Back Matter

Back Matter

Author(s):
Philippe Egoume Bossogo, Jerald Schiff, Miho Ihara, Tetsuya Konuki, and Kornelia Krajnyak
Published Date:
July 2006
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    Appendix I: Data Sources and Issues

    This appendix briefly describes the data sources of selected variables used in this study.

    Labor Force Data

    Main sources: European Union, New Cronos database http://europa.eu.int/newcronos; International Labor Organization (ILO), Laborstawww.laborsta.org; National authorities’ statistical offices, statistical yearbooks, and websites; and World Bank, World Development Indicators.

    Basic employment data mainly come from national authorities’ labor force survey (LFS) data, unless otherwise indicated. As noted at the bottom of each LFS results tables, some countries’ data are end-of-period data, while others are annual average. Although this may make the data set less consistent when making cross-country comparison, such difference is assumed to be small enough to permit reasonable analysis. More important, one should note that the countries of study in this paper did not start conducting the LFS until the early to late 1990s, and the data for the period prior to that come from various sources. We are aware that splicing data from different sources are not deemed to be completely consistent, and our use of such data is limited to grasping the overall trends.

    Years in which countries of the study began conducting LFS: Bulgaria, 1993; Croatia, 1996; Czech Republic, 1993; Estonia, 1993; Hungary, 1992; Latvia, 1996; Lithuania, 1994; Poland, 1992; Slovak Republic, 1994; and Slovenia, 1993.

    The variables that require particular attention because of their different data source (other than the LFS) and/or their definitions are presented below.

    Working-Age Population

    From LFS. Defined as 15 years old and above. However, some countries did not adopt this widely accepted definition when they began conducting LFS, making the time series inconsistent over the period (refer to the footnotes under each table for details).

    Employment

    From LFS. For the period prior to the beginning of LFS, data from the IMF’s World Economic Outlook are used.

    Unemployment

    From LFS. For the period prior to the beginning of LFS, data from the IMF’s World Economic Outlook are used. The series labeled “Registered” come from each authority’s labor office.

    Youth Employment/Unemployment

    From LFS. Defined as 15–24 years old. The series labeled “Registered” come from each authority’s labor office.

    Long-Term Unemployment

    From LFS. “Long-term” is defined as 12—13 months and over. The definition slightly differs depending on the country (refer to the footnotes under each table).

    Unemployment by Education Attainment

    From LFS. The classification of education levels are based on each authority’s definition, and these definitions may not be completely comparable across countries.

    Unemployment Rates (including youth and long-term-both LFS and registered)

    All are calculated using the working-age population presented in the country-by-country tables and the LFS tables as the denominator, and they may not be exactly the same as the “official” rates that may be found in each country’s official sources.

    Private Sector Employment

    Although LFS data are used whenever possible, almost half of what is presented in the summary tables is taken from other sources, including Statistical Appendixes of IMF Country Reports, and authority’s employment registration (refer to the footnote under each table).

    Employment by Industry

    LFS data (taken from ILO’s database, Laborsta) are used whenever available, and they are spliced with the data from the World Bank’s World Development Indicators.

    Regional Employment/Unemployment

    Provided by national authorities or taken from the EU’s New Cronos database.

    Wage Data

    Main sources: National authorities’ statistical offices, statistical yearbooks, and websites; and ILO, Laborstawww.laborsta.org.

    Economy-Wide Monthly Wages

    From the ILO Laborsta database. Original data in local currency units have been adjusted as necessary for cross-country comparison.

    Private and Public Sector Monthly Wages

    Provided by national authorities or taken from national statistical yearbooks or from national authorities’ websites whenever available. Thus, the data may not be completely consistent with economy-wide wages that come from the ILO database, Laborsta.

    Minimum Wage

    Taken from various sources including: authorities- statistical yearbook, statistical offices’ websites, ILO, and IMF staff estimates.

    Labor Market Policies and Institutions

    Main sources: Social Security Worldwide www.issa.int; U.S. Social Security Administration, Social Security throughout the World, www.ssa.gov/international/ and various printed editions; and Vienna Institute for International Economic Studies, www.wiiw.ac.at.

    Duration of Unemployment Benefits; Family Benefits; Early Retirement Age

    Constructed based on the information provided on Social Security Worldwide website and in Social Security throughout the World by the U.S. Social Security Administration. Because the social security information is not published every year, we assumed the policy of the previous year was carried on for the years for which we did not have information, and this assumption may not always be correct for those countries that have gone through rapid change in transition. In addition, such information is descriptive with a wide range of variation in detail across countries, and although we tried to construct the time series in as consistent a manner as possible using the same definition- they may not always be consistent for cross country comparison.

    Tax Rates

    Estimated by using average marginal income tax rate and payroll tax rate listed in Price water house – Coopers, Individual Taxes in each year of the sample period.

    Unemployment Benefits

    Based on the information listed in Social Security throughout the World, the data taken from the Vienna Institute for International Economic Studies database, and data provided by the authorities. The replacement ratio is the ratio of stipulated unemployment benefits to previous earnings during the first six months of the unemployment period. Duration is the one applied to a worker with 20 years of social security contributions.

    Government Spending on Social Security and Welfare

    From IMF, Government Finance Statistics

    Employment Protection Legislation (EPL) Index

    From OECD, Employment Outlook 1999; and World Bank estimates (2002).

    Transition Indicators

    European Bank for Reconstruction and Development, EBRD Transition Report, various editions.

    Appendix II: Country Case Studies

    The sections of this appendix present information on labor markets and conditions in Bulgaria, Croatia, Hungary, Poland, and the Slovak Republic.

    Bulgaria1

    Closer economic links with the former Soviet Union and delays (until 1997) in implementing serious reforms led to a sharper output contraction in Bulgaria than in many other Central and East European (CEE) countries, resulting in one of the largest employment losses and steepest real wage declines of all CEE countries. Participation and employment rates also declined considerably. Despite the strong rebound in economic growth in the aftermath of the 1996–97 banking crisis, high unemployment remains a scourge. Bulgaria significantly reformed its labor laws and regulations to make them consistent with a market economy, while complying with EU directives. At the same time, the country has been expanding active labor market policies to help, in particular, long-term unemployed in the transition back to jobs. The persistence of high unemployment, however, leads one to wonder whether labor market institutions and policies have been an obstacle to unemployment decline, although there has been a marked shift in that direction recently.

    Labor Market Performance

    The end of central planning resulted in the collapse of participation and employment and in a sharp increase in the unemployment rate and its persistence. Economic restructuring and privatization significantly increased redundancy, leading many workers to retire from active participation. The latter declined significantly, mostly among older, less educated, females, and workers in remote regions. During 1993–98, an estimated 40 percent of the unemployed withdrew from the labor force citing “discouragement” from low job prospects, feeding the decline in participation rates. After the initial drop (a third by 1993), employment continued to decline well into the early 2000s, while unemployment went the opposite way, peaking at 22 percent in 2001 after a slight decline prior to the 1995/96 banking crisis, despite continued declines in participation. The acceleration of structural reforms—including enterprise restructuring and privatization—beginning in 1997 brought a new round of labor shedding. As entire industries became obsolete, regions that relied often on one or a few large enterprises registered higher unemployment rates. In contrast, the capital city area was able to soften the impact because it was more diversified and benefited first from the switch toward services. The period since 1989 has also seen a significant emigration, totaling around 9 percent of the 1989 population. Most migrants were aged between 30 and 40, with a secondary education level.

    Productivity gains, skill mismatch, and a shallow housing market are leading causes of long-term unemployment and regional disparities in unemployment. Economic restructuring and the privatization of public enterprises have led not only to higher unemployment, but also to significant gains in productivity—which shot up by 19 percent during 1998–2000. The associated labor supply shock has not yet been fully met by demand, leading to long-term unemployment. In addition, because of the shift away from heavy industries to lighter manufacturing and services, a significant skill mismatch affecting a large segment of the active labor force has developed. The World Bank found that some jobs go unfilled because of the lack of adequately skilled job seekers, while at the same time there are not enough low-skilled jobs created at the prevailing minimum wage to absorb the available low-skilled individuals among the unemployed. This phenomenon seems more pronounced in Bulgaria than in other CEE countries. A disproportionately high number of blue collars workers in regions compared with the capital city area have contributed to persistent large regional disparities in unemployment, since the unemployed find it unappealing to move to a different region where their skills are not in demand. In addition, the high rate of house ownership and the associated shallow housing market may have contributed to the disparities, because individuals are reluctant to migrate, thereby trading a significant part of their net worth for an uncertain future.

