20301
Wage bill16231
Average monthly earnings in industry18213026
Gross labor income per employee20283128
Share of labor income in GDP (percent)46475252
Source: IMF staff estimates.

In all countries under review, regardless of whether nominal wage projections were met, measured real consumption wages declined. Surprisingly, given the great uncertainty under which real wage targets were formulated, the cumulative changes in the first two years of the program were largely in line with program projections (Table 5-8). The sizes of the declines were not related to whether the nominal wage projections were met.

Of course, judging whether the adjustment in the real wage was sufficient is difficult in light of the structural transformations in these countries. The level of U.S. dollar wages, which is an imperfect indicator, suggests that by 1992 wages were reasonably competitive in each of the countries from an international standpoint (Table 5-9).11 In dollar terms, wages in Central Europe were approximately a tenth the level in OECD countries, and about half of the level in a group of middle-income countries in Latin America. Wages in Central Europe were higher than in Africa or most of Asia, but labor productivity was higher as well. Abstracting from differences in labor force participation rates and unemployment rates, a broad measure of labor productivity is GNP per capita. Therefore, a rough measure of “unit labor costs” is the ratio of wages to GNP per capita. By this measure, Central Europe was far more competitive than Africa and Latin America, comparable to the OECD, but a little less competitive than the Asian newly industrializing economies (Hong Kong. Korea, and Singapore). While these comparisons do not necessarily imply that real wages are at their equilibrium levels, they do provide some reassurance that wages are reasonably competitive by international standards.

Table 5-8.Comparison of Projected and Actual Real Wages1(Period overage; percentage change)
Source: IMF staff estimates.

For full definitions, see Appendix 5-2. The real wage is defined as the nominal wage divided by the consumer price index.

No projection made.

Table 5-9.Central European Wages in U.S. Dollar Terms
Average Monthly
Earnings, 1992
per Capita, 1992
per Capita
(index: OECD = 100)
Central Europe1861,932101
Memorandum items:
Latin America53762,115211
Asia, excluding NIEs6120930129
Asian NIEs785712,64086
Source: IMF staff estimates.

For Central Europe, IMF staff estimates (see Appendix 5-2). For the rest of the world, wages in nonagricultural activities, which is the broadest coverage available, for the latest available year from the ILO Yearbook of Statistics 1992. Average exchange rates from International Financial Statistics. The group means are unweighted.

World Bank Atlas 1994.

Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, New Zealand, Portugal, Spain, Switzerland, Turkey, United Kingdom, and United States.

Burundi, Egypt, The Gambia, Ghana, Kenya, Malawi, Sierra Leone, and Zimbabwe.

Brazil, Costa Rica, Chile, Paraguay, Peru, and Venezuela.

China, Jordan, the Philippines, Sri Lanka, and Thailand.

Hong Kong, Korea, and Singapore.

Microeconomic Evidence on Wage Setting

The only systematic firm-level study of enterprise behavior in Central Europe is a World Bank survey of 75 state-owned enterprises in Poland (Pinto, Belka, and Krajewski (1993)). The overrepresentation of labor in the objective function of the firm would seem to be especially a problem in Poland, where managers serve at the pleasure of workers’ councils: state firms are “self-governing” under the direction of a workers’ council that hires and fires managers, determines managers’ compensation, and clears all important strategic and even operating decisions. The study found that wage setting in Poland was similar to bargaining outcomes commonly seen in market economies, which suggests that inadequate investment was not due to excessive payments to labor. Wages were not set to exhaust the surplus, but to share the surplus between labor and capital. Profitable firms paid the highest wages and hence the highest excess wage taxes, but also invested the most and were therefore the least decapitalized. By contrast, decapitalization was pronounced in loss-making firms, which also paid lower wages. This evidence suggests that decapitalization was more of an adjustment phenomenon than a deliberate attempt to squander state assets.12

Table 5-10.State Sector Employment1(Percentage change)
Source: IMF staff estimates.

Data for Hungary and Poland are not available.

Employment in nonbudgetary institutions, given by employment in the material sphere minus private employment in the material sphere (period average).

Employment in the state, communal, and cooperative sectors (end of period).

Employment in the state and cooperative sector (end of period).

State Sector Employment Growth

The third distinctive rationale for wage controls was that ceilings on wage bills would promote needed reductions in state sector employment. This incentive to shed labor was not present with ceilings on average wages. It is difficult to measure the impact of this incentive, because the observed declines in state sector employment reflected other factors also, including the privatization of state sector activity. For example, the reclassification of agricultural workers from the state sector to the private sector has been particularly pronounced in Romania. The limited available data on employment in the state sectors show that the cumulative decline over 1991 and 1992 in Bulgaria, which controlled the wage bill, was greater than that in Czechoslovakia, but similar to that in Romania, both of which controlled the average wage (Table 5-10).

