LABOR MARKETS IN EUROPE AND CENTRAL ASIA TOWARDS CREATING MORE AND BETTER JOBS

Transcription

1 LABOR MARKETS IN EUROPE AND CENTRAL ASIA TOWARDS CREATING MORE AND BETTER JOBS ECA labor market team * Preliminary draft November 2004 * This is a preliminary and incomplete draft It was prepared by a team led by Jan Rutkowski and Stefano Scarpetta that comprises Philip O Keefe and Milan Vodopivec Arup Banerji provided guidance and substantive inputs and Gaëlle Pierre contributed to the drafting of several sections The report draws from background papers produced by a number of colleagues, including Tito Boeri, David Brown, John Earle, Pietro Garibaldi, John Haltiwanger, Peter Huber, Paloma Lopez-Garcia and Paolo Verme This work was supported by the chief economist of the ECA region, Pradeep Mitra, who has provided essential guidance throughout its implementation This draft also benefits from useful suggestions made to the project proposal by John Haltiwanger, William Maloney, Michelle Riboud, Janos Kollo and Mamta Murti 1

2 Contents 1 Executive summary 7 2 Labor market development during the transition The dynamics of employment and unemployment Increasing wage disparities during the transition The changing nature of jobs during the transition Have labor market outcomes been disappointing during the transition? Summary: key stylized facts on labor market transition in ECA 36 3 Macroeconomic policy settings, output and employment: is there any evidence of jobless growth? The employment-output link during the different phases of the transition Any role for macro-policy to influence the employment-output link Summing up: Employment prospects in CEE and CIS countries 42 4 Restructuring, productivity and job creation The required transformation of the transition economies and progress so far What is the role of firm restructuring and the entry and exit of firms for job creation? What is the role of firm restructuring and the entry and exit of firms for productivity and output growth? What drives restructuring of existing firms? How many firms enter and exit the market in transition countries? Summing up: entry conditions and incentives to create jobs are essential for improving job creation in ECA 53 5 The Investment Climate And Job Creation Employers views on the major obstacles to firms operation and growth in ECA The impact of investment climate on job creation in ECA Investment climate in ECA: international comparison and variation within the region Summing up: promoting a better investment climate to foster job creation 64 6 How labor market policy and institutions combine protection with incentives for job creation The impacts of labor market institutions on ECA labor markets The divergent paths of wage bargaining in the transition Employment Protection Legislation have reforms gone far enough? Taxes on labor Passive and active labor programs for the unemployed Summing up: the challenge of labor policy reforms in transition economies 82 References (by chapter) 85 2

3 Boxes 21 Do geo-political groups help in assessing the economic performance of ECA countries? The challenge of job creation in Turkey Growth and Job Creation in Low-income CIS Countries The meaning of informality differs between European and Eurasian economies Economic development and the employment structure Assessing the impact of labor reallocation on productivity growth Are entrepreneurs perceptions a valid indicators of the investment climate? Service sector employment rate as an indicators of job creation potential 58 53: What the official data on entry barriers do not show: the case of Romania 62 Figures A High government interference in the economy is compatible with high employment rate 59 B The reason is that public employment does not respond to the investment climate; if service sector employment is plotted against government interference, a clear negative relation is found The payoff of reforms in ECA countries: higher output but not yet higher employment Unemployment continues to be high in most transition economies The employment/population ratio has declined from above the EU average to below the EU average Real wages plummeted during the early phase of the transition but have started to grow since the mid 1990s; still in most countries they are below the pre-transition level95 24 Wage inequality looms large, especially in CIS Informality looms large in many transition economies Output per capita growth is largely driven by productivity growth rather than employment growth Inflationary pressures have declined over time in most countries Inflationary pressures have declined over time in most countries The employment adjustment has been more marked in 104 CEE than in CIS countries Real wage adjustments have been more marked in CIS than in CEE countries 105 3

