Chapter

V Policy Lessons: Reducing Unemployment in Transition

Author(s):
Philippe Egoume Bossogo, Jerald Schiff, Miho Ihara, Tetsuya Konuki, and Kornelia Krajnyak
Published Date:
July 2006
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This paper has sought to describe and explain labor market performance during transition in CEE countries. Among our key findings are:

  • Initial declines in employment and the emergence of high unemployment have persisted in most transition economies, even following the resumption of reasonably strong economic growth. This partly reflects the fact that growth was initially driven by gains in productivity, including via significant job shedding. Because the scope for such gains is becoming smaller in more advanced transition economies, further economic growth may now become more job-rich. However, countries with significant restructuring remaining may experience further bouts of joblessness.

  • Labor market policies and institutions, while not necessarily a dominant factor, appear to have influenced unemployment developments across countries. Data problems have limited our ability to identify precisely the role of labor policies and institutions. Nevertheless, the paper does find evidence that a higher unemployment insurance replacement rate and a larger tax wedge on labor income limit the ability of economies to generate jobs in response to positive shocks. Moreover, strict employment protection legislation is associated with an expanded shadow economy, with potential impact on productivity and labor demand.

  • Regional variations in unemployment have persisted and, in some cases, widened. The inability to deal with the problems of high-unemployment regions has contributed both to the persistence of high aggregate unemployment as well as the high levels of long-term unemployment in many transition economies. Market forces—the flow of workers to low-unemployment regions or the movement of jobs to regions with surplus labor—have not been effective in addressing these concerns. Rather, the tendency of more highly skilled workers to migrate from poor regions and for advantaged regions to attract greater investment points to the potential for further regional divergence. Labor market policies may contribute to this process if a relatively generous minimum wage is implemented uniformly across regions or if unemployment insurance (or other social assistance) does not take account of differing regional price levels.

  • Continued high unemployment also reflects policies outside the labor market. High home ownership rates, constraints on the development of a housing rental market-and credit market imperfections may hinder labor mobility. Business climate problems can limit the dynamism of the small and medium-sized enterprise sector, which is typically an important generator of jobs. And poor infrastructure can doom regions to a high-unemployment equilibrium

Perhaps the strongest message for transition economies that arises from our analysis is: to bring unemployment down, complete the reform process as quickly as possible. While market-oriented reform is likely to stimulate economic growth before—and in some cases well before—employment growth, advanced reformers do experience employment growth. Many of the countries in our sample now appear to be at the start of the stage in which economic growth is job rich, although several others have seen labor market performance deteriorate with second-round restructuring or macroeconomic downturns. Perhaps the greatest danger is that the political costs of being in the high-growth/low-employment stage of transition will constrain countries’ ability to complete the reform process and move to the stage of more job-rich growth. This consideration is potentially relevant for a broader range of countries than those considered here. Any country implementing reforms that increase productivity sharply may confront the trade-off between short-run employment costs and longer-term gains.

The paper also suggests that transition economies could improve their unemployment picture by cutting taxes on labor income, but this is not an easy task. Labor taxation is one area in which the transition economies score rather badly—worse, in particular, than the EU–15 countries—and our results suggest that a cut in marginal rates could have a modest impact on labor market performance. However, reducing social security contribution rates is complicated Policy Lessons: Reducing Unemployment in Transition by aging populations and already strained pension systems. Moreover, replacing lost direct tax revenue with indirect taxation, while an option, can have negative consequences for income distribution and may be politically difficult.

Our cases studies seem to suggest at least one potential difference between good and bad performers: those with relatively low unemployment tend to have good business climates. Thus, successfully tackling the broad array of issues influencing a country’s overall business climate may be critical in stimulating employment growth in transition, including in small and medium-sized enterprises. In part this may require an overhaul of laws and regulations limiting entry of new firms. But it appears that implementation of these laws and regulations-heavily influenced by the effectiveness of the legal system and governance more generally—may be at least as important. In some countries, rigid employment regulations are likely to have discouraged new business entry or expansion of employment and led to an expanded shadow economy.

The paper suggests also that governments may need to consider policy measures to help specific regions pull out of high unemployment traps. One approach is to remove constraints on labor mobility, by providing better information on job opportunities nationwide and/or addressing housing market distortions—for example, through easing rent controls, appropriately balancing tenant and landlord rights, or eliminating distortions in the tax system tilted toward home ownership and against the rental market. However, simply easing labor mobility is likely to affect primarily the better-skilled, potentially leaving high-unemployment regions further disadvantaged with respect to investment and job creation. Thus, such an approach would need to go hand in hand with efforts to bring jobs to the high-unemployment regions. Our analysis points toward several types of measures that could be effective in this regard, although policy design would need to be carefully considered to ensure that the policies were effective and their fiscal costs acceptable:

  • On the labor supply side, careful design of the tax-benefit system may help eliminate welfare traps. However “subsistence traps” are unlikely to disappear until wages significantly exceed subsistence income—that is, until later stages of transition. Participation rates for the low-skilled may remain low despite welfare reform.

  • Provision of basic infrastructure could be critical in attracting investment and lifting a region out of high-unemployment equilibrium. Putting emphasis on developing transport infrastructure to link problem regions more tightly with foreign and domestic markets should be a priority.

  • Properly designed job training could potentially make a high-unemployment region more attractive to investors, helping to pull the region out of its high-unemployment equilibrium. Most transition countries spend relatively little on training. Bringing the local skill mix closer to the one demanded by dynamic industries could be helped by an emphasis on updating skills and on lifelong learning. Given the extent of the skill mismatch—as a share of the labor force and as the distance between the actual and desired skill mix—active labor market policies could potentially have significant payoffs. However, the evidence on the effectiveness of such policies in mature economies is not clear-cut, and international experience and domestic pilot programs should be used to identify the most promising schemes.

  • Tax incentives for investors in high-unemployment regions could serve as the initial push needed by these regions, but also run significant risks. It is extremely difficult to design and implement such tax regimes in a manner that ensures that only marginal investments receive such benefits and that tax evasion is not facilitated. Further, if the incentives are not effective in attracting a critical mass of investors, agglomeration benefits will not accrue, and the investors may relocate as soon as the incentives expire.

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