    Small and medium-sized enterprises have failed to create as many jobs in Bulgaria as in other transition economies, pointing to potential institutional problems. The shift of activity from heavy industry to light manufacturing and services has meant more small and medium-sized enterprises. But, contrary to a number of other transition economies (for example, Hungary), small and medium-sized enterprises in Bulgaria create far fewer jobs and employ a lower proportion of total workers (only 41 percent). More generally, jobs created in small enterprises (most of which are new) continue to fall short of jobs eliminated in large enterprises. Legal barriers to firm entry do not seem to be the main problem, since Bulgaria does not compare poorly with other CEE countries according to the “Doing business indicators” compiled by the World Bank and based on relevant regulations. However, there is some evidence that implementation of regulations may be a problem. For example, the time required to enforce a contract is high in Bulgaria among CEE countries (see Table 3.3). Business surveys also indicate that Bulgaria scores poorly in administrative burdens for business startups.

    The informal sector is believed to employ many registered unemployed, and recent government measures may have flushed out some of these jobs. The unusually large number of discouraged job seekers suggests that workers take jobs in the informal sector while still receiving social benefits. New regulations introduced in 2003 cut social benefits for those recipients who are not willing to take low-paid jobs offered under government programs. The authorities reckoned that this measure, combined with the newly introduced minimum insurable income, has flushed into the formal sector as many as about 300,000 jobs, contributing to the rapid decline in the unemployment rate.

    Labor Costs

    After declining during the better part of the 1990s, real wages have been increasing moderately, but more slowly than productivity. Real wages dropped at the start of the transition and remained depressed for many years subsequently. Despite some recovery owing to the strong economic growth since 2000, they are still trailing the level in 1989. Productivity, on the other hand, has been recovering faster, contributing to the competitiveness of the economy. Estimating the equilibrium dollar wage (as a function of productivity indicators) in Bulgaria and comparing it with the actual dollar wage, Krajnyák and Zettelmeyer (1998) found that the former was well above the latter, suggesting that the Bulgarian economy remained competitive. The minimum wage was raised steadily to recoup the real erosion that took place over the years. It now represents 38 percent of the average wage, a level that is not terribly high (in France the level is 50 percent) but may limit job opportunities for the less skilled and experienced workers, notably in the country’s depressed regions.

    Other labor costs remain relatively high, in part because of widespread tax evasion. Garibaldi, Dimitrov, and Stoyanova (2000) report a 1996 study that found that a large number of employers and workers evaded payment of social security contributions. To avoid an erosion of collected revenue, the authorities steadily raised contribution rates, possibly leading to a further rise in the informal sector. At up to 50 percent of gross labor income, labor taxes are much higher than in many Western European countries and represent a serious hiring deterrent. The high dependency ratio (ratio of pensioners to contributors, which reached 80 percent in 1998) is a reflection of the large evasion. The new minimum insurable income thresholds were also designed to boost collection of social security contributions by increasing the base (that is, registered work contracts), and while there was some success in the first half of 2003, it is still too early to assess the full impact of this measure.

    Wage Setting Process

    Collective bargaining, although mostly centralized, has not led to high wage pressures. Industrial relations in Bulgaria are based on the tripartite system of negotiation involving the government, labor unions, and employers’ representatives. This system is rooted in the country’s constitution. Negotiations take place at four levels (national, branch, regional, and enterprise) depending on the encompassing nature of the issue. The national minimum wage and wage setting mechanisms, for instance, would be decided at the national level, whereas branches can decide to set their own minimum wage higher than the national level. While wages in the central government are completely centralized, decentralized collective bargaining is more prevalent in the nonbudget state-owned entities and in the private sector. But compared with other countries, centralized collective bargaining is more resorted to and less confrontational in Bulgaria. The ILO in 1998 found that only 70 percent of surveyed units had collective agreements at the local level compared with all units in other CEE countries in the survey, and a higher proportion of labor unionists found the atmosphere of the negotiations “good” compared with their counterparts in other countries. This relative collegiality, coupled with the high level of unemployment, has led to lower union pressure to award high wage increases.

    Labor unions in Bulgaria appear relatively strong, but not confrontational. The two main labor unions in Bulgaria are the Confederation of Independent Trade Unions (KNSB) and the Confederation of Labor (“Podkrepa”), both founded at the start of the transition and with total membership in excess of 1.5 million workers. Through numerous branches they cover virtually all the economic sectors. In a 1998 survey, the ILO found that the percentage of union members in 60 percent of the units surveyed was between 70 and 100 percent, compared with only 20 percent in Hungary and 5 percent in Poland. They found relations between labor unions and employers’ organizations to be characterized by “cooperation and partnership” as opposed to “partnership and opposition” in other countries (as reported in Garibaldi, Dimitrov, and Stoyanova, 1998).

    Labor Market Institutions and Policies

    A succession of amendments have modernized the Labor Code (initially promulgated in 1986) and increased labor market flexibility, but restrictions remain that may constrain employment performance. Employment protection legislation in particular may be a deterrent to job creation. For instance, separations are often referred to courts, where the burden of proof for a range of causes for dismissal (for example, inadequate skills, poor performance, and violation of discipline) falls squarely on the employer. Dismissal related to technological advances or reorganization is prohibited, which may discourage firing during a downturn and hiring during an upturn. The use of overtime work is strictly limited to 150 hours a year (the limit is twice as large as that in Hungary) and must be paid with a premium of at least 50 percent of the base wage. Fixed-term employment contracts are allowed only for work that is temporary or seasonal in nature and can be renewed only once. Also, wage adjustments are restricted: employers must pay 100 percent of wages during work stoppage regardless of whether the stoppage is due to low demand.

    Passive labor market policies compare well with other countries and do not appear high enough to deter job search. To be eligible for unemployment benefits in Bulgaria, one has to be registered in a labor office, have a minimum employment spell of 9 months during the past 15 months, and be willing to accept a job or training if offered. Recipients are paid 60 percent of their last gross salary, capped at 140 percent of the minimum wage, and the entitlement period varies between 4 and 12 months. Because of the growth of long-term unemployment, unemployment benefits have fallen over the past decade. Social assistance, on the other hand, is available to all families on the basis of aggregate family income and the number of children in the household, thus providing a safety net to the unemployed whose eligibility for unemployment benefits has lapsed. Both the replacement rate and the coverage rate in Bulgaria are lower than in many other CEE countries.

    To reduce unemployment the Bulgarian authorities are focusing on active labor market policies (ALMPs). These include temporary employment programs-training with nonguaranteed jobs, training with guaranteed jobs, subsidized employment, employment associations, and self-employment support programs. Although the government continues to spend more on passive labor market policies to support the unemployed, the share of ALMPs in total labor market policy expenditure of the government has increased steadily since 1996, with a significant jump in 2003. During that year, the government set up a program of 100,000 public, low-killed jobs in municipalities for long-term unemployed, who were given the alternative choice to forgo this opportunity and lose social assistance. Although some training goes along with these jobs, the government envisaged to renew them in 2004 and subsequent years, which could create another large public program. Indeed, ALMPs are no panacea and sometime provide only temporary and limited relief to the unemployed. In addition, ALMPs can generate deadweight losses and substitution effects, which negate the policies’ intended goals. Consequently, these policies should be part of a package of labor policies including measures to further increase labor market flexibility, notably the firms’ ability to determine the size of their labor force and wages. But, the government prefers to let social partners negotiate among themselves further measures to increase labor market flexibility instead of imposing them.

    Croatia2

    Like many other CEE countries, Croatia experienced a sharp output contraction and dramatic structural changes in the initial stage of transition. These factors had profound effects on the labor market in the early 1990s. Although real output growth rebounded strongly after the negative impact of initial transition and the war for independence started phasing out in the mid–1990s, the unemployment rate has remained stubbornly high, and the participation rate has been low.

