Chapter

Chapter 3. Long-Term Implications of Fiscal Policy for Labor Market Outcomes

Author(s):
Lamin Leigh, and Ali Mansoor
Published Date:
January 2016
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Author(s)
Ara Stepanyan

Policymakers sometimes view the expansion of public employment as a useful tool for reducing high unemployment. This is probably one of the reasons public employment accounts for an important share of total employment in many middle-income countries (MICs). However, in many countries, including small MICs (SMICs), a relatively large government coexists with persistently high unemployment (Box 3.1).

The academic literature has largely concentrated on explaining the differences in long-term unemployment rates across countries using the heterogeneity of labor market institutions. Given significant heterogeneity of public employment across countries, it is worth exploring whether this heterogeneity could also explain cross-country differences in unemployment.

In theory, creation of public jobs has an ambiguous impact on unemployment. If private employment and the labor force are given, an additional public sector job would reduce unemployment. However, public employment can also affect unemployment indirectly, through its impact on private employment and labor force participation.

In this chapter, we empirically analyze the impact of public employment on labor market performance in the long term. Given that the available data for the seven SMICs this book focuses on1 are not sufficient to empirically estimate the long-term relationship, we expand the sample by including 24 upper-middle-income-countries (UMICs). We do not include low-income countries because they have very different economic conditions and relations. At the early stage of development in low-income countries public involvement might be necessary, and informal employment is high since people cannot afford to be unemployed. The availability of data is the main reason for including UMICs in our sample.

The chapter contributes to the literature in two ways. First, it looks at the impact of public employment on labor market outcomes in developing countries.2 Second, it explicitly examines the role of rents in the public sector and the substitutability of public production in the transmission channels for the impact of public employment on labor market outcomes in developing countries.

The results of our analysis confirm that public employment plays a significant role in the medium-to long-term performance of the labor market. Our results do not support the hypothesis that creation of public jobs reduces unemployment. In addition, the results provide some evidence that creation of public sector jobs destroys private sector jobs. Although the magnitude of the impact of public employment on private employment varies depending on the model specification, its impact increases with the degree of substitutability between public and private production and the size of job compensation in the public sector. These findings suggest that reforms aimed at reducing rents and the size of the public sector may improve labor market performance.

The rest of the chapter is organized as follows: The next two sections provide a review of the literature and cover the methodology, respectively. The subsequent section presents the empirical results and data issues, and the final section summarizes the main findings.

Literature Review

To the best of our knowledge, very little has been written on the macroeconomic impact of public employment on the labor market, particularly for developing countries. Two comprehensive surveys of public sector labor markets, Ehrenberg and Schwarz (1986) and Gregory and Borland (1999), show that studies of public employment in industrial countries have mainly focused on the internal organization of the public sector, especially the influence of trade unions, and on wage differentials between the private and the public sectors. Holmlund and Linden (1993) and Calmfors and Lang (1995) study the macroeconomic effect of temporary employment programs, arguing that temporary public jobs increase wage pressure in the private sector. These papers conclude that wage pressure from public jobs reduces private employment. Holmlund (1997) shows that a public sector expansion is often associated with an increase in equilibrium unemployment if unions are relatively more powerful in the public sector than in the private sector. Finn (1998) analyzes the impact of goods purchases and employee compensation components of government spending on unemployment in a real business cycle model applied to the U.S. economy. The results suggest that positive shocks to purchases of government goods increase private output and private employment, whereas positive shocks to government employment have the opposite effects.

The empirical literature provides some evidence of a crowding-out effect of public employment on private employment in the long term. Time series analyses done by Demekas and Kontolemis (2000) for Greece and by Malley and Moutos (2001) for Germany, Japan, and the United States suggest that public employment has a strong crowding-out effect on private employment. Edin and Holmlund (1997), using pooled cross-section and annual time series data for 22 Organisation for Economic Co-operation and Development (OECD) countries in 1968–90, show that public sector employment decreases unemployment in the short term, whereas there is no significant long-term effect. Boeri, Nicoletti, and Scarpetta (2000) include public employment, along with labor market institutions, as an explanatory variable for the nonagricultural employment rate for 19 industrial OECD countries in 1982–95. Their estimate implies that 1 public job crowds out 0.3 private jobs. Algan, Cahuc, and Zylberberg (2002), in a study in which they control for endogeneity, show that public employment is a significant factor influencing the performance of labor markets. They find that creation of 1 public job crowds out 1.5 private jobs and increases the number of unemployed by 0.3. Behar and Mok (2013) analyze a large cross-section of developing and advanced countries and find full crowding-out effects of public employment on private employment.3Feldmann (2009) uses data from 58 countries in 1980–2003 to analyze how the size of government affects unemployment in developing countries. According to the results, a large share of government consumption in total consumption and a large share of transfers and subsidies in GDP increase unemployment.

Methodology

In this chapter, we analyze the sign and the magnitude of public jobs’ impact on the unemployment rate and private employment, as outlined in the framework by Algan, Cahuc, and Zylberberg (2002).4 This framework focuses on the role of rents in the public sector and the degree of substitutability of public for private employment. It does not incorporate the distortionary impact of taxes in the financing of public jobs, thus providing a partial view. Our aim is to analyze the medium-term effects of public job creation on labor market performance. This work does not capture the effects of nominal rigidities and demand movements that may play an important role in the impact of public sector job creation on labor market outcomes in the short term.

In theory, the impact of public employment on unemployment is ambiguous. Given the level of private employment and the labor force, an additional public job would reduce unemployment. However, public employment can affect private employment and labor force participation and thus indirectly influence unemployment. In general, public jobs could negatively affect private employment by (1) producing goods and services substitutable for those produced by the private sector; (2) improving the expected gains of unemployed people, which increases wage pressure and decreases private employment;5 and (3) increasing distortionary taxes or giving rise to public expenditure switching to finance public job creation. However, the flip side is that public employment can create goods complementary to the private sector, thereby increasing productivity, and the increased employment in the public sector may have some positive externalities.

The impact of public jobs on labor force participation could also go either way. To the extent that public job creation improves the job-finding and wage outlook of unemployed people, it encourages labor force participation and, all else equal, increases employment. However, if the public sector produces goods that increase incentives for citizens to stay out of the labor force, it would negatively affect the participation rate.

In our theoretical model, a representative private sector firm produces goods with decreasing returns to labor, while the public sector produces goods consumed by all individuals.6 In the private sector, all workers are represented by a trade union that bargains wages with the representative firm. A benevolent government sets public employment and negotiates the wage in the public sector with a trade union that represents public sector workers. The benevolent government aims to maximize the difference between the social value of goods that the public sector is producing and its cost. In equilibrium, the public-private wage ratio depends on the bargaining power of trade unions in both sectors, and on the elasticity of private and public labor demand (Equation 3.1.14 in Annex 3.1). Public employment is determined in a way that ensures public wages are equal to the marginal utility of goods produced by the public sector (Equation 3.1.15 in Annex 3.1).

The expected returns to looking for a job in the public sector are obviously increasing with the number of public jobs and with the public wage level. Therefore, the share of the labor force that belongs to the public sector (including public employment and those looking for a job in the public sector) increases with the number of public jobs and the level of public wages relative to private wages (Equation 3.1.8 in Annex 3.1). Thus, public job creation attracts labor into the public sector at the cost of the private sector if the relative wage between the public and private sectors is constant. Given the participation rate, this will crowd out private jobs, and the crowding-out effect would be stronger when wages in the public sector are higher than private sector wages, attracting more workers to the public sector (Equation 3.1.9 in Annex 3.1).

The consequence of increased public jobs on the unemployment rate depends on the size of the crowding-out effect on the private sector. When the size of the labor force is taken as given, the creation of one public job decreases unemployment only if the crowding-out effect is less than one, because the crowding-out effect increases with the relative level of rents in the public sector (Equation 3.1.10 in Annex 3.1).7

By improving employment opportunities, public job creation is likely to increase the size of the labor force (Equation 3.1.11 in Annex 3.1). However, public jobs can also influence private sector productivity. If, by creating public jobs, the government produces goods that are not substitutes for private goods, such as a justice system and a police force, it increases productivity and pushes up wages in the private sector, positively influencing the participation rate. If public jobs produce goods that are substitutes for those produced by the private sector, the relative price of goods produced by the private sector will decrease, negatively influencing wages and the participation rate in the private sector.

