Ecuador: Selected Issues and Statistical Annex

The crisis in the banking sector was one of the major contributing factors that led Ecuador to abandon its own currency and introduce the U.S. dollar as legal tender. However, to illustrate the weak growth performance of the country, it is necessary to examine the structural weaknesses in the labor market, the tax system, and the trade system. These weaknesses resulted in the increase in poverty and inequality. This paper provides a brief summary of recent economic developments and statistical data on economic indices of Ecuador.

Abstract

The crisis in the banking sector was one of the major contributing factors that led Ecuador to abandon its own currency and introduce the U.S. dollar as legal tender. However, to illustrate the weak growth performance of the country, it is necessary to examine the structural weaknesses in the labor market, the tax system, and the trade system. These weaknesses resulted in the increase in poverty and inequality. This paper provides a brief summary of recent economic developments and statistical data on economic indices of Ecuador.

V. Labor Markets and Wage Determination51

82. A very complicated system of wage setting has evolved in Ecuador, featuring semiannual agreements by over one hundred tripartite commissions for virtually all formal sector employees, and eight separate but intricately connected components of a worker’s salary, some of which are paid at different times of the year. Available evidence on the distortive effects of Ecuador’s wage structure is, however, mixed. Empirical studies do not present a compelling case that the structure has led to severe labor misallocation, although the need for flexibility is likely to be much greater under a dollarized exchange rate regime. This paper provides an overview of labor market issues in Ecuador, including the scope of labor market regulation in comparison with the rest of the region, the process of wage determination and the wage components, the effects on labor allocation and wage differentials, and some reforms introduced recently.

A. Scope of Labor Market Legislation

83. The basic philosophy of labor legislation in many parts of Latin America and the Caribbean has been to provide employment stability rather than job creation and protection of the unemployed. Ecuador’s legal framework shares much of this philosophy. According to a study by the Inter-American Development Bank (1996) at least 15 countries in the region impose moderate or severe restrictions on terminating labor contracts while only 8 offer a limited type of unemployment insurance. Almost all the countries have established a minimum wage and compensation for dismissal without just cause. Legislation generally favors hiring for an indefinite period of time, and imposes many restrictions on contracts, which attempt to introduce more flexibility in the hiring period.

84. Box V. 1 provides a comparison of the flexibility of the legal system across the region. Since several other countries have made major reforms in the 1990s, Ecuador now has a relatively inflexible legal system governing labor market arrangements, especially with respect to firing costs. Ecuador has relatively high severance payments requirements, with legislation that sets payments for dismissal that grow with the length of employment; this can be as high as 25 months’ pay when workers have 10 years or more of service. Such excessive rigidity does not contribute to labor stability and might entail high efficiency costs.52 Ecuador like a few other countries in the region, requires that severance payments be periodically deposited in accounts in the name of the workers. These funds build up a fraction of annual wages which, augmented with normal market yields, is available in a lump-sum to the worker if dismissed.

Flexibility of the Labor Legal System in Latin America and Caribbean Countries

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Source: Inter-American Development Bank (1996). Reforms introduced in some of the countries since the study was undertaken would have changed their classification. The main purpose here is to show that the relative classification shows that Ecuador has one of the more rigid labor regimes in the region

F: without restrictions; I: contracts with limited duration and renewability; R: only for temporary workers.

F: up to a monthly salary; I: between one and two salaries; R: more than two salaries.

F: up to six monthly salaries; I: between six and 12 monthly salaries; R: more than 12 salaries.

F: up to 15 percent of salary: I between 15 and 30 percent; R: more than 30 percent.

85. This sum is also available to the worker if he or she voluntarily quits or is fired for cause. There are also supplementary compensations in the event that the company cannot prove just cause. In Ecuador, compensations for dismissal are based on a multiple of the most recent salaries and hence do not reflect a connection between contributions and payments. To a large extent, the extensive job security regulations render hiring decisions practically irreversible, turning labor into a quasi-fixed factor and hindering the speed of labor market adjustment.