4 35 Weakening link between output and employment growth 106 in CEE countries Real interest rates have increased in recent years in CEE countries Loosening of the fiscal stance in CEE countries in recent years Real wages in the public sector have increased more rapidly than in the private sector in CEE countries Different patterns of labor reallocation across transition economies Large job flows in transition economies Unsynchronized job creation and destruction can give rise to unemployment or underemployment Job flow rates, selected transition countries, (percent) Contribution of reallocation to Russian labor productivity growth The relationship between net entry contribution and the productivity growth of incumbents How effects of foreign and domestic privatization on productivity The effects of foreign and domestic privatization on productivity, employment and wages How many firms enter and exit the market Economic and regulatory policy uncertainty, macroeconomic instability, high tax rates and burdensome tax administration are most frequently reported as major obstacles to firm operation in ECA Smaller firms tend to be more constrained by the investment climate Labor regulations in ECA are seen as an less important obstacles than in other regions Firms which reduced employment more often see labor regulations as a major obstacle Service sector employment is higher in countries with easier access to and lower cost of credit Excessive market regulation hurts job creation Managers in ECA spend less time dealing with regulations than in other regions But in Russia, Ukraine and in SEE the cost of regulations is still substantial Protection of property against crime can be costly in ECA, especially in SEE and in low-income CIS countries Firms in ECA rely to a lesser degree on capital coming from formal institutions than firms in other regions Capital markets are least developed in CIS countries and in Turkey 123 4

5 510 While firm formation is key for job creation, starting a business is not easy in many ECA countries, especially in SEE and some CIS countries Job creation in ECA is likely to be hampered by difficult access to credit, especially in CIS and Turkey Markets in ECA tend to be overregulated, especially in CIS and Turkey, which is likely to hamper job creation Corruption is high in ECA raising the costs of doing business and discouraging job creation Density & bargaining coverage, early 2000s Minimum/average wage ratio, 2002 (%) Different patterns of EPL reform in EU accession and other transition economies ECA countries have more stringent regulations on hiring and firings than OECD countries There are significant differences within ECA countries on EPL Informality trends to be higher in countries with strict EPL ECA tax wedge on labor, Tax wedge on labor, ECA and OECD, early 2000s Surge in the tax wedge in EU transition countries during the 1990s Unemployment benefit replacement rates have declined in EU transition countries during the 1990s 135 Tables A Geopolitical location and the level of economic development are closely related 22 B Geopolitical groups and government effectiveness 23 C Geopolitical groups and economic transition 23 A Informal sector in European and Eurasian transition economies Stylized facts Labor markets differ between European and Euroasian economies in a number of important dimensions Labor market transition probabilities 98 Bulgaria Indicators of regional labour market disparities in transition economies at NUTS III level Correlation of unemployment rates, wages and participation rates in the regions of transition countries Migration indicators by country and year 100 5

6 31 There have been significant changes in the correlation between macro-economic variables and labor market indicators The employment structure in CEE and CIS countries The evolution of productivity, wages, and unit labor costs Major obstacles to business activity reported by firms A Contribution of investment climate components to change in service sector employment in the EU CEE countries over the last decade The importance of determinants of job creation varies across sub-regions in ECA : EPL and enforcement typology 129 6

7 LABOR MARKETS IN EUROPE AND CENTRAL ASIA: TOWARDS CREATING MORE AND BETTER JOBS 1 Executive summary 1 The transition countries of Eastern Europe and Central Asia (ECA) essentially, the former centrally planned economies 1 have emerged from a decade and a half of structural changes and restructuring to a situation where most of them are emerging as market economies, growing at a steady, often rapid pace These countries have achieved impressive results in terms of trade and financial-market liberalization, privatization of state-owned enterprises and opening up of their economies to large flows of FDI And after a major plunge in the early phases of the transition, GDP per capita has recovered in many transition countries, being at or above the pre-transition levels in many of them (Figure 1, where the EBRD index is a measure of structural reforms) Figure 1 The payoff of reforms in ECA countries: higher output but not yet higher employment Percentage of mid-1990s in end 1990s BLR UZB AZE RUS KGZ ROM BGR SVN LTU SVK EST POL CZE HUN GDP Employment rate EBRD index 0 2 But despite improvements in growth performance, many countries in transition are still struggling with significant labor market slack Labor market difficulties include high and persistent open unemployment, declining labor force participation, and low and sometimes stagnating real wages (especially in poorer rural areas) The manifestation of labor market slack 1 The transition countries are the 27 countries that can be classified in five broad groupings: Central and East European countries (CEE1= the 8 new EU members as of 2004, CEE2= future EU accession countries), South and East European countries (SEE, which includes much of former Yugoslavia, except Slovenia as well as Albania), Belarus, Russia and Ukraine (BRU), other countries constituting the Commonwealth of Independent States (CIS), and finally, Turkey 7