    Labor Market Performance

    The labor market in Croatia has not performed well. In the early 1990s, economic restructuring and privatization significantly increased redundancies. The war during 1991–95 worsened the situation. While labor shedding by many firms led to improved productivity, it also contributed to massive inflows to unemployment. Although economic growth has remained brisk since the mid–1990s, outflows from unemployment, including outflows to jobs, have not accelerated, and fell short of inflows until 2000. The LFS-based unemployment rate has been hovering around 15 percent for the past five years. A majority of the unemployed (55 percent) are jobless for over one year.3 The labor force participation rate has remained about 50 percent. In particular, unemployment is high, and participation low-among youth. The overall low participation may reflect poor availability of job opportunities and skill mismatch problems.

    Firm-level data reveal that the job reallocation in Croatia is sluggish. Croatian firms yearly close about 5 percent of all jobs, compared with a job destruction rate of 10–11 percent in other CEE countries.4 At the same time, the job creation rate in Croatia is only 3.5 percent, compared with 7–11 percent in other CEE countries. These figures point to the stagnant nature of the Croatian labor market and indicate that, unlike some leading reformers in CEE countries, the Croatian economy has not undergone an intensive enterprise restructuring. In addition, regional analysis has proved that the job creation and destruction rates are modest at most across Croatia, although the unemployment rate varies significantly among regions.5 Regional differences in the unemployment rate are more likely to be of a historic nature rather than the result of recent developments in enterprise restructuring.

    start-ups of small and medium-sized businesses have not created as many jobs in Croatia as in other CEE countries. As in many other CEE countries, small private firms have played a role as an engine of job creation in Croatia. The share of employment by the old sector, consisting of large state-owned enterprises, in total employment has been declining while the share of employment by the new sector, consisting of small private firms, has been expanding. However, these changes have been modest compared with other leading reformers such as the Czech Republic and Hungary-since the rate of new business start-ups has been insufficient to offset the employment reductions by existing firms.6 Between 1997 and 2002, the total number of small and medium-sized enterprises, a proxy for the new sector, has declined by about 20 percent, while their employment has remained stagnant. The share of employment by small and medium-sized enterprises is 46 percent. This lags behind main CEE countries, where the share of employment by small and medium-sized enterprises is well over 50 percent.

    Strict employment protection, which is discussed below, is likely to have discouraged entry or expansion of new businesses in Croatia. According to the World Economic Forum’s “Quality of the National Business Environment,” which ranks almost 100 countries mostly on the basis of survey scores of various factors that affect the business environment, Croatia ranks significantly behind main CEE countries such as the Czech Republic, Hungary, and Poland. Among various factors, Croatia ranks worst in “cooperation in labor employer relations,” which could be explained by the strict employment protection.

    Labor Costs

    Labor costs could partly explain stagnant job creation in Croatia. Gross wage comparison in manufacturing sector among CEE countries by the World Bank (2003) shows that gross wages in Croatia are higher than those in most of other CEE countries. It also indicates that relatively high wages in Croatia could not be justified by proportionately higher labor productivity. Economy-wide gross wage comparisons also support the findings of the World Bank. However, economy-wide unit labor cost dynamics for the past five years indicate that Croatia has contained the labor cost increases more successfully compared with other CEE countries, partly reflecting the government’s efforts to restrain public sector wage level in recent years. The tax wedge on labor income slightly exceeds 50 percent. Although it is higher than most of the EU–15 and non-EU OECD countries, it is moderate among CEE countries (see Figure 2.10). Labor income tax and social security contributions do not seem to have had unfavorable effects on the country’s competitiveness among CEE countries.

    Wage Setting Process

    The wage determination process is centralized in Croatia. About 40 percent of the private sector employees are union members, while most of the public sector workers are union members. Trade unions in the private sector play a dominant role in wage setting because the industry-level bargaining prevails, especially in large firms. Public sector workers’ unions also negotiate collective agreements with the government. Although there is no statutory minimum wage in Croatia, the minimum base for social security contribution- which at present accounts for about 35 percent of the average gross wage, plays the role of the wage floor. This notional minimum wage is as a rule used in collective agreements as the floor for the wage structure, although in some industries, where trade unions’ bargaining position is stronger, this floor is set at a somewhat higher level. Although unions in Croatia generally favor cooperation over confrontation and conflict, they occasionally resort to strikes to force employers or the government to give in. Wage pressure exerted by unions apparently led to some excessive increases in labor costs in Croatia in earlier stage of transition.

    Labor Market Institutions and Policies

    The unemployment benefit system in Croatia is not particularly generous. The unemployment benefit in Croatia is a flat rate benefit in practice, since the fixed maximum amount of the benefit is only about one fourth of the average wage. Relatively few unemployed receive the unemployment benefit. The duration of the unemployment benefit payment is capped at 312 days, which is not out of line with other CEE countries. The benefit coverage rate has been below 20 percent since the mid–1990s, reflecting two factors: (i) the unemployment rate is highest among new entrants to the labor market, who do not qualify for the unemployment benefit; and (ii) a large proportion of unemployed are long-term unemployed who are no longer eligible for the benefit. All these characteristics—low replacement rate, moderate duration of the benefit payment, and limited coverage—indicate that labor supply disincentives related to the unemployment benefit system are likely to be modest in Croatia. In particular, low benefit coverage means that labor supply disincentives are not significant because few people are affected by them.

    However, employment protection in Croatia is among the strictest in CEE countries. According to the estimated value of the EPL (employment protection legislation index), employment protection in Croatia is stricter than that in most of the EU–15 and other CEE countries (see Table 2.12).7 Until the amended labor law took effect in January 2004, individual dismissals were costly because of the long advanced notice period and high severance pay. Collective dismissals were even more difficult, mostly because of the overly inclusive definition of collective redundancy. Although fixed-term employment is a way of circumventing high costs of terminating regular employment contracts, the labor law until recently restricted its use by requiring that fixed-term contracts be signed only on exceptional basis. World Bank (2003) concludes that stringent employment protection has contributed to the stagnant labor market performance in Croatia, such as low job creation and hiring, long duration of unemployment spells, and the concentration of unemployment among disadvantaged worker groups. It also points out that the country’s strict employment protection also provides an incentive for firms to move to or remain in the informal sector in order to lower labor costs.8

    With a view to making the labor market more flexible, the labor law was amended in July 2003. The amended labor law, which fully entered into effect at the beginning of 2004, has lowered Croatia’s EPL index by 23 percent. The main changes include: (i) relaxing restrictions on the use of fixed-term contracts; (ii) easing the preconditions for valid dismissals; (iii) shortening the advanced notice period from six to three months; (iv) reducing the amount of severance pay from half to one-third of the monthly pay; and (v) relaxing the definition of mass layoffs.

    The chronic unemployment problem prompted the government to initiate a number of active labor market measures in early 2002, including self-employment promotion, subsidies and loans to small and medium-sized enterprises, and public works.9 Some of the measures are focused on promoting hiring of young and highly educated people by subsidizing at least 60 percent of their gross wages for the first year. Also, an employer of workers with university education receives a one-off subsidy of €1,000 if the employment extends beyond one year and becomes permanent. Although it is too early to evaluate the effects of these active labor market measures, local economists cast some doubts whether they are well targeted (Institute of Economics, 2002). In particular, young people coming out of universities tended to manage to find jobs before the introduction of the new measures. Consequently, they can have only a minor impact on boosting employment.

    Hungary10

    Hungary’s successful transition, backed by significant structural reforms and supported by a competitive export sector, especially in the 1990s, has contributed to relatively low unemployment. But the labor market in Hungary is not without its weaknesses, especially a low participation rate and high regional inequality. This note briefly reviews labor market performance and policies in recent years.

    Labor Market Performance

    Strong economic activity in recent years has contributed to low and declining unemployment, which reached its lowest level, 5.5 percent, in December 2003. The decline in unemployment has been generally accompanied by rising economy-wide employment, and, although quite low, rising participation rates. However, the labor market has been characterized by important weaknesses.