86. Traditionally, Latin American and Caribbean countries have had pay-as-you-go, defined benefit social security systems, although this situation is now changing in many countries. Since payroll contributions are not linked to workers’ benefits, the contributions generally have come to be perceived as a tax and the benefits as entitlements. An additional feature in Ecuador is that the basis of the contribution is the “base salary” as opposed to the mandated benefits, which has created incentives to reduce the share of “base salary” in total compensation in order to avoid social security contributions.

B. Wage Determination53

87. Ecuador’s complicated system of wage determination features government involvement in the setting of private sector wages through the establishment of a national minimum wage, mandatory wage adjustments to compensate for increases in the cost of living, and a vast array of other mandated benefits. Each of these benefits is determined according to a specific rule and paid at a different point in time. Some of them are proportional to the base wage of the worker, while others are set as a lump sum; some are paid monthly, while others are due at specific points in time.

88. Basically, the government establishes a national minimum wage that serves as a reference point for the setting of wages throughout the economy. A total of 119 sectoral salary commissions then set minimum wages at the sectoral level, as well as for each occupation within each sector. These are tripartite commissions made up of representatives of the government, employers and workers. Their decisions are made with some reference to changes in the minimum wage. In addition, the government, by executive order, periodically grants nationwide wage increases. In certain sectors, minimum daily wages or minimum tariffs are established.54

89. In addition to the base wage, a typical salary includes a number of mandated benefits (bonificaciones). These mandated benefits include four salary components (thirteenth, fourteenth, fifteenth, and sixteenth salaries), a cost-of-living compensation, a complementary bonus and a transportation bonus (see Box V.2 for descriptions). The thirteenth salary was established in 1962 and the sixteenth salary was introduced 30 years later. Each benefit has its specific characteristics, including the time it is paid during the year.

Ecuador: Components of Wages and Salaries

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90. In addition to the mandated benefits, both the employee and the employer have to contribute to social security. Social security contributions amount to 20.5 percent of the base wage in most cases. Mandated benefits, such as the four salary components, were not subject to social security contributions until recently.55 Fiscal considerations have featured prominently in the decisions to expand the range of mandated benefits as opposed to simply increasing base wages. First, the minimum wage was tightly linked to a number of public sector wages so that the ripple effect of a rise in the minimum wage magnified the cost to the government. According to World Bank estimates, a 1 percent increase in the minimum wage would increase the government’s wage bill by 2.4 percent. Second, creating new salary components not related to social security contributions, limits the government’s liability to the social security institute.

91. Enforcement of minimum wages is weak since the punishment for noncompliance with labor legislation is relatively low.56 Although enforcement is somewhat more effective regarding payroll taxation, firms with less than 10 employees are not targeted for inspection. The official estimate is that about 22 percent of the contributions are evaded by the private sector.

92. Trade unions are particularly strong in the public sector and less prevalent in the private sector. Only 350,000 workers, or about 10 percent of the labor force, are unionized, and there has been a decline in union strength over time. However, union closed shops are allowed; that is, union membership may be a requirement for employment in these firms.

C. Effects on Labor Market Flexibility

93. A key concern is the impact of such complex labor market regulation on economic efficiency. On the face of it, Ecuadoran labor costs would appear to be high because of the existence of so many mandated benefits. However, a study by Maclsaac and Rama (1997) provides evidence that the effect of these benefits is actually mitigated by a reduction of base earnings. The reduction is larger in the private than in the public sector and is negligible for unionized workers. Furthermore, they note that in spite of mandated benefits, inter-industry wage differentials are comparable to those of Bolivia, a country characterized by “flexible” labor markets but otherwise similar to Ecuador.57

94. Maclsaac and Rama find that Ecuadoran labor market regulations do raise labor costs, but to a lesser extent than suggested by the mandated benefits. On average, take home pay is about 18 percent higher for private sector jobs complying with labor regulations than for otherwise identical jobs. Moreover, the effect of mandated benefits on labor costs is smaller than suggested by this 18 percent increase in take-home pay because mandated benefits, unlike base earnings, are not subject to social security contributions and payroll taxes. Thus, total labor costs, including social security contributions and payroll taxes, increase by some 8 percent for an employer complying with labor regulations. The effect of mandated benefits on take home pay is drastically attenuated by a decrease of the base earnings on top of which mandated benefits are paid. This decrease, of about 39 percent is in turn facilitated by the low level and weak enforcement of minimum wages.