Magnitude of the Costs of Wage Controls

Empirical evidence does not yet exist to evaluate meaningfully either the degree to which wage controls have impeded the needed shift toward a more differentiated wage structure or the effect of wage distortions on economic growth. The sketchy data available suggest that there has been at best a small increase in differentiation.13 In Bulgaria, the variation of wages across industrial branches has increased, but there has been little movement in the occupational wage structure. In Czechoslovakia, interindustry wage dispersion has risen and survey data point to a small increase in the return to education, but enterprise-level data indicate no increase in wage dispersion across firms. In Hungary, the variation of wages across industrial subsectors has increased, but the relative wages of professional workers have changed only a little. In Poland, the coefficient of variation of wage increases across sectors remains small. In Romania, the structure of wage differentials is broadly unchanged, and average wages across enterprises in the same sector of the economy can vary by as much as 250 percent, without any apparent economic justification.

IMF Conditionality on and Monitoring of Wage Controls

IMF conditionality on and monitoring of wage controls varied considerably across countries. The arrangements with Poland and Yugoslavia included quarterly ceilings on wages as performance criteria; the implementation of wage controls was a prior action in the arrangements with Bulgaria and Romania; in Czechoslovakia, wage controls were mentioned specifically as being subject to review only in 1991; and no conditionality was attached to wage controls in Hungary.

In Poland, the performance criterion was a wage ceiling, the level of which in any quarter was determined by backward-looking partial indexation. The system of wage controls in Poland created a distinction between a firm’s wage norm and actual wages paid by the firm: the wage norm was determined by the government, but wages themselves were set by enterprises. The performance criterion applied to actual wages, rather than the wage norms. Performance criteria are not always set only on items that are directly controlled by the government, and it is certainly true that the government’s general policy stance would be reflected in the growth of the nominal wage. However, especially because deviations from the wage norms were explicitly allowed in the excess wage tax system, it might have been preferable to set the performance criterion on the wage norm and its enforcement through the application of tax penalties, and to set indicative targets for the growth of the actual wage. In fact, the 1993 stand-by arrangement with Poland included a benchmark rather than a performance criterion on average monthly wages.

In the 1990 stand-by arrangement with Poland, the performance criterion on wages was observed in March and June, but was breached in September. Subsequently, the arrangement remained off-track and expired in March 1991 with no further purchases made. The 1991 extended arrangement went off-track immediately, although wage growth was below the projected performance criteria through September 1991.

In Yugoslavia the performance criterion on wages was also a ceiling on actual wages in the socialized sector. However, in Yugoslavia wage controls took the form of a law that froze wages in the entire socialized sector for six months. Under these circumstances, actual wages should have been under the direct control of the government. The 1990 stand-by arrangement went off-track immediately, partly because the performance criterion on wages was breached.

In the other four countries, the monitoring of wage policy differed. In each country except Hungary, there was extensive discussion of wages in IMF staff reports. Often, however, the complexity of the wage controls and the weak data base made it difficult to portray these developments precisely. In most of the countries, wage policy was explicitly subject to review: even when there was not an explicit review clause, however, staff reports usually reviewed wage policies comprehensively.


In the initial IMF-supported programs in Central Europe in 1990–91, the exceptional challenges of stabilization and transition, the unusually large shocks, and the high degree of uncertainty about the capacity of existing and emerging institutions to prevent wage-price spirals argued for using wage controls despite the rigidities they imposed. Wage controls were potentially an important tool in the stabilization of prices and in addressing the distinctive problems of state enterprises during the transition.

The wage controls, which were tax-based, were restricted to the state sector, and had firm-level ceilings on the average wage or the wage bill, were designed to limit their distortive effects and permit needed flexibility in wage-setting behavior. With respect to the nominal anchor role of wage controls, the greater the degree to which wage norms were set exogenously with adjustments only in extreme circumstances, the more likely was wage and credit restraint. When wage restraint occupies a particularly important role in the stabilization process (as in Poland and Yugoslavia), there is a case to put a performance criterion on wage policy. However, reflecting the principle of putting performance criteria on instruments and not objectives, if deviations from wage norms are explicitly permitted under the wage policy, then it might be preferable to put the performance criterion on the wage norm, and to set indicative targets for the growth of actual wages.