8 assumes different forms in the various groups of countries: Central and Eastern European countries tend to be characterized by higher open unemployment but also relatively higher real wages and lower wage inequalities 3 The low open unemployment and high employment/population ratio that prevail in many CIS countries hide significant problems in their labor markets They often point to delayed enterprise restructuring with persistent over staffing and especially in low-income CIS to the dominance of low productivity jobs in the informal sector as a means of earning subsistence income The latter feature is typical of developing countries, where social protection is lacking and thus for most workers unemployment is not an affordable option 4 The natural implication of this point is that labor market outcomes in CIS are most likely to deteriorate along with the progress of restructuring Enterprises will downsize more aggressively to be competitive, as they did in CEE, and non-profitable firms will close Thus inflows into unemployment are likely to increase as restructuring progresses What will be the distribution of job losers between those who will find jobs in the new private sector, or in the informal sector, or enlarge the unemployment pool remains to be seen But the outcome will depend on improvements in the investment climate and the pace of job creation in the new private sector PERSISTENT UNEMPLOYMENT AND MANY LOW PRODUCTIVITY JOBS 5 Unemployment rates are high in most CEE economies, often above the average in OECD countries or in the old European Union From being almost zero before transition, open unemployment increased dramatically to reach percent in many countries in the mid-1990s, and it is still often above 10 percent nowadays (Figure 2, which reports unemployment rates from labor force surveys) In Central and Eastern Europe (CEE) and South- Eastern Europe (SEE), unemployment rates are often in double digits, reaching highs of over 30 percent in Macedonia and 20 percent in Poland In most CIS countries, measured unemployment tends to be relatively lower (with Georgia, at over 12 percent, being an outlier), but many workers are engaged in low-productivity activities or have moved back to subsistence agriculture (see below) In the CEE countries, high and persistent unemployment has been accompanied by a major fall in participation rates which, starting from relatively high levels, are now well below the Figure 2 Unemployment continues to be high in most transition economies, 2003 Unemployment rate, Percent Macedonia, FYR _SEE Poland Slovak Republic Albania Serbia and Montenegro Croatia Bulgaria Lithuania _CEE Latvia Turkey Estonia Ukraine _EU15 Moldova Czech Republic _OECD Romania Slovenia Hungary 8

9 EU average Both these factors -- open unemployment and low labor force participation -- in CEE have led to a low employment/population ratio, which is a summary measure of the utilization of labor resources (Figure 3) Employment rates are below the EU s Lisbon target of 70 percent of the working age population in all CEE countries and in most of the other transition countries 6 Unemployment is also highly persistent, and is unevenly distributed even within a given country In many cases, more than 50 percent of jobseekers remain without a job for more than one year Unemployment is also concentrated amongst the low skilled and youth, as well as in backward areas where productive jobs are scarce For instance, in Bulgaria and Slovakia, over one-third of the youth labor force is unemployed Again, the disparity in regional labor market conditions is pronounced in Russia in Moscow, St Petersburg and Jaroslavkaya, oblast unemployment is negligible (less than 4 percent), while in Dagestan and even more so in Ingushetia it is alarmingly high (24 and 44 percent, respectively) With geographical labor mobility tending to be low in ECA, being severely inhibited by underdeveloped housing markets, it has proved insufficient in lessening regional unemployment disparities Figure 3 Employment rates have declined and are generally below the Lisbon target of 70% Employment to Working Age Population Ratio Georgia Kazakhstan Czech R Serbia and Montenegro Russian Federation Estonia Slovenia Lithuania Romania Kyrgyz Republic* Ukraine Moldova* Slovakia Hungary Latvia Bulgaria Poland Turkey Macedonia, FYR Table 1 Large geographical disparities in unemployment rates, 2003 Average Minimum Maximum Capital City Region Czech Republic Hungary Poland Romania 1 ) Estonia Latvia Lithuania Slovenia Slovakia Russia (2002)