    • The participation rate is the lowest in the EU-15 area. This reflects a number of factors. First, weaknesses in labor demand, particularly for low–paid jobs. Second, although the transfer system is not generous with respect to benefit levels, it is generous in its coverage. For more than 25 percent of the working-age population (15 to 64 years), transfers (social or labor market related) are the main source of registered income. Total social security outlays paid by the government are higher than in other CEE countries, reflecting these high take-up rates. Third, for older age groups, the low participation rate reflects the combination of a low statutory retirement age—the statutory retirement age has been steadily increased and is now at 62 for men and 59 for women, which is low relative to other OECD countries—and sizable early retirement schemes. Fourth, the take-up of disability benefits in Hungary is very large in international comparison (about 9 percent of the 20–64 age group are on disability benefit).11

    • Regional inequalities are high. Low-employment areas register more than half the employment rates of high-employment areas (Table A2.1). This is partly due to the regional variations in the purchasing power of benefits. While benefit levels are low on average (see discussion below), their purchasing power varies widely across regions: the costs of living are much lower in the less-developed northern and eastern parts of the country than in the prosperous central and western regions. This, in particular, reduces incentives to move from the poorer regions to those where job search has more chances of success.

    Table A2.1.Regional Inequalities in Hungary-2003:Q3(In percent)
    RegionsParticipation Rate1Unemployment Rate
    Central Hungary57.84.1
    Northern Hungary58.44.7
    Northern Great Plain58.24.4
    Southern Great Plain51.97.9
    Central Transdanubia50.09.4
    Western Transdanubia49.76.2
    Southern Transdanubia50.46.3
    Country total54.15.7

    Population aged 15–74.

    At times, foreign-owned firms have had a significant role in the creation of new jobs. According to Kaminski and Riboud (2000), foreign-owned firms were responsible for the creation of 75 percent of all new jobs during 1992–97 in Hungary. At that time, new entry by foreign companies helped to absorb workers from public enterprises, and foreign companies helped to contain unemployment in the relatively early stage of transition.

    Labor Costs

    Wages have increased rapidly since 2000, reflecting large increases in minimum wages, strong aggregate demand, possible lagged inflation expectations, and demonstration effects from increases in public sector pay. Most public sector employees received a 50 percent increase in wages in the fall of 2002. Together with increases in the minimum wage of over 90 percent during 2001–02, these increases spilled over into the private sector. This contributed to private sector wage inflation significantly above productivity (Figure A2.1), and a surge in real wages on an economy-wide basis by some 14 percent in 2002 and 10 percent in 2003 (Figure A2.2).

    Figure A2.1.Productivity, Wages, and Unit Labor Costs in the Private Sector

    (Annualized quarter-on-quarter growth rates, in percent)

    Also significant has been the increase in the number of workers subject to a minimum wage. Until 2000, the minimum wage had been decreasing in real terms and so had its incidence. The hikes in statutory minimum wages reversed this trend. While about 7 percent of business employment was on the minimum wage in 2000, this share had risen to 18 percent in 2002, with a similar proportion earning wages no more than 10 percent above the minimum statutory level. The direct increase in labor costs from the minimum wage hike hit small domestically owned firms particularly hard because these employ the large majority of low-paid workers.

    Figure A2.2.Real Wages

    (Year-on-year growth, in percent)

    Empirical evidence on the effect of the minimum wage increases on labor demand and supply is scarce. Kertesi and Köllő (2003) estimate wage elasticity of demand for various categories of labor and find that unskilled workers have the highest elasticity, in the 1 to 1½ range. Applying this to data on the wage distribution suggests that the demand for unskilled labor might have declined by some 6 percent as a result of the increase in minimum wages. The impact is likely to be quite uneven across industries, and probably higher in the textile industry, assembly line productions, and low-paid services activities such as tourism. Also, obtaining a clear picture of the impact of the minimum wage is not without difficulties: some analysts argue that the minimum wage increases may have prompted some employers (particularly small and medium-sized enterprises) to under report hours worked or to shift jobs to the gray economy, thus distorting estimates of that impact on the formal economy.

    Despite a decrease in social security contribution rates since the early years of transition, total taxes and contributions on labor remain among the highest in the OECD, and particularly high given the level of economic development. While this does not necessarily discourage labor demand per se, the difficulty in controlling the informal economy and preventing tax evasion results in excess burden on those who do not evade. In turn, this contributes to weaker official labor demand and supply, providing a strong incentive not to declare employment both to the tax authorities and in surveys recording labor market activity.

    A key element of the tax wedge, weakening incentives to employ low-skilled and part-time workers, is the employers’ lump-sum contribution to health care funds. In 2003, this fixed contribution represented 7 percent of the employer’s contribution at the average wage but 17 percent at the minimum wage. This not only makes for relatively high nonwage costs on low-paid workers but also dissuades the development of part-time employment. Part-time work is indeed very little developed in Hungary, representing slightly less than 7 percent of total registered employment in 2003, against 15 percent in the OECD. The government had plans for a gradual phasing out of the fixed health contribution by 2006, partly in order to harmonize with EU rules on part-time work but also reflecting concerns about its impact on the labor market. However, after a reduction by almost 25 percent in 2003, the phase-out was to be slowed down in 2004 for fiscal reasons, and the 2004 act on taxation abolishes the contribution only for part-time workers on parental leave and for long-term unemployed over 50 coming back to work. Under the agreement reached in October 2003 in the National Reconciliation Council, the fixed health contribution was to be reduced across the board to HUF 2,250 in 2005 and to be eliminated completely in 2006.

    Wage Setting Process

    Hungary has a national collective bargaining system whereby, each year, discussions aimed at agreement on wage guidelines are held by the Interest Reconciliation Council (IRC). The IRC includes representatives of trade unions, employers, and the government. Agreement is not binding, but it is viewed as the floor for sectoral or firm-level negotiations. Although the IRC agreement is generally applied in the public sector, actual wage increases in the private sector have generally exceeded IRC recommendations. The recommendations have usually been made in terms of nominal gross wage increases. For 2003, the recommendation was couched in terms of a real net increase. This weakened the transparency of the recommendation, and the IRC switched back to making the recommendation in gross nominal terms in 2004.

    In practice, wage formation has tended to reflect an increasing decentralization of the wage bargaining system. The number of national branch agreements affecting the private sector declined rapidly in the 1990s, and, in many branches, wages are now decided directly at the firm level. Also, some rapidly expanding sectors of the economy (the financial sector, some sectors where multinational corporations are dominant) are not represented in the IRC. Moreover, unionization is only around 20 percent. While scarce, there is some evidence that wage negotiations in the private sector indeed take place now mainly at the enterprise or individual level: wage differences across companies tend to reflect productivity, location, size, and ownership, and to highlight the dominance of company-level bargaining (Köllő, 2002b).

    Labor Market Institutions and Policies

    A number of changes have been made to the unemployment insurance scheme in recent years, which makes it much less accessible and generous than in the past. The conditions for eligibility have been tightened, and the maximum duration of benefit has been reduced from 12 to 9 months. In addition, the replacement rate has been significantly reduced. The statutory replacement rate is 65 percent, but with a ceiling of HUF 39,240 per month (2003 figures) or 180 percent of the minimum old-age pension, which is equivalent to three, quarters of the minimum wage and about 30 percent of the average wage.

    Unemployment assistance is available for those who are not eligible for unemployment insurance (or who have reached the end of unemployment insurance benefits). The assistance benefits have been significantly altered in recent years. An “unemployment assistance” benefit for long-term unemployed has been gradually eliminated and replaced by an access to regular social assistance, conditional on acceptance of public sector work when offered. A new assistance benefit was introduced in July 2003: the “job-search allowance.” For eligibility, individuals must have been on unemployment insurance benefits for at least 180 days and must be willing to engage in intensive cooperation with labor centers. The allowance is 85 percent of the minimum old-age pension in 2003, a sum of HUF 18,530. The maximum duration is six months (nine months for those aged over 45). A key goal of the scheme is to encourage individuals to take up work: if the recipient is employed, even in a part-time job, before the exhaustion of the disbursement period, half of the remaining subsidy to the end of the disbursement period can be paid in a lump sum on request.