In practice, the extent of wage restraint across countries and across time was remarkable. While the short time that has elapsed since transition began in Central Europe does not permit a rigorous testing of the role of wage controls in this restraint, a review of the experience gives rise to three main observations. First, the available evidence indicates that wage ceilings were not binding during the initial period when most prices were liberalized. Second, the patterns of credit and wage growth tend to suggest that more often than not the stance of financial policies, and the extension of credit in particular, led wage increases. Had wage developments led increases in credit, this would have tended to confirm the presumption that wage controls substantially influenced credit growth. Third, following the removal or temporary suspension of wage controls in a few countries, wages typically failed to spurt upward. All this is not to say that wage controls had no restraining effect—particularly through their role in helping to focus wage settlements and to reduce inflationary expectations—or that they conferred no benefits. Rather, the evidence in the countries under review points to the limits of these benefits.

While there is no doubt that the state sectors in transition economies faced and continue to face distinctive problems—including soft budget constraints, an exceptionally weak relationship between ownership and management, and bloated employment—the degree to which wage controls could and did address these problems is less clear. In any economy, the ultimate strength of the budget constraints facing firms is a function of policy choices made by the fiscal and monetary authorities. To the extent that the fiscal and monetary authorities do not enforce hard budget constraints (and enterprises have easy access to credit), the penalty of an excess wage tax is softened. Did wage controls help enterprise managers to resist pressures for increases in the labor share? The fact that real wages declined in every country regardless of the degree of nominal wage restraint, and that wages in U.S. dollar terms in 1992 appeared to be quite competitive by international standards, point to moderate labor influence in these economies. Consistent with this macroeconomic evidence are the survey data from Poland, which suggest that wage-setting behavior may not be as dissimilar as often thought from that in market economies. Altogether, while experiences may differ from country to country, in general the record does not provide strong evidence that wage controls made a significant contribution to either improving corporate governance or encouraging labor shedding in the state sector.

While wage controls can help to secure macroeconomic stabilization, they impede the structural adjustment of the economy by perpetuating wage distortions and wage indexation. An insufficiently differentiated wage structure not only causes the misallocation of existing resources, but also distorts the incentives that guide physical and human capital investment. Any movement toward de facto wage indexation makes subsequent attempts to reduce inflation or adjust real wages more difficult. However, like the benefits of wage controls, the costs of wage controls are difficult to measure, and may become important only over time. Data on the structure of wages are weak, and in the short time since reform started it is not clear how much progress in improving the wage structure could have been made.

These considerations suggest that it should not be taken for granted that wage controls in transition economies play a role in restraining nominal wage growth and addressing corporate governance problems, particularly after the initial stabilization phase of adjustment. While tripartite consultations on wages may be desirable, they do not necessarily require the vehicle of wage controls. Even when there is a strong conviction that wage controls are needed, they should not be viewed as anything more than a small part of much broader efforts to control inflation and improve corporate governance. Against these possible benefits are the well-known distortionary effects of wage controls, which have militated against their prolonged use in other countries. Thus, in deciding whether to maintain wage controls after the initial stabilization, it is important to weigh expected benefits against the risks of perpetuating distortions.

Appendix 5-1: Setting of Wage Norms

In Bulgaria, in the first half of 1991, wages were still centrally determined. From mid-1991 to April 1993, the ceilings for the wage bills were set on the basis of projected inflation, and compensation for actual inflation was allowed only if actual inflation exceeded projected inflation by at least 10 percentage points. This threshold was breached in the first half of 1992, and the wage ceilings were adjusted. In April 1993, the wage ceilings were fully indexed to past inflation, but in early 1994 the authorities committed to reintroducing indexation based on projected inflation.

In Czechoslovakia, the system for setting wage norms changed several times during 1991 and 1992. For January and February 1991, the wage norm was set in advance on the basis of projected inflation. In March, an adjustment for past inflation was allowed, since actual inflation had exceeded projected inflation during the first two months of the year. The wage ceilings were adjusted so as to ensure that real wages remained at least 12 percent below their end-1990 level. For the remainder of the year, the wage ceilings were effectively fully indexed to inflation. For 1991 as a whole, actual wage increases were well below the levels permitted—in fact, only 13 firms in the entire economy were liable for the excess wage tax. In the first five months of 1992, the formulation of wage regulation was held up by a political deadlock. For the final seven months, wage ceilings were set on the basis of projected inflation. In November, the wage ceilings were adjusted upwards for all firms, and Slovak firms that were current on their tax payments were exempted from wage controls.

In Hungary, the wage ceilings were backward-looking in 1990 and forward-looking in 1991. In 1990, wages were allowed to increase in line with enterprise value-added. In 1991, the wage ceilings were set for the year as a whole on the basis of projected inflation and were not subsequently adjusted to reflect past inflation.