95. The results of Maclsaac and Rama suggest that, while cumbersome, Ecuadoran labor market regulations cannot be held responsible for a great deal of labor market segmentation. Compliance with these regulations is associated with significantly higher take home pay only in the public sector where trade unions are active. Apart from the weakness of enforcement capabilities, they argue that even if regulations were enforced, private contracts could still undo part of the potential distortions: to the extent that mandated benefits are fungible with base earnings, the latter can be adjusted downwards so that take-home pay (including the benefits) remain equivalent to the relevant alternative wage.

96. Nonetheless, results from an IDB (1996) study suggest that high adjustment costs (which include the severance payments costs) have contributed to the slow response of employment in Latin America to economic expansions. In particular the study pointed to an output-unemployment elasticity that was virtually zero in the case of Ecuador. To the extent that labor market regulations in Ecuador render hiring of workers as in the nature of acquisition of quasi-fixed factors, this limits the amount of new labor hired during expansions, particularly expansions perceived to be temporary.

D. Recent Reforms

97. Although employers and workers have discovered ways of circumventing the complex system, the administrative cost of implementing the scheme represents a deadweight loss to society without much apparent benefit. The authorities have therefore started a process of rationalization. The first step was the introduction in the Economic Transformation Law of:

  • Separation of the minimum wages in the public and private sectors;

  • The fifteenth and sixteenth salary were added to the base wage and the complementary and cost of living bonuses will be gradually added to the base wage also;

  • Allowing hourly employment (minimum of six hours work per day).

Shifting the fifteenth and sixteenth salary components to the base salary should provide increasing revenues to the social security system, since it increases the base for contributions.

98. Additional measures are included in legislation that was submitted to congress in mid-July, 2000:

  • Further unification of salary components with base salaries in the public sector;

  • Unification of the thirteenth and fourteenth salary components with the base salary for the private sector;

  • Strengthened enforcement of minimum wages.

References

  • Cox Edwards, Alejandra, 1997, “Labor Market Regulations in Latin America: An Overview,” in Labor Markets in Latin America: Combining Social Protection with Market Flexibility, ed. by Edwards, Sebastian, and Nora Claudia Lustig (Washington, D.C., Brookings Institution Press), pp. 127150.

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  • Cox Edwards, Alejandra, (1996), “Towards a Labor Market Reform in Ecuador,” in Ecuador Poverty Report (World Bank), pp. 295309.

  • Inter-American Development Bank, 1996, Chapter 6 on “Labor Reform, Economic and Social Progress in Latin America, Making Social Services Work,” pp. 185229.

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  • Maclsaac, Donna, and Martin Rama,Determinants of Hourly Earnings in Ecuador: The Role of Labor Market Regulations,1997, Journal of Labor Economics, vol. 15, no.3, pt. 2, s136s165.

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51

Prepared by Alvin Hilaire.

52

Although in principle severance payments schemes would not necessarily have distortionary effects if they merely represented an income smoothing mechanism, in practice they are often viewed by employers as equivalent to a tax on dismissals, and so discourage job creation. (See Cox Edwards (1997).)

53

This section draws heavily on MacIsaac and Rama (1997).

54

In January 1998, there were minimum daily wages established for 8 sectors; minimum tariffs were established in 12 sectors specifying payment per unit of output.

55

See next section.

56

The penalty is limited to five times the monthly minimum wage, regardless of the severity of the fault or the number of workers affected.

57

None of the mandated benefits in force in Ecuador, except the thirteenth salary, exist in Bolivia.