The Danish labor market model has been dubbed “flexicurity” for its ability to deliver simultaneously labor market flexibility and social security. Employers are free to hire and fire, which has encouraged them to employ a record number of people. In return, workers are entitled to generous social security benefits if they lose their jobs. At the same time, active labor market policies ensure that no person remains unemployed for more than six months at a time before being offered a new job or training. This unique mix has reduced unemployment in Denmark to a 30-year low and has helped make its economy one of the strongest in Europe. Could the Danish model work in other European countries? Paul Hilbers and Jianping Zhou of the IMF’s European Department have analyzed the Danish flexicurity model and find that it can help reduce unemployment, but is costly to implement and therefore not automatically applicable elsewhere.
Denmark’s economy has been shining recently. Economic growth averaged slightly above 3 percent in 2005 and the first half of 2006, and unemployment fell to 4.4 percent this summer (see Chart 1). In contrast, most other European countries continue to suffer from chronically high unemployment. Reforms that would help labor markets perform better in the long run and create more jobs encounter strong political opposition from workers and unions, who fear that their rights will be eroded. Because the Danish model has managed to achieve buy-in from all partners in the labor market and has enjoyed obvious success, it has caught the attention of policymakers elsewhere in Europe. At recent summits discussing the Lisbon Agenda (the European Union’s blueprint for improving competitiveness), the European Commission has encouraged member states to pursue reforms based on the flexicurity model.
Chart 1Putting people to work
Denmark has outperformed the euro area in reducing unemployment.
Citation: 35, 20; 10.5089/9781451968835.023.A009
The model (see Chart 2) combines three key elements:
• Labor market flexibility. Measured by how restrictive employment protection legislation is, the Danish labor market is more flexible than that in many other European countries. In practice, this means that Danish employers, both in the public and private sectors, can lay off workers rather easily. This is not a novel aspect of the Danish social system—protection against dismissal has historically been low, a feature that has been linked to the country’s openness and its many small and medium-sized enterprises.
• An extensive social safety net. Danes enjoy a high level of social protection, including generous unemployment benefits. The average net replacement rate (what people receive from the state when they lose their jobs, calculated as a percentage of their salary) is about 80 percent, among the highest in Europe.
• Active labor market policies. A large variety of labor market programs facilitate and encourage reintegration of the unemployed into the labor market. But these programs are expensive. As a result, Denmark is at the top in terms of its per capita spending on labor market programs.
Chart 2The flexicurity model
Denmark combines flexibility for employers with a strong social safety net.
Citation: 35, 20; 10.5089/9781451968835.023.A009
1Organization for Economic Cooperation and Development (OECD) index on employment protection legislation for regular jobs (2003). Higher numbers indicate more restrictions on hiring and firing.
2In percent of GDP; includes both active and passive labor market measures.
Each element of the Danish model has a different effect on unemployment. On the positive side, the flexibility enjoyed by employers helps reduce structural unemployment by improving labor market dynamics. Active labor market policies also contribute to lowering structural unemployment, although this is partly due to a well-recognized statistical phenomenon: participants in labor market programs are considered to be employed. On the negative side, generous unemployment benefits increase structural unemployment by reducing incentives to work and by raising reservation wages (the wage at which unemployed people are willing to work). Similarly, the tax wedge on labor income that is necessary to finance labor market programs and welfare benefits raises unemployment through its negative effect on labor demand and labor supply. On the whole, however, the positives outweigh the negatives. The reduction in unemployment in Denmark since the early 1990s that can be attributed to flexibility and labor market programs appears to have more than offset the negative impact of the high labor taxes on employment.
Should other European countries seek to emulate Denmark? The answer is not obvious. First, Denmark has traditionally combined a flexible labor market with a high level of income protection. But the results have not always been good. In the early 1980s, Denmark experienced high and rising unemployment and inflation, chronic current account deficits, and mounting public deficits. Only after unemployment benefits and labor market policies were tightened did unemployment come down.
Furthermore, other countries in Europe have been able to lower their high unemployment rates with rather different social models. For example, Sweden, which is comparable to Denmark in terms of the size of its public sector and the generosity of its welfare system, has a more rigid labor market—as measured by the level of protection against dismissal—but has achieved lower unemployment during most of the past three decades. Ireland and the United Kingdom have achieved substantial reductions in their unemployment rates by using the so-called Anglo-Saxon model, which is characterized by relatively low unemployment protection and low replacement rates.
Bad memories drive economic reform
The Danish economy has undergone major changes over the past two decades. In the early 1980s, the economy suffered from chronically high inflation and unemployment, unsustainable budget deficits, and large current account deficits. A macroeconomic stabilization program was adopted in the mid-1980s, followed by structural reforms in the 1990s.
Memories of bad times and the payoffs of reforms have cemented a strong nationwide consensus on the need for prudent economic policies. As a result, economic performance has been much more favorable since then. Significant growth during the late 1990s was sustained through labor market reforms that reduced structural unemployment. Fiscal consolidation and the buoyant economy turned large fiscal deficits into sizable surpluses, and the public debt-to-GDP ratio fell sharply. As Denmark registered current account surpluses, the foreign debt position improved markedly.
Since 2001, Denmark has given higher priority to fiscal consolidation and increasing the labor supply. Key objectives of the current coalition government include making public finances sustainable in the long term and increasing the labor supply so that Denmark can tackle the pressures arising from an aging population. In this context, the recent welfare agreement, which includes key measures to push back retirement, was an important step forward in addressing these issues.
Also, the cost of implementing the Danish model is often overlooked. The tax burden in Denmark is relatively heavy, which is necessary if the country is to finance its high spending on labor market programs and unemployment benefits (the two programs amount to about 5 percent of GDP a year). Because most countries that are tempted to adopt the Danish model typically start from a high unemployment level, a move toward the Danish model would, in the short run, trigger a sharp increase in the cost of unemployment benefits and labor market programs. This would, in turn, widen the tax wedge, which would have a negative impact on employment. Using a calibrated model for France as an example, the analysis finds that implementing the flexicurity model might be costly, and the reduction in structural unemployment during the first few years may be limited. The costs associated with flexicurity may make the model less applicable to countries with high unemployment and weak public finances.
Even so, key aspects of the Danish model may warrant consideration by other countries. The notion of a trade-off between the population’s willingness to accept labor market flexibility and the presence of a well-functioning social safety net is worth looking at, as is the need to develop effective labor market policies to avoid high costs and perverse incentives. The Danish government’s ongoing analysis of the challenges facing the flexicurity model, as well as its ability to respond to them with policy changes, is also noteworthy. For instance, since the economic crisis in the early 1980s, reforms have been implemented to shorten the maximum period that people can participate in labor programs (see box). The government has also tightened the eligibility criteria for unemployment benefits. Finally, the welfare agreement reached by major political parties in June 2006 included further measures to reduce the period during which unemployment benefits are offered.
Paul Hilbers and Jianping Zhou
IMF European Department
Copies of IMF Country Report No. 06/342, Denmark: Selected Issues, are available for $15 each from IMF Publication Services. See page 324 for ordering information. The full text of the report is on www.imf.org.