    ALMPs (active labor market policies) now absorb around 60 percent of the Labor Market Fund, which finances passive and active labor market policies. Several years ago, reforms to ALMPs raised spending on such measures considerably and devolved more responsibility to local governments. These policies consisted mainly of public works, training, and wage subsidies. Public works allowed long-term unemployed to break their unemployment period and provided localities with community services that they would not have afforded otherwise. In principle, since public work schemes also make it difficult to continue informal work while on unemployment benefits, they encourage people to take official market jobs that offer better wages and working conditions.

    However, impact studies of ALMPs seem to indicate little positive effect from such programs in terms of success in rehabilitating the long-term unemployed into regular private sector jobs. For instance, Fazekas (2004) concludes that in the majority of cases, public works have proved unable to transfer unemployed persons into formal market jobs. Wage subsidies—provided generally for one year to employers (mostly small and medium-sized enterprises) who hire the long-term unemployed with the obligation to employ them for another year after the supported period—seem to have been more successful because employment has been continued beyond the period when employers have signed up to employ them in 70-90 percent of the cases. Köllő(2002b) provides an overall assessment of recent reforms to passive and active labor market policies in recent years, and concludes that, while the reforms have reduced the number of benefit claimants significantly, they have not increased private sector employment and the labor force.12

    In recognition of the influence of transfers on labor market participation, eligibility criteria for state financed early retirement schemes have been significantly tightened since the second half of the 1990s. Currently, only older workers with long contribution histories are allowed to benefit from early retirement, and less than 170,000 people—or 2.6 percent of the working-age population—are now receiving these benefits, compared with more than 500,000 in 1999. To promote labor force participation among people on old-age pensions, the government has fully excluded old-age pensions from the taxable income. Previously a pension formed part of the tax base if the person was getting additional revenues through work. Because a number of retirees seem to be already working in the informal sector to supplement their revenues, this should provide an incentive for them to switch to the formal economy.

    Poland13

    The transition shock left Poland with double-digit unemployment rates that a spur of strong growth in the mid–1990s helped to ease. However, the 1998 Russia crisis and a subsequent wave of restructuring and privatization reversed this improvement. Under the influence of these shocks and of cyclical macroeconomic factors, unemployment soared in the late 1990s and early 2000s. The adverse labor market impact of these shocks persisted, partly because of policy and institutional problems. Despite the economic rebound in 2003–04, the labor market performance continues to disappoint, with high unemployment and low employment and labor force participation rates.

    Labor Market Performance

    Poland has had one of the worst labor market performances among new EU member states. Having declined from 14 percent in the early 1990s to almost 10 percent in early 1998, the unemployment rate rose rapidly, exceeding 20 percent in 2002, as employment and labor force participation rates fell to 51 and 64 percent, respectively. Some improvement in the labor market took place during 2003–04, largely because of higher economic growth, which helped reduce unemployment to under 19 percent and raise employment to 52 percent in 2004. The labor force participation rate remained at around 64 percent.14

    These negative trends are a legacy of economic transition and restructuring. Initially, restructuring and closing down old industries led to massive job destruction during 1990–93 and resulted in double-digit unemployment rates. While there was simultaneous private sector job creation, skill mismatches occurred that, along with a sharp productivity increase in the mid 1990s, help explain the lack of aggregate net employment growth. Job losses recurred in large numbers in the second wave of restructuring after the Russia crisis, which seems to have mostly affected exporters and heavy industries. Privatization also led to job shedding, as did the slowdown that gripped the country in 2001–02. Therefore, by 2004, redundancy or closing down of businesses explained nearly half of unemployment among previously employed persons.

    The uneven impact of these factors across the country has led to regional labor market disparities. The process of industrial destruction at the onset of the transition has led to regional disparities in labor market performance. Mobility seems partly hampered by housing market problems, including little availability of rental units associated with rent controls and overly protective tenant rights. Also, the uniform application of benefits and minimum wages across regions has tended to raise workers’ effective reservation wage in poorer regions, discouraging labor supply. Lack of labor cost differentiation to reflect differences in average labor productivity across regions—with the uniform minimum wage also contributing to the lack of such differentiation—is suspected to be another factor that impeded growth of labor demand.

    A number of policy and institutional problems likely contributed to persistently high unemployment since the late 1990s. The factors that seem to have particularly exacerbated the impact of transition, restructuring, and cyclical shocks include, in no particular order and certainly not exclusively, the following: (i) regional and skills mismatches resulting from shortcomings in infrastructure, in incentives for labor mobility, and in the education and training systems; (ii) easy access to benefits; (iii) high labor costs; and (iv) an insufficient degree of flexibility in regular employment contracts.

    Labor Costs

    Despite some pick-up in early 2004, real wage growth remains contained. Real wages had grown strongly in the late 1990s, exceeding productivity growth, which contributed to a decline in competitiveness. The second wave of restructuring in the late 1990s, however, resulted in accelerated productivity growth; at the same time, real wage growth slowed, which restored part of the lost competitiveness. Recently, real wage growth has remained moderate overall, and smaller than productivity growth.

    It is widely believed that high payroll taxes have tended to discourage employment in Poland. OECD estimates for 2004 indicate that the tax wedge in Poland, at about 42 percent, is between 10 and 15 percentage points above the OECD average. Social security contributions are an important component of that tax wedge. They are relatively high, at about 45 percent of gross wages, and their burden is shared almost equally between employers and employees.

    Wage Setting Process

    Wage negotiations are largely decentralized in Poland. A tripartite commission, representing the government, the private sector, and trade unions, sets the wage for the public sector—for employees in both the administration and public enterprises—on the basis of a bargaining process. The role of private sector representatives is restricted to giving an opinion on how much public sector wages should increase without active participation in the negotiations. In the past, the bargaining process often failed, and the government had to decide on public wage increases by decree. Private sector wages are negotiated at the firm level and bear no formal relationship to increases decided for the public sector. Labor unions are generally weak and unable to exert pressure during wage negotiations.

    Minimum wages are also set by the tripartite commission in case of agreement. The minimum wage was around 42 percent of the national average wage in the early to mid–1990s, but this share has declined since and reached 36 percent in 2004. The uniformity of the minimum wage across regions is suspected to be an obstacle to job creation: the minimum wage is likely to be more binding in poorer regions because of the large economic differences they exhibit vis-à-vis richer ones (Estevão, 2003; Selassie, 2001).

    Labor Market Institutions and Policies

    The Polish labor code dates from 1974 but has been amended to adapt to Poland’s post-transition status. The first reform of the labor code took place in 1996 and usefully clarified many employment rules, although it did not seem to remove rigidities from the system overall. This reform was relatively favorable to employees in several respects—such as the prohibition of firing employees in case of mergers; the shortening of the weekly working time; and the increase in the length of the annual leave entitlement for some employees. Another labor code reform followed in 2002 that helped improve labor market flexibility, particularly in favor of small businesses. For example, a new type of contract was introduced to ease the hiring of temporary workers replacing employees on extended leave; the amount of additional remuneration for overtime work was reduced; the minimum number of employees for which a code for work had to be written was raised to 20 employees; and most employee entitlements became a function of the duration of employment with the current employer, rather than total lifetime employment.

    Additional amendments to the labor code in 2003, largely needed for compliance with EU regulations, represented some backtracking from the 2002 reforms. These amendments, effective from 2004, introduced daily and weekly statutory rests and limits on overtime work, limiting the flexibility of work arrangements. Leave arrangements were changed to the workers’ advantage. Also, mass layoff procedures were lengthened, and entitlements for severance payments were extended in cases of employment restructuring.

    The government has taken steps to address Poland’s labor market problems. To improve youth employment, a law was passed in October 2002 setting the minimum wage for new entrants at 80 percent (90 percent) of the nationwide minimum wage in the first (second) year of work (so-called “first job” program). A reform to the disability system effective in 1998 tightened eligibility requirements and introduced frequent reviews of disability certificates and measures to prevent work accidents. The retirement age became compulsory with the 1999 pension reform for persons who were integrated in the new pension system, although it remained at 65 for men and 60 for women. Some forms of preretirement allowances15 were eliminated (albeit with grandfathering) from January 2002. A law on Employment Promotion and Labor Market Institutions, passed by parliament in April 2004, tightened eligibility for registering as unemployed and receiving social benefits, and reduced the length of access to unemployment benefits in some regions.