Empirical Results

Data

Our empirical analysis is based on the data for 24 UMICs in 1995–2011.8 The main sources for standard labor market data are the Key Indicators of the Labor Market and LABORSTA databases from the International Labour Organization, and different publications of countries’ statistical offices and other agencies.9 In general, the quality of labor market statistics is worse than other macroeconomic statistics, which makes econometric analysis in this area challenging. As noted in Leigh and Flores (2013), there are significant variations between unemployment indicators in a numbers of countries in the region and in the estimated implied unemployment rates for these countries. This discrepancy highlights the severe weakness in unemployment data for the sub-Saharan Africa region.10 We use a narrow definition of public employment that does not include employment by state-owned enterprises.11 To remove the effect of cyclical fluctuations, we average the time-dependent macroeconomic variables over three-year periods.12 Because of joint determination of public employment’s and aggregate unemployment’s evolution over time, we instrument public employment using variables meant to capture fairly general features of economic and sociological cross-country variation. We use the urbanization rate as a measure of economic development, which is related to public infrastructure, spending, and employment growth on the basis of Wagner’s law.13 Population density is used to capture the fixed cost of providing government services. We incorporate exposure to international trade, which is predicted by many theories to have important effects on public employment. Higher foreign exposure should reduce the size of the public sector if international tax competition is an important constraint on public policy, but a larger public sector may be observed to have a risk-reducing role when economies are more significantly exposed to external shocks (Rodrik 1997). Also, five features of the wage-setting and labor-employer framework from the World Economic Forum are included: an index of cooperation in labor-employer relations, flexibility of wage determination, rigidity of employment, hiring and firing practices, and redundancy costs.

Stylized Facts

Our data analysis over time and across countries reveals significant heterogeneities. The share of public employment in total employment averages 13 percent across countries in the sample for 1995–2011, and in 60 percent of countries it increases over time (Table 3.1). In 2011, the share of public employment in total employment ranged from 4.7 percent in Kazakhstan to 23.9 percent in Belarus, highlighting the heterogeneity in public employment among UMICs.

Table 3.1Selected UMICs: Public Employment and Unemployment Rate, 1995–2011
Public Employment in TotalStandard Deviation
1995-2011Latest

Available
Unemployment

(u)
Public

Employment (Lg)
Correlation

(u, Lg)
Albania14.517.75.80.8−0.51*
Belarus24.023.91.00.4−0.54*
Botswana16.020.92.70.30.26
Brazil10.610.92.50.90.74*
Chile9.410.33.70.40.39
Colombia5.35.03.10.90.62*
Costa Rica12.311.81.40.6−0.32
Dominican Republic4.64.82.00.2−0.53
Jordan18.015.83.41.50.07
Kazakhstan5.24.72.80.90.38
Malaysia10.812.51.81.30.74*
Mauritius14.013.84.60.20.63*
Mexico4.95.01.30.1−0.27
Namibia20.920.14.20.2−0.56
Panama9.68.84.00.10.54*
Peru9.09.71.50.4−0.84*
Romania3.54.82.30.30.06
Russian Federation7.67.82.10.30.15
Seychelles29.219.71.71.0−0.53
South Africa11.412.55.32.3−0.07
Thailand8.210.01.10.6−0.28
Turkey14.613.31.70.7−0.84*
Ukraine32.419.62.26.50.82*
Uruguay14.214.83.00.9−0.57*
Total Average12.9212.432.720.91−0.02
Sources: Country authorities; International Labor Organization; and IMF staff calculations.Note: UMIC = upper-middle-income country.* p<0.05.
Sources: Country authorities; International Labor Organization; and IMF staff calculations.Note: UMIC = upper-middle-income country.* p<0.05.

There is a high degree of heterogeneity in the dynamics of public employment as well. In two countries (Mexico, Costa Rica) of our sample, public employment as a share of the working-age population was stable over time; for five countries (Belarus, Chile, Malaysia, Peru, Thailand) the share of public employment increased steadily in 1995–2008; in three countries (Jordan, Kazakhstan, Turkey) the share of public employment in the working-age population has steadily decreased over time; and in the remaining countries there were large swings in the share of public employment.

In many countries, policymakers respond to a high level of unemployment by creating new public jobs or expanding existing public employment programs. Half of the countries in our sample show a positive correlation between public employment and the unemployment rate; in the remaining half the correlation is negative. However, the correlations are statistically significant in 6 (Brazil, Colombia, Malaysia, Mauritius, Panama, and Ukraine) out of 12 countries with positive correlation and 5 (Albania, Belarus, Peru, Turkey, and Uruguay) out of 12 countries with negative correlations. The positive correlation could reflect governments’ response to increasing unemployment in these countries. The cross-country dimension of the data suggests a negative, though statistically insignificant, correlation between public employment and the unemployment rate (Figure 3.1).14

Figure 3.1Share of Public Employment in Working-Age Population and Unemployment Rate, Average 1995–2011

Sources: International Labour Organization; country authorities; and IMF staff calculations.

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

In the sample of 24 MICs, SMICs in sub-Saharan Africa stand out with their relative size of government and high unemployment.15 The average share of public employment in total employment for the SMICs in sub-Saharan Africa is about two times higher than the average for the entire sample (Figure 3.2). Wages are also high in the public sector relative to the private sector in these SMICs. This situation has resulted in a bloated wage bill in the public sector and a persistently high unemployment rate. The unemployment rate for most of these SMICs has been about 20 percent for the past two decades.

Figure 3.2Public Sector Wage and Employment Policies and Labor Market Outcomes in Small Middle-Income Countries in Sub-Saharan Africa

Source: IMF staff calculations.

Econometric Analysis

The literature traditionally explains unemployment dispersion across countries by the underlying heterogeneity in national labor market features. However, as illustrated in Table 3.1, heterogeneity of the level of public employment is significant across countries. We test whether this cross-country variation in public employment also matters in explaining the variation in unemployment. First, we link unemployment to traditional labor market institutional variables. Then we add public employment and estimate the impact of this variable on unemployment. We also control for global shocks by introducing a full set of period dummies. For each model specification, we report pooled ordinary least squares (OLS), generalized least squares (GLS), fixed effect16 estimates, and estimates with errors robust to the country clustering. To further explore the channel through which public employment affects unemployment, we estimate its impact on private employment as well.

Labor market institutions provide some explanation for the cross-country differences in the unemployment rate in the equations without public employment (column 1 of Tables 3.2 and 3.3). However, most of them become insignificant when using GLS estimators (column 4 of Tables 3.2 and 3.3). The only factor that is significant in all specifications is hiring and firing practices, which suggests that more flexible labor market practices are associated with lower unemployment. Cooperation in labor-employer relations and rigidity of employment have a significant negative impact on unemployment only in the OLS specification. Public employment appears to have a statistically significant effect on unemployment, at least at the 10 percent confidence level, for fixed effect and GLS methods, suggesting that public employment is a key factor in explaining unemployment, in addition to institutional variables. Public employment is statistically significant at the 5 percent level and has a negative impact on private employment only in the OLS regression (Table 3.3). However, all estimates presented in Tables 3.2 and 3.3 are distorted by the endogeneity bias because public employment, private employment, and unemployment are jointly determined.