10 7 Casual and more informal jobs are also proliferating, more so in the FSU than in CEE For example, self-employment accounts for about 20 percent of total employment in EU transition economies, and for some 50 percent of employment in low-income CIS Similarly, informal sector employment as a share of total employment is estimated at around percent in European transition economies, and around 40 percent in CIS Fixed-term employment contracts have become a popular method used by employers to circumvent strict employment protection legislation For example, in Croatia, the majority of workers are hired using fixedterm contracts 8 Differences in labor market conditions in ECA countries depend on the pace and strength of reforms as well as on the coping strategies of workers In most cases, the labor market outcomes that have emerged during the transition were expected and have been an unavoidable consequence of profound institutional changes and restructuring associated with the transition Some unemployment was largely anticipated, given the need to reallocate many workers across sectors, firms and locations But high unemployment was expected to be transient, with the expansion of new activities absorbing workers released from the shrinking public sector This has proved not to be the case Workers who lost their jobs have found it extremely difficult to find new ones, as the pace of job creation has often lagged behind the pace of job destruction (see below) As a result, unemployment has often become a stagnant pool The pace and strength of reforms in Central and Eastern European countries have been more Figure 4 Wage inequality looms large, especially in the CIS Decile ratios D9/D Azerbaijan Russia Kyrgyzstan SAM Armenia Estonia a) Romania Ukraine Bulgaria Belarus Lithuania Hungary a) Latvia Poland Slovenia Czech R Decile Ratio 2002 OECD marked than those of other transition economies This has led to large job losses in downsizing sectors but also job creation in emerging activities Open unemployment is often higher in these countries than in CIS countries also because social benefits have cushioned the labor market adjustment and allowed workers to devote more time to job search This tendency is reinforced by these countries institutional convergence to the relatively more generous social support regimes of the EU However, the evidence of little employment growth in recent years in some CEE countries, despite often significant output growth, has further contributed to the idea that structural factors prevent the labor market from fully accommodating and reacting to macroeconomic stimuli Some have even conjectured that transition economies are already manifesting clear signs of the Eurosclerosis that has afflicted many of their western neighbors 10

11 over the past two decades 2 9 By contrast, in the countries of the CIS, there has been less intense adjustment of employment and thus lower levels of unemployment The major adjustment has, instead, been in declining real wages One consequence of this has been broader underemployment, moonlighting and multiple job holdings in the CIS, rather than open unemployment And wage dispersion has been higher in the CIS (Figure 4), underlining the emergence of a more dualistic structure, with a relatively low median wages compared to CEE countries The wage distribution was compressed under central planning owing to the egalitarian ideology and to the centralized wage setting mechanism The change in the wage setting mechanism from administrative to market based (though this change has been less pronounced in the public sector, especially in CIS), led to the sharp increase in wage dispersion POOR LABOR DEMAND, NOT JUST POOR LABOR INSTITUTIONS 10 The key area of concern for most policy-makers is still the relatively poor record of job creation across ECA, despite the resumption of economic growth The correlation between output and employment growth has been declining since the late 1990s, after being relatively high in the early transition Similarly, the correlation between unemployment and GDP growth went from being strongly negative at early stages of transition to statistically insignificant in the last few years In some cases this has led to jobless growth Poland is the best example: since the late 1990s employment has been falling and unemployment persisting despite a relatively high rate of economic growth 11 In fact, in many countries job creation still lags behind job destruction, leading to employment decline Overall, job reallocation (the sum of job creation and destruction) in ECA increased dramatically in response to transition from less than 10 percent of the workforce in the late 1980s to more than percent in the 1990s But countries such as Romania have had significantly more jobs destroyed as part of the transition process than have been created by new firms or by continuers (Figure 5) The main differences across countries, however, are in job creation While countries lagging behind on reforms, such as in the CIS, were able to contain job destruction in the early phases of transition, job destruction later took off to high levels But this was not accompanied by new private initiatives to emerge and create new jobs Figure 5 Un-synchronized job creation and destruction can give rise to unemployment or underemployment Synchronized job flows Less synchronized job flows Estonia Russia % of total employment Job creation Job destruction % of total employment % of total employment Slovenia See for example, Riboud et al (2002); Boeri (2000); Boeri and Terrell (2002); and Haltiwanger, 6 Scarpetta and Vodopivec, (2003) % of total employment Romania Net employment losses