    The government also uses active labor market programs to promote employment. Spending on these programs rose to about 1.3 billion zlotys (under 0.2 percent of GDP) annually during 2003–04, more than double the level in the previous two years. The activation of new graduates (in the context of the “first job” program) captured more than one-third of that amount; about a fifth of it was spent on public works programs; and about 16 percent of the total spending went to subsidized employment programs.

    Poland’s social security and social assistance systems include a range of benefits. Employees and the self-employed have access to old-age insurance; disability, sickness, and maternity insurance; and to work injury and occupational disease insurance. Farmers have access to a separate social security system that includes similar benefits. Unemployment benefits are granted for a period of 6,12, or 18 months, depending on the region where the unemployed person is registered. In addition, based on the revenue situation of the family, benefits can be provided that include family benefits, nursing benefits, child-care benefits, and alimony benefits. The minimum revenue criterion for access to family and alimony benefits was lowered in 2003, and other criteria for eligibility for family and nursing benefits were also tightened, resulting in fewer beneficiaries. Low-income households can also be entitled to housing benefits paid by local authorities outside the social assistance system.

    Poland’s benefit replacement rates tend to increase once individuals are no longer eligible for unemployment insurance but are eligible for social assistance. This holds for most individuals but not for single persons without dependents. Nevertheless, compared with other Visegrad countries, benefit replacement rates do not seem to be excessive in Poland. OECD estimates for 2002 indicate that long-term net replacement rates for a number of family types in Poland were below counterpart rates for the Slovak Republic and were broadly similar to rates in the Czech Republic, although they exceeded relatively significantly replacement rates calculated for Hungary.

    Slovak Republic16

    This section briefly reviews the reasons for high unemployment in the Slovak Republic, and key institutional aspects including the new labor code, the wage setting process, the social safety net, unemployment insurance, and pensions.

    Labor Market Performance

    Unemployment remains high by regional standards. According to the LFS,17 the unemployment rate was 17.4 percent in 2003. Although down more than 2 percentage points from its peak in 2001, the unemployment rate has not fallen below 12 percent since the start of the transition, and it remains the second-highest in the OECD (unemployment is higher only in Poland, at just below 20 percent in 2003). Several recent studies18 emphasize the following structural causes of unemployment in the Slovak Republic: (i) the skills mismatch for workers whose jobs disappeared at the start of the transition, and whose skills are very different from those required by new jobs in the market economy; (ii) for low-skilled workers, and especially outside the capital Bratislava, the gap between wages and unemployment benefits, which can be very low (in poorer regions, wages are lower, but benefits are the same as in richer regions, limiting incentives to seek work); and (iii) the spatial mismatch and low labor mobility (in the first half of 2003, unemployment ranged from around 6½ percent in the Bratislava region in the west, to well over 20 percent in eastern regions).

    Despite the recent pick-up, employment remains low. Employment increased by 1.8 percent in 2003 and is growing strongly in the construction and service sectors, offsetting a slight fall in industrial employment and a sharper fall in agricultural employment. But overall employment remains below 60 percent of the working-age (15–64) population, one of the lowest rates in the OECD. This entirely reflects high unemployment; the corresponding participation rate of about 70 percent of the working-age population is in line with the OECD average.

    As in many other CEE countries, small private firms have played a key role in employment creation. Small and medium-sized firms were employing almost 60 percent of total employment by 1998. Despite these developments, however, a 2001 World Bank study noted that small firms face serious obstacles in their expansion.

    Labor Costs

    Real wages are quite low. In 2003, the economy-wide average wage was Sk 14,365 (about 390 a month). Real wages have remained broadly flat over the past five years. However, productivity growth has been strong through this period, and with wages low compared with other EU accession countries in the region, the Slovak Republic has consolidated a strong labor cost advantage (OECD, 2003c). This competitive advantage has contributed to the Slovak Republic’s recent appeal as a destination for foreign direct investment.

    Despite recent reductions, overall payroll taxes remain high relative to contribution rates in OECD countries, although comparable to those in other advanced transition economies. Including health care and sickness contributions, total payroll taxes are 48.6 percent of gross income, of which employees pay 13.4 percent and employers 35.2 percent. Payroll taxes were reduced by 3 percentage points for employers, and raised by 0.6 percentage points for employees, effective January 2004.

    Wage Setting Process

    The government approves annual increases in the statutory minimum wage, based on a tripartite agreement among the ministry of labor, the confederation of trade unions, and employer representatives. In the absence of a tripartite agreement, the government makes the final decision. Effective October 2003, the minimum monthly wage rose to Sk 6,080 (172), roughly 45 percent of the economy-wide average wage. Although less than 1 percent of all workers receive this minimum, it is a reference point for a system of “wage tariffs,” or minimum salaries based on the difficulty of a job—there are six salary tiers strictly defining the wage entitlements of all employees unless their wages are directly set by collective bargaining, and increases in the level of the minimum wage result in increases in these entitlements.

    Until recently, the wage setting process had been highly centralized, with collective bargaining conducted at the national, sectoral, and firm level (see OECD, 2002b): At the sectoral level, unions and employers’ associations negotiate directly, with sectoral agreements acting as floors for firm-level wage setting. Until 2002, the Ministry of Labor could make the outcome of these negotiations binding for other employers not represented in sectoral agreements. With the new government that took office in 2002, the extension was approved by the minister only if firms had no objections to the collective agreement. This practice is currently being anchored in legislation stipulating that firms should concur with the terms of the collective agreement in order for the latter to be extended to them. In the public sector, wages are now subject to collective agreements between the trade unions and the corresponding government units.

    Trade unions seem to have weakened recently, and the share of workers whose wages are determined outside collective agreements is increasing. Trade unions failed to obtain the minimum wage increase they had sought in 2003, and the general strike called to protest this (and other labor market policies), attracted little support. According to press reports, collective negotiations seemed to affect only about 20 percent of employees in the private sector, while the remaining 80 percent negotiated their wages and other working conditions individually. Only about half of the public sector employees are unionized.

    Labor Market Institutions and Policies

    Unemployment benefits are not particularly generous. An unemployed person is eligible for benefits for up to six months (until end-2003, nine months) depending on contribution history. The beneficiary must have contributed for 24 of the previous 36 months to be eligible. The replacement rate is 50 percent of past gross income (until end-2003, 55 percent for the first six months, then falling to 45 percent for the last three months). However, benefits are subject to a ceiling—previously around half the economy-wide average wage, in 2004 raised to 60 percent of the average wage (with government plans to increase the ceiling further in 2005 and 2006). Contribution rates are 3 percent of gross income for employers (2.75 percent until end-2003), and 1 percent for employees.

    Labor legislation has recently been in flux, but the most recent amendments significantly contributed to increased labor market flexibility. A new labor code took effect in April 2002, consistent with EU standards and replacing with one law several diverse labor laws implemented over the past decade. However, the new code introduced rigid and specific regulations on work arrangements and schedules that hindered labor market flexibility, and the code was heavily amended in June 2003 with a view to streamlining it and reversing the new rigidities. Notably, overtime limits were increased to 400 hours per year (previously limited to 150 hours); flexible types of labor contracts were introduced; the costs of separation of redundant workers were reduced; and the requirements for dismissing employees for unsatisfactory work were simplified.