Table 3.2Estimates of Unemployment Based on Labor Market Institutions and Public Employment
OLS: InstitutionsOLS: Institutions

and Public

Employment
Fixed Effect:

Institutions and

Public Employment
GLS: InstitutionsGLS: Institutions

and Public

Employment
12345
Public employment−0.04480.232**0.19
(0.13)(0.11)(0.11)
Cooperation in labor-−2.367***−1.989**−2.465−2.105
employer relations(0.87)(0.94)(1.59)(1.65)
Flexibility of wage0.6260.460.6210.938
determination(0.72)(0.83)(1.67)(1.68)
Rigidity of employment−0.138***−0.126***−0.14−0.136
(0.03)(0.04)(0.07)(0.08)
Hiring and firing−4.304***−3.742***−4.224*−5.177**
practices(1.01)(1.19)(2.61)(2.64)
Redundancy costs0.0310*0.0315*0.03320.0406
(0.02)(0.02)(0.03)(0.03)
Time effectYesYesYesYesYes
Number of observations148128128148
R-squared0.2680.2350.183
Source: IMF staff calculations.Note: Standard errors in parentheses. GLS = generalized least squares; OLS = ordinary least squares.*** p<0.01, ** p<0.05, * p<0.1
Source: IMF staff calculations.Note: Standard errors in parentheses. GLS = generalized least squares; OLS = ordinary least squares.*** p<0.01, ** p<0.05, * p<0.1
Table 3.3Estimates of Private Employment Based on Labor Market Institutions and Public Employment
OLS: InstitutionsOLS: Institutions

and Public

Employment
Fixed Effect:

Institutions and

Public Employment
GLS: InstitutionsGLS: Institutions

and Public

Employment
12345
Public employment−0.6960.15−0.0467
(0.32)(0.37)(0.43)
Cooperation in labor-3.5622.6483.2233.164
employer relations(2.26)(2.26)(4.72)(4.78)
Flexibility of wage−5.023**−5.972***−4.654−4.715
determination(1.97)(1.99)(4.07)(4.08)
Rigidity of employment0.165*0.157*0.2540.253
(0.09)(0.09)(0.19)(0.19)
Hiring and firing practices7.975***10.21***8.7168.868
(2.69)(2.83)(6.38)(6.40)
Redundancy costs0.0866**0.0715*0.1130.112
(0.04)(0.04)(0.01)(0.10)
Time effectYesYesYesYesYes
Number of observations124124124124124
R-squared0.1660.2010.057
Source: IMF staff calculations.Note: Standard errors in parentheses. GLS = generalized least squares; OLS = ordinary least squares.*** p<0.01, ** p<0.05, * p<0.1
Source: IMF staff calculations.Note: Standard errors in parentheses. GLS = generalized least squares; OLS = ordinary least squares.*** p<0.01, ** p<0.05, * p<0.1

To address the inherent endogeneity bias, we estimate simultaneous equation regressions.17 Based on our theoretical model, the unemployment rate or private employment is defined as a function of public employment, productivity, and labor market institutions. Meanwhile, public employment is linked with productivity, labor market institutions, and valuation of public goods. The weight attached to public goods in policymaking is determined by the urbanization rate, population density, and trade openness, which are used as instruments for public employment.18,19 The level of productivity enters the equations using GDP per capita as a proxy, which is specified in first differences consistent with Okun’s law. Similar to three-stage least squares regressions, we estimate simultaneous equations in two specifications: (1) with variables on labor market institutions and (2) with country-specific effects instead of labor market institutions.

The impact of public employment on the unemployment rate is still positive and statistically significant in the specification with country-specific effects (Table 3.4). The coefficient is very close to the one obtained in the fixed effects and GLS regressions (0.299 as compared with 0.232 and 0.190, respectively), highlighting the robustness of this relationship. To interpret this result, it is helpful to compute explicitly the impact of public employment on the number of unemployed workers. The coefficient of the impact of public employment on unemployment is 0.299 with a standard error of 0.11. This result implies that the creation of 100 public jobs adds about 20 unemployed workers with a 95 percent confidence interval of [10, 40].20 In this specification the impact of public employment on private employment, although negative, is not statistically significant.

Table 3.4Three-Stage Least Squares Estimates of Simultaneous Equations: Unemployment–Public Employment and Private Employment–Public Employment
UnemploymentPublic EmploymentPrivate EmploymentPublic Employment
Country-specific effects
Public employment0.299***

(0.11)
−0.15

(0.28)
Change in productivity−3.277***0.9994.107*0.96
(0.90)(0.72)(2.31)(0.75)
Urbanization rate0.141

(0.09)
0.12

(0.09)
Population density0.0894***

(0.03)
0.0960***

(0.03)
Foreign trade openness2.183*

(1.14)
3.106**

(1.25)
Fixed effectYesYesYesYes
Time effectYesYesYesYes
Number of observations109109105105
R-squared0.9410.9290.9370.925
Institutional variables
Public employment−0.192

(0.13)
−0.706**

(0.33)
Change in productivity−0.07180.207.3720.223
(3.00)(2.00)(7.49)(2.01)
Urbanization rate0.0841***

(0.03)
0.0750***

(0.03)
Population density0.0013

(0.00)
0.000628

(0.00)
Foreign trade openness4.638***

(0.97)
4.334***

(0.98)
Cooperation in labor-employer relations−2.394**−2.362***4.929*−2.358***
(1.05)(0.73)(2.63)(0.74)
Flexibility of wage determination0.40−1.530***−7.193***−1.448**
(0.89)(0.59)(2.20)(0.58)
Rigidity of employment−0.144***(0.03)0.189*−0.0311
(0.04)(0.03)(0.10)(0.03)
Hiring and firing practices−3.344***3.255***9.970***3.245***
(1.25)(0.81)(3.10)(0.80)
Redundancy costs0.0314*−0.01780.0852*−0.0139
(0.02)(0.01)(0.05)(0.01)
Fixed effectNoNoNoNo
Time effectYesYesYesYes
Number of observations109.00109.00105105
R-squared0.2430.3840.2140.372
Source: IMF staff calculations.Note: Standard errors in parentheses.*** p<0.01, ** p<0.05, * p<0.1
Source: IMF staff calculations.Note: Standard errors in parentheses.*** p<0.01, ** p<0.05, * p<0.1

We find that public employment’s impact on private employment is negative and statistically significant in the regression specification with labor market institutions. The coefficient is very close to the one obtained in the OLS regression (−0.706 as compared with −0.696). This negative relationship suggests that public employment crowds out private employment, implying that the creation of 100 public jobs destroys 70 private jobs, on average, with a confidence interval of [−137, −5].21 This is a larger effect than the one identified by Boeri, Nicoletti, and Scarpetta (2000), who estimate destruction of 30 private jobs in response to the creation of 100 public jobs, but smaller than the estimates by Algan, Cahuc, and Zylberberg (2002) and Behar and Mok (2013), who estimate 150 and 100 crowding-out effects, respectively.

Trade openness appears to be the most significant variable determining public employment. It is significant at least at the 10 percent level in all specifications of the three-stage least squares regressions. This is also consistent with Rodrik’s (1997) findings. Although productivity growth increases public employment in line with Wagner’s law, its effect is not statistically significant. Population density is significant in the regression with country-specific effects but loses its significance when labor market institutions are added to the regression. In contrast, the urbanization rate is significant in the regression with labor market institutions and insignificant in the regression with country-specific effects. These estimates should be interpreted with caution, because the magnitude of the impact of public employment varies across different model specifications. However, one would expect a similar picture because the theory predicts that the impact of public employment should depend on the size of rents in the public sector, the substitutability of public production, and the impact of public employment on labor force participation.

The analysis below looks at the countries in which public employment destroys many jobs. The theoretical model suggests that these interactions should differ across countries according to two main criteria: (1) the size of rents in the public sector and (2) the degree of substitutability between public and private production. As a natural proxy for public sector rents we use the relative wage of the public sector with respect to the private sector.22 However, wage differentials do not fully account for the relative attractiveness of public employment, which also depends on working conditions, power and hierarchy aspects, job security, and other hard-to-measure characteristics. Therefore, we also use the Corruption Perception Index as an indirect measure of public sector rents. Based on the relative wage indicator, in about 80 percent of the countries considered, average public wages are greater than average private wages. Given that data on the shares of employment across different public activities are not available for a large set of countries, we use public-expenditure-based measures to cluster the countries by the substitutability criteria. We use two indicators: (1) the share of public spending on the health sector in total government spending, which has high substitutability; and (2) the share of public spending in total public expenditure devoted to defense, justice, and general administration, which has low substitutability. As in other cases, we run three-stage least squares estimates in two specifications: first with country-specific effects and second with variables that describe labor market institutions instead of country-specific effects.