Poland adopted explicit backward-looking partial indexation of the wage norms. The indexation coefficient was between 0.2 and 1.0 in 1990 and 0.6 in 1991 and 1992. At the outset of the program, the low indexation coefficient, which averaged about 0.25 for January–April 1990, meant that wage controls were not too different from a forward-looking scheme. In 1991 and 1992, the indexation coefficient of 0.6 was chosen to reflect the expected deceleration of prices. On the face of it, the indexation coefficient of 0.6 implied that the real wage ceilings would fall sharply as long as inflation persisted. In practice, exemptions, adjustments, and ad hoc modifications to the wage ceilings after mid-1990 caused the wage norm to be effectively fully indexed. For example, at the beginning of 1991 and 1992 part of the previous year’s violation of the wage ceiling was forgiven.

In Romania, wage norms were effectively partially indexed to inflation through the periodic adjustments of the wage norms. Although wage controls in principle included some forward-looking elements, the system is sufficiently complicated that it is impossible to disentangle these elements. In practice, despite the authorities’ repeated commitments to implement a forward-looking wage indexation scheme, wage norms were frequently adjusted to take account of past inflation. Typically, this took the form of lump-sum adjustments for all workers.

Appendix 5-2: Definitions of Variables

Nominal Wage

Bulgaria: Net average monthly earnings in the slate sector.

Czechoslovakia: For 1988–90, gross average monthly earnings in the state and cooperative sector, excluding unified agricultural cooperatives (JZDs), For 1990–93, weighted average of the gross average monthly earnings in industry (in firms with more than 25 employees) in the Czech and Slovak Republics.

Hungary: Gross labor income per employee.

Poland: Net average monthly wages in the six main sectors of the socialized sector, excluding premia from profits.

Romania: Average monthly wages, net of taxes and social security contributions, excluding private sector.

Gross Dollar Wage

Bulgaria: Gross earnings calculated by assuming an average tax rate of 54 percent.

Czechoslovakia: Gross average monthly earnings in the state and cooperative sector, excluding JZDs.

Hungary: Gross average monthly earnings (these data are unavailable prior to 1992).

Poland: Gross average monthly wages (these data are unavailable prior to 1992).

Romania: Gross average monthly wage (these data are unavailable prior to 1992).

Consumer Price Index

Bulgaria: Retail price index.

Czechoslovakia: Consumer price index.

Hungary: Consumer price index.

Poland: Retail price index.

Romania: Retail price index.

Real Consumption Wage

Average nominal wage deflated by the average consumer price index.


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This review will focus on the real consumption wage, that is, the nominal wage deflated by the consumer price index.

Though wage controls were not intended to address the distinctive circumstances of a transition economy in the 1990 standby arrangement with the former Yugoslavia, the subsequent arrangements with successor states have included wage controls for this purpose.

However, an emerging concern is that newly privatized firms may not behave so differently from state-owned enterprises, depending on the effectiveness of outsider control.

Although the exemption of bonuses might appear to be a good idea because it would encourage the reporting of profits, it also provides another avenue to circumvent the controls. This avenue will be taken if the effective marginal rate of taxation of wage payments is less if they are paid out in bonuses rather than base wages. In Poland, bonuses were subject to a progressive tax schedule if they exceeded a specified norm.

The effect of the control variable on wages for their role as nominal anchor is discussed in Box 5-2.

This depiction of real wages is based on measures of wages deflated by consumer prices. Deflating by producer prices, which rose less than consumer prices, results in far smaller declines, and in some cases, increases in measures of real wages.

In Poland, wage controls were abolished as of April 1, 1994. In the Slovak Republic, wage controls were reintroduced in January 1994, but their enforcement was suspended in February 1994.

Evidence on the behavior of wages relative to wage norms is not more broadly available because the complexity of wage controls generally precludes the calculation of economy-wide wage-norms. In any event, comparing wages to wage norms might be less revealing than one might expect, because wage ceilings could appear binding when wages would have grown slowly anyway, and breached ceilings might still have had a dampening effect. Wage targets differed from hypothetical wage norms to the extent that wage norms were adjusted with the path of actual inflation.

This table is presented in order to provide a sense of orders of magnitude rather than a precise picture. The wages reported for different countries do not necessarily measure exactly the same concept of labor earnings, and even if they did. differences in employer-paid social insurance contributions would affect labor costs. Further, there are well-known problems with cross-country comparisons of GNP per capita.

A World Bank study of the behavior of firms in Russia also found no evidence of decapitalization through greater borrowing or predatory wage settlements. See Commander and others (1993a).

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