    The Slovak Republic has made limited use of active labor market policies. Government annual spending on such policies has hovered around 0.2–0.3 percent of GDP since 2000. Special programs initiated in 2000 to address long, term and youth unemployment created about 60,000 and 30,000 long-term positions in 2000 and 2001, respectively. In 2003, the Slovak Republic spent 0.2 percent of GDP on active labor market policies, including training programs and policies geared toward encouraging labor mobility to enable the unemployed to find a job in the existing market rather than relying on jobs created specifically for them. However, spending on active labor market policies is expected to increase following the Slovak Republic’s accession to the EU.19

    Social Safety Net

    Until reforms effective in 2005, the social assistance system created disincentives to work. The social assistance system in place until end–2003 featured generous benefits and high effective marginal tax rates (EMTRs). The safety net included income assistance to reach a “Minimum Subsistence Income” (MSI), which—for all households other than single individuals—exceeded the statutory minimum wage, and even exceeded the net average wage for families with two or more children. Income assistance could be provided for an unlimited duration, but the mean stesting mechanism—a simple top-up to reach the MSI—implied an EMTR of 100 percent (or higher, taking into account transportation and other work related expenses). Moreover, the MSI applied nationwide despite significant regional variations in the cost of living. The combination of the benefit levels and EMTRs generated significant disincentives to work.

    The reformed social assistance system aims to correct work incentives. EMTRs have been reduced to around 75 percent. Individuals who make active efforts to seek work are eligible for the “activation allowance.” The reform does not lower social assistance benefits for small families whose adults qualify for the activation allowance. However, benefits for large families are 10 to 20 percent lower compared with those under the old system; the reduction is larger if adults do not qualify for the activation allowance.

    The pay-as-you-go pension system also weakens incentives, but reforms have been approved in this area as well. The current benefit formula is extremely redistributive and weakens incentives to work, especially for low-income workers who have incentives to retire early. Parliament has approved a pension reform, effective January 2004, that—in addition to raising retirement ages—will more closely link future pensions to earnings.

    Appendix III: Models of Worker and Firm Decision Making in a Regional Context

    The worker’s participation and location decision is considered in the framework of a simple linear model.1 Let us consider the decision facing an old individual in a distressed region. The individual has four labor market options:

    The first option (S, P) is to stay in the region and participate in the labor market. If the individual chooses this option, he will receive the imputed rents A from his house, wages w if he is employed, and benefits and income from subsistence activity if he is unemployed. His total expected income—both in real and nominal terms, since the price level is normalized to unity—can be expressed as:

    (S, P): A + u (b + αs) + (1 − u) w,

    where u is the probability of unemployment, b is the level of benefits, and s is income from subsistence activity. Assuming that the unemployed cannot be occupied full time with subsistence activity, α<1 holds.

    The second option (S, NP) is to stay in the region but not to participate in the labor market. In this case, the only sources of income are imputed rents, benefits, and full-time subsistence activity:

    (S, NP): A + βb + s,

    where β<1 indicates that the full range of benefits is not necessarily available to nonparticipants.

    The third option (M, P) is to move to the other region and participate in the labor market there. This requires that the individual sell his house in a costly transaction and buy another in the target region, which would yield imputed rents A* < A. In addition to this, the individual will receive wages w* if he is employed, and benefits and subsistence income if he is unemployed. His total real income is:

    (M, P): A* + 1/Pu*(b + αs) + 1/P (1 − u*)w*,

    where u* is the probability of being unemployed in the target region, and P is the relative price level. Because the target region is the advantaged one, P > 1 is likely to hold.

    The last option (M, NP) is to move to the other region but not to participate in the labor market. Income is derived from rents, benefits, and full-time subsistence activity:

    (M, NP): A*+ 1/Pb + s).

    The individual compares his expected real income under the four options, treating all variables and parameters as given, and picks the most lucrative course of action. Figure A3.1 illustrates that the optimal choice depends on the costs of selling one’s house—in the left-hand panel, where these costs are high, it is best not to move. The right-hand panel illustrates that with such costs sufficiently low, moving will be the top choice. In Figure A3.1 we keep transaction costs constant and show how the various choices compare under varying values of wages, probability of unemployment, benefits, and subsidies. The two figures illustrate the following:

    • Limited portability of assets biases decisions toward staying. Moving is encouraged if transaction costs are small (Figure A3.1).

    • Worse relative labor market conditions in the home region (lower wages or higher probability of unemployment) than in the target region tend to induce the decision to move (upper two panels of Figure A3.2).

    • However, declining relative wages in the home region may lead to nonparticipation rather than out-migration.

    • The level of benefits and subsistence income tends to influence the participation choice but has less impact on mobility.

    • Although it depends on the design of the benefit system (in the model, the parameters α and β), the participation decision will in general be more strongly influenced by changes in subsistence income than changes in benefits.2

    Figure A3.1.Benefits from Labor Market Choices Under Different Transaction Costs

    Source: Illustrative staff calculations.

    Young and Old

    How should we modify the model to describe the options of a young individual? In the model, the only difference between the young and the old is in their accumulated assets. While the old are expected to lose on the transaction when they sell their house and buy another in the target region, the young are yet to accumulate their assets. Instead of imputed rents, A and A* for the young represent future labor income in the home and target regions, respectively. If prospects are significantly better in the target region, A <A* will hold, but the four equations describing total income under the various options will remain the same. Clearly, the young will be biased toward moving—other things being equal, smaller wage and unemployment differences between the regions trigger the young individual’s move compared with the old individual’s—but all other conclusions remain similar.

    Labor Market Privileges

    To accommodate labor market privilege in the model, further modifications are necessary. If we interpret u and u* in the equations not only as the probability of unemployment for the individual in the home and the target regions, but also as the respective regional unemployment rates, the equations describe a world with random unemployment—that is, one without labor market privilege. If, however, insiders and outsiders coexist on the labor market, they do not have the same total income from the decision to stay and participate. That is, the probability of unemployment depends on labor market privilege. Insiders (those previously employed) can expect to remain employed unless they are fired, while outsiders (those previously unemployed) can expect to remain unemployed unless they manage to exit the stagnant pool of unemployed:

    (S, P|E): A + f(b + αs) + (1 − f)w

    (S, P|U): A + (1 − x) (b + αs) + xw,

    where f is the probability for an insider to be fired, and x is a probability of exiting unemployment for an outsider.

    If labor market privilege does not travel well, and all movers have to compete for jobs with the unemployed in the target region, prospects for insiders and outsiders differ only in the home region. Figure A3.3 compares the insiders’ and the outsiders’ decisions under varying values of wages, exit rate from unemployment, firing rate, and subsistence income. The following conclusions can be drawn:

    • Outsiders tend to be more mobile than insiders: they move in response to smaller differences in regional labor market performance.

    • Since insiders lose their privileged labor market position when moving, they only move if benefits are sufficiently high to provide insurance in case they remain unemployed in the target region.

    • Owing to their worse labor market prospects, outsiders are more prone to dropping out of the labor force—they decide not to participate at lower levels of benefits and subsistence income than insiders do.

    Figure A3.2.Benefits from Different Labor Market Choices Under Various Labor Market Conditions

    Source: Illustrative staff calculations.

    Figure A3.3.Benefits from Different Labor Market Choices for Insiders and Outsiders if Privilege Is Not Portable

    Source: Illustrative staff calculations.

    Portable Labor Market Privileges

    The first and second conclusions change completely once privileges are assumed to carry over to another region. Consistent with empirical evidence for transition countries and elsewhere in Europe, the model now predicts that insiders will have a higher propensity to move, while outsiders will tend to drop out of the labor force rather than move to another region (Figure A3.4).

    Figure A3.4.Benefits from Different Labor Market Choices for Insiders and Outsiders if Privilege Is Portable

    Source: Illustrative staff calculations.

    Framework for the Firm’s Decision

    The firm’s location decision is considered in the framework of an economic geography model presented by Puga (1999). In the model, two industries—agriculture and manufacturing—locate across two regions. The regions are endowed with labor (used by both industries and perfectly mobile across them) and a fixed amount of arable land (used only by agriculture). While agriculture is perfectly competitive and produces a costlessly tradable homogeneous output, manufacturing is imperfectly competitive and produces differentiated goods that can only be traded at a cost. Workers and landowners consume both the agricultural good and manufactures.

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    However, for some countries, such as Poland, second rounds of restructuring or cyclical downturns have led to increases in unemployment in recent years.

    EU–15 refers to EU members pre–2004: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

    Note that the employment data, from the World Bank, underlying sectoral productivity numbers are not consistent with those total employment data reported in Tables 2.3-2.11 which are from either national sources or labor force survey (LFS) results.