The distortionary impact of public employment is stronger in countries with high public sector rents and highly substitutable public production compared with the private sector. We estimate simultaneous equation regressions based on splitting the sample according to rents in the public sector and degree of substitutability. When we use country-specific effects in all country group regressions, but substitutability based on health expenditure, public employment has a positive and statistically significant effect on the unemployment rate (Table 3.5). However, when we use variables describing labor market institutions instead of country-specific effects, the impact of public employment on the unemployment rate also becomes insignificant in the country group regression based on high wage premium (Annex Table 3.2.1). In addition, estimated coefficients of public employment based on split samples, even if they are statistically significant, are not statistically different from the coefficients estimated based on the full sample. In contrast, the estimated impact of public employment on private employment is negative and statistically significant in the regressions based on split samples using both country-specific effects and variables for labor market institutions. Moreover, the impact of public employment on private employment is much more negative with statistically significant differences from the coefficient estimated based on the full sample. This finding implies that public employment destroys more jobs in countries where public sector rents are higher relative to private sector rents and the public sector produces goods that are highly substitutable for private production. These results differ from Behar and Mok’s (2013) work. Behar and Mok (2013) find that public employment fully crowds out private employment, although it does not have a statistically significant impact on the unemployment rate. Our results based on split samples suggest more the full crowding out of private employment and the positive impact of public employment on the unemployment rate.

Table 3.5Three-Stage Least Squares Estimates of Public Employment Impact on Unemployment and Private Employment According to the Size of Public Rent and the Degree of Substitutability of Public Production
High Wage

Premium
High

Corruption
High Public Goods

Substitutability

(Spending on defense)
High Public Goods

Substitutability

(Spending on health)
Unemployment rate
Public employment0.464*0.219**0.334***0.321
(0.28)(0.10)(0.09)(0.35)
Productivity−2.480**−2.646***−4.751***−2.819*
(1.21)(0.94)(0.91)(1.62)
Fixed effectYesYesYesYes
Time effectsYes*Yes*Yes*Yes*
R-squared0.9350.940.9670.924
Number of observations83544860
Private employment
Public employment−1.451**−0.192−1.125***−1.882**
(0.69)(0.36)(0.30)(0.82)
Productivity3.9616.832*10.11.27
(3.11)(3.63)(6.29)(4.11)
Fixed effectYesYesYesYes
Time effectsYes*Yes*Yes*Yes*
R-squared0.9350.8680.430.947
Number of observations80534556
Source: IMF staff calculations.Note: Standard errors in parentheses.*** p<0.01, ** p<0.05, * p<0.1
Source: IMF staff calculations.Note: Standard errors in parentheses.*** p<0.01, ** p<0.05, * p<0.1

Conclusion

Policymakers often use public employment programs as a response to persistently high levels of unemployment. In the short term there might be some gains, but in the medium to long term, public employment may well increase unemployment. Public job creation could cause the destruction of private jobs by, for example, increasing labor taxes or exerting competitive pressure on private producers’ output and wages in the labor market in general.

We do not find any evidence that public employment reduces the unemployment rate in the medium to long term. If anything, we find some evidence that the creation of public sector jobs may increase the unemployment rate. However, this impact is not robust across different model specifications.

Our analysis provides support to the hypothesis that creation of public jobs in the medium to long term crowds out private sector jobs. More important, the negative impact of public employment on labor market outcomes is amplified when rents in the public sector (that is, wages and other nonwage benefits) are higher relative to the private sector and the government hires workers to produce goods that are substitutable for private sector goods, putting competitive pressure on private producers’ output. A large pool of well-paid public jobs creates biased incentives and attracts many people into the public sector, influencing their schooling decisions and eventually giving rise to a skills mismatch in the labor market. Our findings support the need for reforms to reduce the rents and the size of the public sector, which can improve labor market performance.

Governments in sub-Saharan Africa urgently need to invest in strengthening statistics on their labor markets, most notably on unemployment. As noted in Leigh and Flores (2013), unemployment indicators and the estimated implied unemployment rates vary significantly in a number of countries in the region. This divergence highlights the severe weakness in unemployment data for the sub-Saharan Africa region. More broadly, monitoring the effectiveness of job-creation policies in sub-Saharan Africa would require high-quality labor market statistics.

Our econometric results should be interpreted with caution.

They do not provide an assessment of the optimal level or size of public employment in SMICs. To determine the optimal level of public employment for these countries, policymakers should take into account a number of other country-specific features, such as exposure to international trade, the level of education of the population, the size of the country, and the degree of urbanization.23 However, to improve labor market outcomes in these countries, our results underscore the need for aligning public sector wages with those of the private sector, and for the public sector to provide complementary goods to the private sector.

Moreover, the results abstract from the fact that in the short term, some employment can be supported through some level of public intervention. In fact, some of these interventions, if well implemented, can enhance long-term employment. These policies are known as active labor market policies (ALMPs) and they include public works programs, for instance, temporary youth wage subsidies and other schemes to provide work experience and on-the-job training. As discussed in Annex 3.3, good ALMPs should be regarded as a bridge to long-term employment, and hence, aim to improve the employability of the labor force. ALMPs that are part of a package that tackles policy-induced distortions have had a significant and durable effect on employment. More successful ALMPs were designed with private sector cooperation as market-conforming interventions to correct distortions and failures in the labor market. A key consideration is that ultimately the effectiveness of ALMPs depends on prevailing conditions in the labor market and complementary measures to promote private investment and enhance global competitiveness. However, they should be carefully designed to prevent abuse and create net employment, with spending in this area tightly controlled given the fiscal cost of such schemes.

Box 3.1Why Structural Unemployment Has Been Persistently High in Botswana

Any discussion of the labor market in Botswana must recognize problems arising from the lack of timely and reliable data. Measures of unemployment are both irregular and infrequent—the most recent published estimates are for 2009/10; similarly, estimates of formal sector employment, plagued by poor survey response rates, are available only up to 2012 and omit small businesses, thus excluding a major driver of growth, economic diversification, and job creation. Any analysis must be tempered by recognition of these gaps. More generally, it reminds us that adequate investment in statistics is not a luxury for countries seeking to promote an inclusive growth agenda.1 In the absence of data, discussions of key policy issues such as poverty and unemployment, including assessments of the impact of government interventions, may be driven as much by misconception and unsupported assertions as informed analysis.

However, chronic unemployment is clearly a major developmental challenge for Botswana. The estimate for unemployment for 2009/10 is 17.8 percent of the active labor force ages 12 and older, and is typical of the estimates since the mid-1990s. This figure increases significantly if the number of discouraged workers and extent of underemployment are taken into account. Table 3.1.1 summarizes the breakdown of aggregate unemployment by age group, level of education, location, and gender. In summary, unemployment is concentrated among the young and among those living outside urban areas, those with less education, and those who are female.

Table 3.1.1Unemployment in Botswana. 2009/10(Percent)
Age (years)EducationLocationGender
<2037.0None11.7Cities/Towns13.1Male14.5
<3027.4Primary16.4Urban villages23.4Female21.4
<4015.3Secondary24.4Rural16.0
<5010.1Tertiary6.9
<608.4
60+2.5
Source: Statistics Botswana, Botswana Core Welfare Indicators Survey 2009/10.
Source: Statistics Botswana, Botswana Core Welfare Indicators Survey 2009/10.

Such a profile is broadly consistent with what might be expected, given Botswana’s development pattern. Notably, unemployment is lowest in the cities and towns, where a more dynamic market-based economy has been successfully established (in Gaborone, the capital city, unemployment was only 9.8 percent), and highest in the “urban villages,” which have largely moved away from the traditional rural lifestyle in which subsistence agriculture still absorbs available labor, but have not yet established major sources of job creation outside the public sector.