12 12 This is due to four broad and inter-linked sets of factors: defensive restructuring by firms has caused shedding of jobs rather than turning productivity gains into strategic expansion and hiring the change in employment structure in some countries has pushed employment to lowproductivity, relatively low growth sectors such as agriculture poor investment climates have stifled the entry of job-creating new firms and have dampened incentives for existing firms to invest, expand and hire relatively onerous labor market institutions have served as a disincentive for firms to hire new (regular) workers, and for labor to search actively for formal sector jobs 13 For the last three factors, there are clear differences between the CEE countries and those in the CIS, with the latter having declining industrial employment, a higher share of microinstitutional obstacles in the overall investment climate, and lower enforcement of labor regulations than in the CEE countries 14 Defensive Restructuring Firm-level data for a sample of CEE countries as well as Russia and Ukraine suggest that since the beginning of the transition reallocation of employment across firms and industries has gained a stronger role in promoting productivity growth (Figures 6 for the example of Russia) But firms experiencing an increase in productivity were also losing employment shares, ie their productivity growth was associated with restructuring and downsizing rather than expansion Indeed, domestic firms in much of ECA are still largely engaged in defensive restructuring with large reductions in over-staffing rather than strategic restructuring with new investment and new hires Figure 6 Labor reallocation has played an increasing role in promoting productivity growth in Russia 15 Often, the impetus for defensive restructuring was privatization In background work to this report that analyzed the effects of restructuring and reallocation of labor on productivity for a group of CEE countries, Russia and Ukraine, productivity growth in these firms was found to be clearly a result of such defensive restructuring rather than reallocation of production factors to most productive uses (strategic restructuring) 3 Many low-productivity industries, sheltered from competitive pressure, have managed to contain job destruction, but may still have to go through a period of downsizing and restructuring, which will likely cause further increases in 3 See Grosfeld and Roland (1996) for a discussion of defensive vs strategic restructuring 12

13 unemployment 16 The ownership of privatized firms matters a lot for subsequent performance Evidence from Hungary, Romania, Russia and Ukraine suggests that foreign privatization has increased productivity and employment and wages in all countries, though the effects are not always strong Domestic privatization has been less kind to workers, however, as wages suffered in all four countries, and employment rose only in a few instances (see Figure 7 for evidence on multifactor productivity and employment) 4 Figure 7 The effects of privatization on productivity tend to be positive, those on employment less so in case of domestic privatization 06 Estimated Effects of Foreign and Domestic Privatization on multifactor productivity Hungary Romania Russia Ukraine Foreign Domestic Estimated Effects of Foreign and Domestic Privatization on Employment Hungary Romania Russia Ukraine Foreign Domestic 4 These results come from regression analysis of firm performance: more than 20,000 firms in Hungary and Romania; 120,000 firms in Russia and 46,700 firms in Ukraine See Brown, Earle, and Telegdy (2004a, 2004b) Similar results are also in Djankov and Murrell (2002) 13

14 17 But there are also significant differences across types of workers Thus employment composition and relative wage changes have been significantly biased toward white-collar employees This is consistent with the idea that foreign privatization, by promoting the upgrading Figure 8 Different patterns of labor reallocation: Czech Republic (CEE) versus Kyrgystan (CIS) The structure of employment in Czech Evolution over the transition and with respect to benchmark Agriculture/Bmark Industry/Bmark GDP/PPP/x GDP/PPP/x Agriculture Bmark Industry Bmark Market Services/Bmark GDP/PPP/x 2002 Non-Market Services/Bmark GDP/PPP/x Market Services Bmark Non-Market Services Bmark Bmark= Benchmark based on the estimated market-based structure The structure of employment in Kyrgyzstan Evolution over the transition and with respect to benchmark Agriculture/Bmark Industry/Bmark GDP/PPP/x GDP/PPP/x Agriculture Bmark Industry Bmark Market Services/Bmark GDP/PPP/x Non-Market Services/Bmark GDP/PPP/x Market Services Bmark Non-Market Services Bmark Bmark= Benchmark based on the estimated market based structure of production process with new technologies, tend to be skill-biased 18 Sectoral Shifts Looking at changes in the sectoral composition of employment suggests that all transition countries experienced a process of deindustrialization, but this was associated with significantly different patterns across them In most of CEE countries, with the exception of 14