    In 2003, for example, France, Belgium, and Italy had unemployment rates for workers under age 25 that ranged between 21.8 percent and 26.7 percent.

    The EPL is a weighted average of 22 indicators representing the degree of restrictions on worker dismissals. Data to compile the EPL for Bulgaria, Romania, Latvia, and Lithuania are not available.

    See Riboud, Sànchez–Pàramo, and Silva–Jàuregui (2002), for detailed discussion on EPLs in OECD countries.

    Panel (1) of Figure 3.1 shows the production function; panel (2) depicts the labor-capital isoquant; panel (3) represents the labor market; and panel (4) summarizes the relation between employment and output per capita in transition countries. The subscript T relates to the end of central planning and the beginning of the transition period.

    The OECD index on labor protection is available for only 7 of 11 countries in the sample.

    Table 3.1 reports results from the A-B estimations, correcting for heteroscedasticity.

    While the positive coefficient in the second stage was not predicted by the theoretical framework, this may simply suggest that the stages as defined based on the EBRD average do not correspond precisely to the stages in the theoretical framework. Indeed, the data series for the estimation starts only in 1993, while in many of the countries transition began in earnest in 1989. In fact, out of 110 observations only 9 (8 percent) are classified as phase 1 of the transition.

    Following other studies (IMF, 2003), we interacted labor policies and institutions with each other to no significant results and decided to drop them.

    The results are symmetric, so that a negative terms of trade shock would have a smaller impact on employment and unemployment when labor market policies are less favorable. This is consistent with the experience in much of the former Soviet Union, where a massive output decline had only a modest impact on measured employment and unemployment.

    Upward wage pressure exerted by unions apparently led to some excessive increases in labor costs in Croatia in the earlier stage of transition.

    Farrell (2004) provides empirical analysis on the relation between the shadow economy and the productivity of the entire economy.

    The employment and unemployment data used in this paper are LFS based and reflect employment in the unofficial sector.

    As regards the size of the shadow economy, this empirical study uses estimations by Johnson, Kaufmann, and Zoido-Lobaton (1998) that are based on electricity consumption. This measure avoids the endogeneity issues, unlike the estimates in Schneider (2002a), which are inferred from institution variables.

    Schneider and Enste (2000) provide an illustrative survey on this issue.

    The business regulation index compiled by the Economic Freedom Network is used as a measure of strictness of business regulations. It takes into account price controls, time required for business entry, and the extent of irregular payments to business regulators. It ranges from 1 (most strict) to 10 (most liberalized).

    NUTS2 (Nomenclature of Territorial Units for Statistics/Nomenclature des Units Territoriales Statistiques) regions are territorial units of broadly comparable size. Throughout this section, unemployment and participation rates are based on Eurostat LFS data.

    Of course, the key concern is de facto, rather than de jure, equivalence of the business environment, and regional differences may arise. For example, if learning-by-doing by local administrators plays a role in how easily and speedily the steps necessary for setting up a business can be completed, regions with more numerous start-ups may develop an advantage.

    The measure of structural change is based on changes in industry shares in regional output. Following Newell and Pastore (2000), the index is defined as S = 100.0.5 sumi (|s(i, t), s(i, 0)|), where s(i, t) is the share of industry i in total output at time t. It would be interesting to look at this index early on in the transition, but data availability constrains us to the 1998¯99 period.

    There is generally no information on price levels across regions, and data are especially scarce in the area of housing costs. In addition, regional differentiation in benefits would be politically difficult to implement, and very cumbersome and costly to enforce.

    See country notes in Appendix II.

    For example, GaluščáK and Münich (2004) for the Czech Republic; IMF (2003) for Poland; and Kertesi and Köllő (1999) for Hungary.

    Note, however, that full-time farmers are usually considered employed in the LFS data even if they only produce for their own consumption. In countries where the importance of small farms in agriculture is large—for example, Poland—this tends to weaken the correlation between regional unemployment and nonparticipation.

    Kertesi and Köllő (1999) estimate that a worker who, based on his characteristics such as age, education, etc., can be expected to have a long unemployment spell but leaves the benefit rolls earlier accepts a wage cut of 13 percent in a region with 10 percent unemployment. He receives an 18 percent cut in a region where unemployment is 20 percent. Workers who can be expected to have a short unemployment spell accept wage cuts of 5 and 8 percent, respectively.

    For example, to commute to a job the employee needs to have the means to get to his job before business starting hours, and then back home after closing hours. Places where such connections do not exist cannot be considered as feasible commuting targets.

    See data reported by Cseres-Gergely (2002). The difference is not due to different propensities to migrate (move to another region): as mentioned before, about 2 percent of the population in Hungary as well as in the Netherlands and Sweden migrates each year.

    Calculations cited in Köllö and Vincze (1999). Note, however, that these subsistence farmers are considered self-employed by Romanian statistics.

    The fact that the role of external trade is large in these economies and that foreign direct investment appears to be geared toward production for exports suggests low transport costs. However, the fact that market access rather than cheap labor tends to motivate location decisions suggests that transport costs between transition countries and the rest of Europe are significant. These observations can be reconciled if we consider that transition countries are not yet in equilibrium. Export capacity may still be below its long-run value, while the home market may be underprovided. In addition, there are likely significant differences in transport costs across industries; hence, the relative importance of various motives for production location should also vary. Some industries may seek low labor costs, others market access, yet others high-skill labor. In addition, the observation that regional convergence does not appear to be taking place suggests a situation where multiple equilibria may arise.

    The author of this case study is Philippe Egoumé-Bossogo.

    The author of this case study is Tetsuya Konuki.

    See Rutkowski (2003) for detailed discussions on labor market performance in Croatia.

    Rutkowski (2003) presents cross-country comparison of job creation and destruction among the CEE countries.

    See Bisogo (2002) and Rutkowski (2003) for regional analysis.

    See World Bank (2002b) for cross-country comparison in employment

    World Bank (2003) presents cross-country comparisons of the EPL indices among the CEE countries and EU-15 countries.

    See Ott (2002) and Schneider (2002b) for the estimation of the size of the shadow economy in Croatia.

    Mainly due to lack of resources, active labor market policies in Croatia were carried out in very low volume before 2002.

    The author of this case study is Paulo Drummond.

    The average disability benefit received by people of working age was equivalent to around 50 percent of the average wage in early 2003, somewhat above the OECD average.

    Note that it is difficult to establish a clear picture of the effectiveness and cost efficiency of ALMPs, as in many other countries.

    The author of this case study is Nada Choueiri. It draws heavily on Choueiri (2005).

    All numbers are based on seasonally adjusted quarterly LFS data for the working-age population (ages 15–64). Data for 2004 are for the first three quarters of the year.

    Preretirement allowances are granted to older workers who fulfill specific eligibility conditions—women with 30 years of work experience or men with 35 years of work experience—upon becoming unemployed, in lieu of unemployment benefits to bridge the gap to retirement.

    The author of this case study is David Moore.

    Monthly data on registered unemployment are more timely, but less reliable because of labor force measurement problems. The registered unemployment rate was 15.3 percent in April 2004.

    The Slovak Republic’s May 2004 Convergence Program envisages spending on active labor market policies to rise to 0.4 percent of GDP by 2007, despite a projected decline in unemployment.

    This appendix was prepared by Kornélia Krajnyák.

    The exception is α = β = 1, when the decision is equally sensitive to benefits and subsistence income.

    Note: For information on the titles and availability of Occasional Papers not listed, please consult the IMF’s Publications Catalog or contact IMF Publication Services.

    Occasional Papers: Recent Occasional Papers of the International Monetary Fund

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    206. The Dominican Republic: Stabilization, Structural Reform, and Economic Growth, by a staff team led by Philip Young comprising Alessandro Giustiniani, Werner C. Keller, and Randa E. Sab and others. 2001.

    205. Stabilization and Savings Funds for Nonrenewable Resources, by Jeffrey Davis, Rolando Ossowski, James Daniel, and Steven Barnett. 2001.

    204. Monetary Union in West Africa (ECOWAS): Is It Desirable and How Could It Be Achieved? by Paul Masson and Catherine Pattillo. 2001.

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