Overall, the relative constancy of the unemployment rate over a sustained period indicates that job creation has been sufficient to match population growth; in turn, this has been crucial for the extent of poverty reduction since the mid-1980s. Nonetheless, an overall unemployment rate of 17.8 percent is clearly too high for a country with Botswana’s record of sustained growth, average income levels, and development aspirations. A survey conducted by Afrobarometer in mid-2014 indicates that unemployment is regarded as the most pressing social problem facing the country, and the government has prioritized job creation, especially among the youth. This policy effort requires some understanding of the major structural impediments to job creation:

Skills mismatch. The World Economic Forum’s annual Global Competitiveness Report regularly identifies inadequate education of the labor force as among the most challenging factors for doing business in Botswana. Within the country, it is also widely accepted that high levels of spending on education, which have translated into favorable rankings on intermediate indicators such as enrollment rates, have not been matched by outcomes. One sign of this is that the highest rates of unemployment are for those who have completed at least some secondary education, indicating that such qualifications, while elevating their holders’ expectations, have little value in the workplace. Conversely, within the tertiary category, those with specific skills-related qualifications that are closely matched to job requirements (in the health and education sectors, for example) have the lowest unemployment rates.

A particular concern surrounds the rate of unemployment for people with tertiary education, which is perceived to be rising rapidly; however, in the absence of reliable and up-to-date information, most of the evidence for this is anecdotal and, quite possibly, exaggerated. (Unemployed graduates tend to be very vocal about their plight.) A breakdown of unemployment by education level still clearly indicates that unemployment is lowest for those with tertiary education. However, the days when graduates were in such short supply that they were rationed among potential employers are over, with a corresponding need to move beyond the belief, still widely held, that tertiary qualifications should be a passport to well-paid employment.

Low productivity. Analysis elsewhere in this book indicates that Botswana is no exception to the problem of low productivity growth among small middle-income countries in Africa. Inadequate skills are clearly a major contributor to low productivity growth, while a poor work ethic is another of the major challenges regularly highlighted in the Global Competitiveness Report. Statutory minimum wages in Botswana do not appear high compared with, for example, neighboring South Africa. But there is little sign that this spurs employment creation.

However, the use of total factor productivity as an indicator—although data issues again mean that such measures must be used with caution—is a reminder that productivity is not purely the responsibility of workers, but the production structure as a whole, including management, investment decisions, and more broadly, external influences that can affect, positively or negatively, business operations. Here, the role of government is crucial. Botswana may win plaudits for being ranked the least corrupt country in Africa; but this says little about basic issues of excessive bureaucracy and administrative inefficiency, which are regularly flagged in other assessments such as the Ease of Doing Business index from the World Bank. Moreover, potentially conflicting policy objectives, including demands for “citizen empowerment” that drive an increasingly restrictive approach to the use of foreign labor to supplement the local skills base, can be a further drag on productivity and competitiveness. Transport logistics, key for a land-locked country, are another area in which Botswana continues to lag behind its peers.

High reservation wages. The issue of high reservation wages is relevant across a range of skill levels, indicated by an array of evidence. Unemployment has continued to remain concentrated among the youth rather than feeding over time into older cohorts, suggesting that most of the initially unemployed eventually find jobs or become discouraged workers and drop out of the labor force. It is also notable that the largest number of work permits (26.7 percent as of September 2012) are for elementary occupations, predominantly in agriculture, where minimum wages, even if applied, are much lower than for other sectors. At the other end of the scale, evidence of high reservation wages among graduates is supported more by anecdotal evidence, including frequent complaints that that they are not offered remuneration in line with their qualifications.

Government employment policies. Government accounts for by far the largest share of formal sector employment (39 percent in 2012; or 44 percent if parastatals are included), and for unskilled workers in particular there is a substantial premium compared with the minimum wage. However, limited recruitment in recent years has restricted the number of employment opportunities, while minimum wages necessarily follow government salary adjustments. Thus, social welfare policy interventions,2 under which payments may be sufficient to deter job-seeking among the less skilled while providing little in the way of skills transfer to improve employment prospects, may have a more significant impact on wider labor market outcomes. For those with more skills and experience, the wage premium is reversed, with the private sector offering more attractive remuneration.

This box was prepared by staff from Bank of Botswana.1 At the time of writing, of the six African small middle-income countries, only Mauritius subscribes to the IMF’s Special Data Dissemination Standard, which includes labor market indicators as a key component.2 The Ipelegeng (labor-intensive public works) program, for example, which, as of late 2012 covered about 52,000 people, the equivalent to almost 16 percent of those in formal employment.

Box 3.2Implementation of Active Labor Market Programs in Selected Small Middle-Income Countries in Sub-Saharan Africa

Botswana’s Road Maintenance Project (1999). This project was implemented to alleviate poverty through employment creation and enhance infrastructure development. The program provided young people in rural areas with short-term employment in public works and technical training in road maintenance and repair.

Botswana’s and Namibia’s Sector-Specific Tax Incentives were implemented in part to enhance job creation. Since 2000, as part of their efforts to compete for capital and foreign direct investment in the region and also to alleviate poverty, these two SMICs used tax incentives to specific sectors to create job opportunities. However, the incentives did not address the underlying causes and weaknesses in the labor market and the broader economy that gave rise to high levels of structural unemployment. These programs have so far not been successful in creating a large number of jobs in a sustainable manner.

Namibia’s Targeted Intervention Program for Employment and Economic Growth (TIPEEG). In the fiscal year 2011/12 budget, the government of Namibia announced TIPEEG to support job creation and more diversified growth in the economy. TIPEEG aimed to create permanent and temporary employment in selected economic sectors and in the public sector, as well as in critical infrastructure needed for sustained growth. A number of issues prevented TIPEEG from creating as many jobs as initially estimated. One was the lack of skilled engineers to implement projects targeted by TIPEEG. The initial program could also have built in a skills-development component so that workers could be employable after the program. TIPEEG led to a large fiscal expansion, and as noted in Chapter 2, in a pegged exchange rate regime fiscal expansion can often lead to a decline in official reserves to less than their appropriate or optimal levels, thereby creating external vulnerabilities for the economy.

Namibia’s Vocational Education and Training Levy. Taxation and incentives to companies were used to retain and train employees, with the levy covering the administrative costs of the National Training Fund, the training grants, and key priority grants. A 1 percent levy is imposed on the payroll of every employer with an annual payroll greater than 1 million Namibian dollars. Employers are then eligible to apply for training grants provided they comply with certain requirements, such as proportion of employee being trained; training linked to the business objectives of the company; training aligned with the labor market; training that provides skills for accelerated development, and competencies are developed during the training; training that provides avenues for promotion or employability; and training that provides access to opportunities and equity. At the time this chapter was prepared, the program was in its infancy, thus it is premature to assess its impact.

Mauritius’s public works program focuses on both improving a wide range of government services and providing work experience to young graduates through internships for up to three years. Nonetheless, relatively high wages in the public sector have raised reservation wages and lengthened job search. In the face of labor shortages, the country has had to import foreign labor because the unemployed are unwilling to take available private sector employment. In response, the government has attempted to lower entry level wages in the public sector.

Mauritius’s wage subsidy program is part of a social contract with employers to deal with the market failures that often contribute to skills mismatches in the labor market. Half of the wages and training costs in private sector employment are borne by the government. As a result, long-term employment is offered to at least half of those hired under the program. Complementary measures include facilitation of the hiring of foreign workers to meet remaining skills shortages, improvements to the business climate based on close coordination with the private sector, and creation of mechanisms to involve private sector input in education content.

Annex 3.1. Theoretical Model

We consider a labor market with private and public jobs. Working-age population is normalized to 1, and N ≤ 1 denotes labor market participation. In the private sector, a representative firm produces output using labor as the only factor in the production function:

in which Lp denotes private employment.

There are Lg jobs in the public sector, each producing a unit of a public good. All individuals have the same preferences, and an individual whose income is w has the following utility:

Unemployed workers have no income, and only derive utility from the public good. There is no job-to-job mobility. The unemployed workers (U = NLpLg) can search either for a public job or for a private job. In equilibrium, they must be indifferent between the two choices on the basis of rational expectations as to wages and employment prospects in the two sectors.

A trade union aims to maximize the total utility of the Np workers who belong to the private sector. Assume that the expected utility of an unemployed worker in the private sector has the following form:

in which wp and up = (NpLp)/Np) are the wage and the unemployment rate in the private sector.

The objective of the trade union is

The implications of this simple model are qualitatively similar to those of a model with explicit flows between employment and unemployment (Layard, Nickell, and Jackman 1991). A standard right-to-manage Nash (1950) bargaining program with π ∈ [0,1] bargaining power of workers and disagreement payoffs NpZp for the union and zero for the firm yields the following condition:

This provides an interior solution with Lp < Np.24 The Cobb-Douglas technology implies that the unemployment rate is independent of the labor force size, and only depends on the wage markup μp in the private sector. By substituting equation (3.1.4) into equation (3.1.1) we have

Thus, private sector unemployment is not directly influenced by public employment, which can affect aggregate unemployment by altering the allocation of Ng and Np workers to the two sectors. Hence, the private wage, wp = AF′[Np(1 – up)], is also influenced by the size of the public sector through changes in Np.

In the public sector, the job-finding probability is Lg/Ng. Thus, the expected utility of a worker who looks for a job in the public sector is

in which wg denotes the wage in the public sector. For simplicity, let the wage in the public sector be proportional to the private wage, wg = λwp, where λ > 0 measures the relative level of public sector wages with respect to private sector wages.25

In equilibrium, unemployed workers must have the same expected utility in the private and public sectors:

which, combined with equations (3.1.1), (3.1.5), (3.1.6), and (3.1.7), yields

Hence, the number of workers in the public sector increases with the number of public jobs, and does so more strongly when λ is large (public wages are high relative to private wages). Using equations (3.1.5), (3.1.8), and the identity ugNg = NgLg yields

This result suggests that the unemployment rate is higher in the public sector than in the private sector if and only if λ > 1, that is, if wages are higher in the public sector.

From equations (3.1.5) and (3.1.8) and the identity N = Np + Ng we have

This suggests that private jobs are necessarily crowded out by public jobs, and the effect is stronger when λ is larger. We can derive an expression for the aggregate unemployment rate using the identity U + Lp + Lg = N together with equations (3.1.5) and (3.1.9):

Public sector expansion decreases the unemployment rate if and only if λ = wg/wp < 1.

The results derived above take the participation rate as given. It is not difficult, however, to study the effects of public employment on participation. Let individuals enjoy different utility levels Z when out of the labor market. The distribution of utility levels is denoted F(Z). Labor market participation is only attractive for individuals whose Z is such that utility out of the labor force, Z + H(Lg), is lower than the Z level of utility defined in equation (3.1.7). Using equations (3.1.6) and (3.1.8) and the relationship wp=AF(Lp)=AF[Nμp-λLg], we can write the participation rate F[z − H(Lg)] of the unitary population as follows:

This equation implies that the participation rate increases with public employment, which crowds out private jobs, increases marginal productivity and wages in the private sector, and therefore attracts workers into the labor market. According to equation (3.1.9), there are N/μp – λLg private jobs; hence, higher participation increases private employment and reduces the crowding-out effect of public jobs on the private sector. Accordingly, our basic model suggests that the response of participation to public employment tends to soften the crowding-out effect of the public sector. Public jobs, however, may influence participation through several other channels. They can affect the out-of-labor-market welfare Z by producing goods valuable in that state, and they can also influence productivity in the private sector.

For public employment we consider the case in which its level is chosen by a benevolent government to maximize the difference between a public good’s social value, H(Lg), and its cost, wgLg. For simplicity, suppose public employment is financed on a lump-sum basis. Then, public labor demand is given by the following condition, H′(Lg) = wg. Also for simplicity, let participation be exogenous (N = 1), and suppose public wages are negotiated by a representative trade union and the government.26 Then, the objective function of the public sector trade union is similar to the private sector one above:

With the γ ∈ [0, 1] relative bargaining power of public sector workers, wages are set by the Nash program as follows:

whose interior solution satisfies

in which β = Lg H′(Lg)/H(Lg). Equation (3.1.13), together with equation (3.1.4) and the arbitrage condition in equation (3.1.7), implies the following:

Thus, relative wages in the two sectors are determined by wage markups, which in turn depend on labor demand elasticity and bargaining power parameters. According to Ehrenberg and Schwarz (1986), labor demand elasticity is empirically similar for public and private jobs. Trade union density, however, is usually higher in the public sector. Thus, employees may enjoy higher rents in the public than in the private sector.

Because the public wage is equal to marginal productivity in the private sector, equations (3.1.9), (3.1.13), and (3.1.14) yield the following:

Equation (3.1.15) shows that the government creates public jobs up to the point at which the marginal utility of the public good is equal to its marginal social cost. As the marginal cost of the public good increases with the ratio λ = wg/wp, a high wage in the public sector induces the government to create fewer public jobs.

Annex 3.2. Results of Three-Stage Least Squares Estimations with Labor Market Institutions
Annex Table 3.2.1Three-Stage Least Squares Estimates of Public Employment Impact on Unemployment and Private Employment Based on the Size of Public Rents and the Substitutability of Public Production, with Labor Market Institutions instead of Country-Specific Effects
High Wage

Premium
High

Corruption
High Public Goods

Substitutability

(Spending on

defense)
High Public Goods

Substitutability

(Spending on health)
Unemployment rate
Public employment0.3140.169*0.268***0.253
(0.28)(0.10)(0.09)(0.35)
Productivity−2.484**−2.642***−4.671***−2.789*
(1.21)(0.94)(0.91)(1.62)
Cooperation in labor-employer relations2.351**3.197***2.087***5.612***
(1.04)(1.00)(0.57)(0.69)
Flexibility of wage determination−2.588***−1.255*−3.000***3.173
(0.98)(0.68)(0.41)(3.34)
Rigidity of employment0.0432**

(0.02)
−0.0271

(0.02)
−0.025

(0.03)
−0.132

(0.11)
Hiring and firing practices2.902***0.3530.858−9.298***
(1.00)(0.76)(0.98)(1.61)
Redundancy costs3.70E-050.0828***0.209***0.147***
(0.02)(0.02)(0.01)(0.05)
Time effectsYes*Yes*Yes*Yes*
p-value of the interaction coefficient10.6870.7330.7130.83
R-squared0.9350.940.9680.924
Number of observations83544860
Private employment
Public employment−2.009***−0.0615−1.125***−2.694***
(0.48)(0.36)(0.30)(0.81)
Productivity9.856.168*10.11.588
(9.00)(3.62)(6.29)(4.11)
Cooperation in labor-employer relations8.06***−16.56***−5.3816.203***
(2.81)(3.77)(4.16)(1.61)
Flexibility of wage determination−6.369*25.67***−3.41338.95***
(3.36)(2.57)(2.85)(7.72)
Rigidity of employment0.001840.02310.243−1.127***
(0.11)(0.09)(0.17)(0.25)
Hiring and firing practices6.294*−1.814.03***−18.98***
(3.63)(2.87)(4.03)(3.70)
Redundancy costs0.0834*0.07890.134**−0.523***
(0.05)(0.06)(0.06)(0.12)
Time effectsYes*Yes*Yes*Yes*
p-value of the interaction coefficient10.004***0.003***0.000***0.000***
R-squared0.3450.8670.430.946
Number of observations80534556
Note: Standard errors in parentheses.

This is the p-value from a test that the interaction coefficient on higher rent in the public sector and higher substitutability of public prudaction in a full-sample specifications is equal to zero.

*** p<0.01, ** p<0.05, * p<0.1
Note: Standard errors in parentheses.

This is the p-value from a test that the interaction coefficient on higher rent in the public sector and higher substitutability of public prudaction in a full-sample specifications is equal to zero.

*** p<0.01, ** p<0.05, * p<0.1
Annex 3.3. Active Labor Market Policies (ALMPS) In Sub-Saharan Africa—Cross-Country Experience27

With many countries in the region facing challenges in boosting job creation, the issue of public intervention in the labor market—either through public works or through wage subsidies—is gaining prominence. This annex summarizes the state of play of active labor market policies (ALMPs), particularly on subsidized employment, in SMICs in sub-Saharan Africa. The findings suggest that, although these programs could be part of the broader policy agenda for supporting more inclusive growth, and provide an important safety net for the unemployed, in many cases they tend to be costly and generally do not have a sustained impact on job creation. For the impact of subsidized employment to be significant and durable, ALMPs need to be part of a package that tackles policy-induced distortions. A key consideration is that ultimately the effectiveness of ALMPs depends on prevailing conditions in the labor market and on complementary measures to promote private investment and enhance global competitiveness. ALMPs are more likely to succeed if they are designed together with the private sector as market-conforming interventions to correct distortions and failures in the labor market.

ALMPs have been introduced in many developing countries to raise employment levels. With objectives ranging from consumption smoothing to poverty reduction and sustainable economic development, they aim to help the unemployed find productive employment by improving the matching of labor demand and supply. ALMPs can be classified into two main categories according to the activities they use to increase employment opportunities:

  • Enhancing the employability of labor supply. Employers usually consider unskilled and inexperienced job seekers to be risky investments, in part because of the high fixed costs of training. Markets are imperfect in transmitting information to employers on the capacity of potential employees, and the education system, as well as parents and students, may not have information about the skills that will be required on graduation (resulting in the so-called skills mismatch). Therefore, when unemployment is concentrated among the unskilled and inexperienced, market-conforming interventions may be required to emphasize the role of relevant training in increasing employment opportunities. Policies in this category include education reform (including stronger consultations with employers on their needs and emphasis on job placement during tertiary education), vocational or entrepreneurial training schemes (that could also be offered at subsidized rates to those offered employment), job search assistance, and access to financing for self-employment.
  • Stimulating labor demand. ALMPs to boost labor demand through subsidized employment programs can be implemented in either the public or private sector. The market failures may reflect temporary shocks that depress labor demand below its trend. Intervention may be useful to the extent that there is a loss of skills during unemployment and that retraining newly hired workers, even with experience, may be costly. Moreover, the social costs to support those who are unemployed may be higher than the costs to subsidize their employment. Because of the high costs of implementation and the transitory nature of the shocks they respond to (such as natural disasters, conflicts, macroeconomic crises, or seasonal fluctuations in employment28), such programs are usually used only temporarily. ALMPs may also be used to deal with structural unemployment. However, these efforts are unlikely to be successful unless the labor and product market distortions that limit labor demand are tackled in parallel. International experience suggests that there is no excess labor supply in a business-friendly environment and with macroeconomic policies that sustain global competitiveness. In addition to actions to unlock private investment and exports, ALMPs that aim to stimulate labor demand should mostly be combined with measures to enhance the employability of labor. The interventions should target the inexperienced or long-term unemployed, and focus on skills development, which would improve employability upon expiration of the program. In other words, ALMPs with the objective of increasing long-term employment should be regarded as a bridge to employment, and thus temporary.

To address high unemployment, particularly among the youth, ALMPs in sub-Saharan Africa often take the form of subsidized employment programs, which combine enhancing the employability of labor with stimulating labor demand.29 Unemployment in sub-Saharan Africa, particularly for youth, is partly due to the lack of skills and experience. First, subsidized employment programs can create short-term employment opportunities for the unemployed and inexperienced workers. Second, these jobs are temporary and aim to offer training, which allows workers participating in these programs to gain relevant skills needed for them to obtain permanent employment in the labor market. Third, from a political economy perspective these subsidized employment programs have the added benefit of ensuring that the government is perceived to be doing something to address the situation. These subsidized employment programs include the following:

  • Public employment programs provide the working population with not only short-term employment and a source of income but also experience and possibly training that could facilitate their absorption into the labor market. Public employment programs usually create job opportunities by expanding labor-intensive production through government-funded projects in sectors such as infrastructure, the environment, and social sectors (del Ninno, Subbarao, and Milazzo 2009). As a result, they can also promote public services. For example, employment opportunities in various countries are created for road maintenance projects (for example, in Botswana), microenterprises, and home-based care.
  • Wage subsidies offer firms incentives to employ more workers by, for instance, directly subsidizing the cost of labor or providing tax credits (for example, in Botswana and Mauritius). Their objective is to expand employment and output by lowering employers’ costs of employment without affecting workers’ take-home wages. Wage subsidies can affect the composition of the labor force as a result of their targeting scheme. Their direct effect on overall unemployment, however, depends on the elasticity of substitution of factor inputs (Heintz and Bowles 1996). In addition, wage subsidies could affect overall employment through long-term changes in profitability and labor productivity, which induce greater investment. This is known as the scale effect of wage subsidies (Lewis 2001).
  • Generous tax incentives to specific sectors are offered in some of the SMICs in sub-Saharan Africa as an unorthodox ALMP measure to boost job creation, especially in natural-resource-rich countries. However, such sector-specific tax incentives are often implemented without thorough analysis of the fundamental causes of high structural unemployment. Depending on the sector, these causes could include a lack of appropriate skills, bottlenecks with logistics and infrastructure, obstacles to technology transfer, poorly designed regulation with costly compliance, and macroeconomic policies that fail to promote global competitiveness. Attempts to promote employment creation through generous tax incentives not only leave the underlying problems unaddressed, but may also reduce the incentives for the government to work with the private sector to address them. Thus, they could undermine the sustainability of employment creation. In addition, reducing the effective cost of capital through tax incentives will limit the current bias of tax incentives toward capital-intensive sectors in many MICs. “Picking winners” and other ALMPs may be costly and therefore difficult to scale up if distortions and market failures that limit investment and production are not also addressed. Consequently, ALMPs do not necessarily deliver a sustained impact on job creation, and may create further distortions in the labor market. Instead, emphasis should be put on measures that would boost competitiveness and economy-wide productivity to enhance job creation through investment and globally competitive production.

Country Experiences

What does experience in sub-Saharan Africa and other regions suggest about the types of ALMPs that work? Although there are no silver bullets, experience thus far seems to suggest that ALMPs must be implemented with great care to avoid undesirable results such as crowding out private sector employment, labor market distortions, and misallocation of public resources. In particular, if inappropriately designed, public employment programs and wage subsidies would not lead to a net increase in permanent employment, and often are costly to the budget. Specifically, the following issues need to be borne in mind when looking at ALMP measures:

  • First, if wages are set at an inappropriate level, subsidized employment in the public sector can crowd out private employment by increasing average wages and encouraging queuing for subsidized jobs. The queuing to enter subsidized sectors has been evident in some SMICs, such as Botswana, Mauritius, and Namibia. More flexibility in the wage-setting mechanism, supported by well-designed and targeted active labor market measures as in Mauritius, can, in some specific circumstances, support employment by better aligning wages with productivity levels at the firm level.
  • Second, workers targeted by the program may be substituted for other workers because the targeted workers have relatively cheaper labor costs (Aislabie 1980). Concerns have been rising in some SMICs about the adverse substitution effects of the employment tax incentive due to limited worker protection. Without proper monitoring, this effect would create dual or segmented labor markets and result in the replacement of existing workers who may have been subsidized workers in an earlier period. This would lead to effects that are similar to those of the so-called insider-outsider phenomenon. The stronger substitution effects would lead to a lower impact in reducing overall unemployment.
  • Furthermore, skills obtained from such a program, if any, may not be sufficient or relevant to make employment in the private sector more productive. As a result, job creation may not be generated on a sustainable basis, especially in countries where lack of skills and experience is an important cause of unemployment among low-skilled youth (for example, Mauritius and Namibia).30 This suggests that effective coordination between the public and private sectors is needed to identify the skills required in the labor market, for instance, through internship programs between the government and various industries that are currently being piloted in Botswana. It also suggests that programs should focus on subsidizing employment in the private rather than the public sector.
  • Moreover, subsidized employment programs are financed either by reprioritizing the budget or by increasing revenues through general taxation. The negative effects of these financing options might offset the positive impact of subsidized employment programs, particularly if the impact is not durable and the cost is too prohibitive to allow the scaling up that would be required to solve the unemployment problem.31 This fallacy of composition could be aggravated when there is a youth bulge entering the labor market.
  • Finally, a nontraditional ALMP that is now increasingly used in SMICs is targeted tax incentives to sectors in which the employment multipliers are deemed to be high. This policy creates further distortions in the labor market, and is costly and nontransparent because the tax expenditures are not evident. Paradoxically, job creation can be boosted in many SMICs by reducing tax incentives provided to capital and redistributing these benefits by lowering income tax rates. The increased effective cost of capital would constrain the current bias toward capital-intensive sectors (without increasing tax burdens), and thus make labor less costly in relative terms. Nonetheless, some caution is warranted because there could be a potential employment loss, particularly when capital and labor are strong complements.

Assessing ALMP Measures in IMF Surveillance of SMICs

In general, there is a need to be pragmatic and results-oriented when looking at ALMP measures in the context of country work on SMICs. Assessments of ALMPs need to take into account the prevailing conditions in the labor market (including labor market institutions) and the distortions, as well as policy and market failures, that limit private investment for globally competitive production. Specifically,

  • ALMPs, by themselves, are not a panacea for addressing the persistently high level of unemployment in many SMICs, especially when the unemployment challenge is largely structural rather than cyclical.32 In addition, significant time is often required to design and implement such a program, which makes it even more difficult to act countercyclically during a downturn (in some countries, such as Botswana, the downturn is seasonal, for example, due to drought, and the government has a set protocol in place). Furthermore, public works programs will likely not have a permanent impact on job creation in the presence of broader distortions in the labor market, including rigid labor laws. Thus, they need to be implemented in an environment of more flexible wage bargaining mechanisms and low costs of hiring and firing. Policies should aim to protect employment and not jobs.
  • Public works programs also need to include a skills-development component to give workers the chance to acquire skills that will be marketable upon completion of the public works projects. More generally, a durable pickup in job creation that reduces mass unemployment seems unattainable without major labor and product market reforms, including smarter regulations that have low compliance costs. Reducing the skills deficiencies of the unemployed is a gradual process that takes time to yield fruit in many countries in sub-Saharan Africa. Deep reforms to the education and vocational training systems will be required with strong inputs from private employers. Within any given distribution of skills, the ability of individuals to find jobs depends, in part, on the structure of the labor and product markets. Ultimately, structural policies are needed to raise potential growth and make it more labor intensive.
  • In the short term, some employment can be supported by ALMP measures. These policies include temporary youth wage subsidies, transport subsidies for job seekers, and schemes to provide work experience and on-the-job training. However, the schemes should be carefully designed to prevent abuse and create net employment, with spending in this area tightly controlled given the fiscal cost of such schemes. Temporary public works programs could also provide an important safety net for the unemployed, would be self-selecting if wages are kept low, and would not permanently increase the public wage bill.
  • In many SMICs, however, the recent increase in public sector employment is not a cost-effective or efficient way to increase employment. Public sector employment increases tend to generate a host of other distortions in the labor market that, on balance, destroy jobs (as demonstrated in this chapter). They could also crowd out critical social spending and put upward pressure on wages in the economy, thereby limiting the impact on aggregate employment. Another aspect of ALMPs is how they can handle the gender aspects of unemployment. For more details on ALMPs and gender-biased unemployment, see Dejardin (1996).
  • Overall, the high unemployment rate in many SMICs in sub-Saharan Africa is driven by public sector wage policies, which distort labor market outcomes (Leigh and Flores 2013) and impede a business-friendly climate. Macroeconomic policies may also need to be adapted to support global competitiveness. In many SMICs, government hiring practices and wage awards for public servants have typically inflated wage expectations and placed a premium on graduates with degrees that fail to provide the skills in demand in the private sector. They also sometimes lead to high reservation wages and extended job search periods. Too often, this situation exacerbates the misalignment of labor productivity and real wages, further depressing overall employment and generating more pressure for inappropriate expansion of public sector employment.
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1Botswana, Cabo Verde, Lesotho, Mauritius, Namibia, Seychelles, Swaziland.
2To our knowledge the only other paper that looks at the impact of public employment on labor market outcomes in developing countries is Behar and Mok (2013).
3The studies done by Algan, Cahuc, and Zylberberg (2002) and Behar and Mok (2013) are the most relevant to this chapter. While, similar to our work, Algan, Cahuc, and Zylberberg (2002) explore the role of rents in the public sector and substitutability of public employment in the impact of public employment on unemployment and private employment, Behar and Mok (2013) look only at the impact of public employment on the unemployment rate and private employment at the aggregate level.
4We follow a simple theoretical framework, similar to that outlined in Algan, Cahuc, and Zylberberg (2002).
5For more details, see Holmlund and Linden (1993) and Holmlund (1997).
6A detailed description of the theoretical model is presented in Annex 3.1.
7Rents in the public sector refer to wages, nonwage benefits, and other hard-to-measure factors, such as job security and working conditions.
8The sample size was subject to the availability of data across of our cross-country sample. This a heterogeneous group and some countries included in the sample are different from the seven SMICs that are the focus of this book.
9Data for unemployment do not include discouraged workers.
10Four out of the seven SMICs that are the subject of this book—Botswana, Mauritius, Namibia, and Seychelles—are included in our sample.
11In some of the countries, public employment may include temporary public workers. However, the share of temporary public workers in total public employment is very small.
12Data limitations prevent us from averaging time-varying series over five-year periods; the three-year periods may not fully assume away the impact of transitory shocks. However, the fact that private sector labor demand is lower during periods of weak economic activity will be controlled for by GDP per capita growth in the simultaneous equation regression.
13Wagner’s law predicts that the development of an industrial economy will be accompanied by an increased share of public expenditure in gross national product (see Musgrave 1985).
14Ukraine and Belarus play a significant role in generating the negative correlation, reflecting the fact that in both countries the share of public employment in the working-age population was broadly stable at a relatively high level, while unemployment has decreased and stabilized at a low level.
15This difference would be even more pronounced if we use the share of public employment in total employment, given the low labor force participation rate in the SMICs in sub-Saharan Africa.
16The variables describing labor market institutions have displayed small variations during the past few decades. Therefore, traditionally they are considered to be time invariant in this literature and capture country fixed effects.
17We use a two-stage least squares estimation method as well, which produces broadly similar results.
18The J test for overidentifying restrictions failed to reject the null hypothesis that the coefficients on the instruments are zero.
19All instruments included in the first stage individually have statistically significant impacts on public employment. The F-statistic of the first stage of the three-stage least squares regressions for both equations is about 2. Although this suggests that the coefficients of all instruments jointly are different from 0 at the 95 percent confidence level, it also suggests that our instruments are not very strong.
20If the unemployment rate in the regression is a fraction of labor force (LF), while public employment (PE) is a fraction of the working-age population (WA), we have dU = 0.299 × (LF/WA) × dPE. Because (LF/WA) on average is 0.696, we have the estimated 0.2 effect on the number of unemployed people.
21Because both public and private employment (PRE) are fractions of the working-age population, we have dPRE= -0.7 × d.PE.
22We do not have relative wage data for two countries in our sample.
24An efficient bargaining model as in MacDonald and Solow (1981) would have the same qualitative implications.
25It could be shown that such proportionality can be rationalized by an explicit model of collective bargaining in the public sector.
26Holmlund (1993) makes similar assumptions in a model focused on distortionary taxation effects.
27Prepared by La-Bhus Fah Jirasavetakul and Lamin Leigh.
28Labor-intensive public works in Botswana were historically associated with drought relief.
29Examples of these subsidized employment programs in sub-Saharan Africa are presented in Box 3.2.
30This is a point that was also noted in the 2014 annual meetings by the African Development Bank.
31In addition, ALMPs could have a significant impact on growth and productivity through debt financing. The recent work on policies that could lift up potential growth in MICs shows a concave relationship between debt and total factor productivity (see Chapter 4 of this book and IMF [2014]). One way to interpret the concave relationship between debt and growth is as follows: At the initial stage, issuance of government debt contributes to the development of financial markets, which positively affects productivity growth. However, a high level of government debt starts to crowd out private investment and pushes long-term interest rates up, which has negative implications for productivity.
32Despite being more relevant to MICs (because of the main objective of reducing unemployment through formal job creation), ALMPs could also be tailored to some of the frontier markets in sub-Saharan Africa, where informality and underemployment—rather than unemployment—are the main issues. In this case, ALMPs should focus on interventions to increase productivity in the informal sectors in the long term, such as entrepreneurial skill development and business training. In addition, ALMPs in sub-Saharan African frontier markets could be supported by policies to enhance the business environment, including the development of product-market networks and regulations.

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