15 Romania, deindustrialization was associated with a reduction in employment in agriculture In 2002, the share of agriculture in total employment in most CEE countries was close to what is seen in many EU countries By contrast, the CIS countries and, within the group, the poorest countries in particular -- saw a rise in relative and even absolute employment in agriculture, often as the employer of last resort given the lack of job openings in other sectors Agricultural employment accounted for almost 40 percent of total employment in CIS countries in 2000, up from 31% in , while industrial employment has fallen to 18% compared to 30% before transition It is not clear whether this is only temporary, or a more profound and long-lasting reversion towards employment patterns more typical of countries with relatively low-income per capita In the case of Kyrgyzstan in Figure 8, agricultural employment has shown a steady increase through output decline and recovery with agriculture being the employer of last resort given the lack of job openings in other sectors and while employment in market services has increased, the pace and amount of increase has been slow 19 Investment Climate New firms have been the major driver of job creation in ECA, as they have developed new activities and better harnessed new technologies Firm entry largely outpaced firm exit in CEE countries for which data are available 5 Obviously this is related to the process of transition and is not sustainable over the longer run Still, it points to the fact that new firms not only displaced obsolete incumbents in the transition phase, but also filled in new markets which were either nonexistent or poorly populated in the past The net entry effect (entry plus exit) on productivity is generally positive in most transition countries, accounting for between 20 percent and 50 percent of total productivity growth In particular, there is clear evidence that the exit of obsolete firms released resources which could be used more effectively by new or existing firms And, while lack of experience and small size often make new firms less productive than the average incumbent in OECD countries, in transition economies new firms are on average more efficient than the incumbents They have been able to fill in new market niches and adopt new and more efficient technologies, thereby contributing to productivity and output growth 20 Yet, except in a few CEE countries, new firms have not been entering the market in sufficient numbers to compensate for the job losses due to defensive restructuring and firm closures Key to the low rate of entry has been a set of disincentives created by problems in the investment climate Surveys of entrepreneurs and international comparisons suggest that uncertainty, corruption, lack of access to credit, opacity of regulations in different markets and a heavy tax burden all contribute to discourage firms from expanding and hiring more workers However, firms in the World Bank s investment climate surveys located in the countries that have joined the EU in 2004 are more likely to cite economic and regulatory policy uncertainty, macroeconomic instability, tax rates, cost of financing, access to financing, corruption and anticompetitive practices as major obstacles In the poorest CIS countries, while factors such as corruption, macroeconomic instability and tax rates are also frequently mentioned as major obstacles, there are significant differences as well Cost of financing is seldom cited as a primary problem in the poor CIS, while legal systems and dispute resolution issues loom larger there than in their richer counterparts (Figure 8 gives some overall responses) 21 Generally, therefore, there is a difference as to what factors matter most for the investment climate across ECA For the poorest countries, the lack of basic market institutions for information flows, contract enforcement and competition policy are fundamentally important For the CEE, where these institutions are more developed, what seem to loom larger for firms are the effects of policy uncertainty and expensive credit, due the adverse consequences of tight 5 Firm level data are available for Estonia, Hungary, Latvia, Romania and Slovenia Additional information on firm level dynamics is also available for Russia and Ukraine 15

16 monetary policy and loose fiscal policy Figure 8 Major obstacles to firm activity (% of firms reporting) Proportion of firms which report the following as major or severe obstacles ECA 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Transportation Labor regulations Telecommunications Skills and education of available workers Access to land Business licensing and operating permits Electricity Legal system/conflict resolution Crime, theft and disorder Anti-competitive or informal practices Customs and trade regulations Access to financing Corruption Cost of financing Tax administration Tax rates Macroeconomic instability Economic and regulatory policy uncertainty 22 The adaptability of the labor market Most transition economies, and in particular CEE countries, have made significant reforms of their labor market over the course of transition All of them introduced unemployment benefit schemes and active programs to facilitate the mobility of workers, though they have reduced benefit generosity over time to minimize disincentives on job search and comply with fiscal constraints They also reformed employment protection legislation (EPL) to improve labor market flexibility However, despite EPL reforms, protection of permanent workers and in a number of countries, in particular in SEE, also of temporary workers - remains high, and costs associated with dismissals are higher than in most OECD countries (Figure 9) 23 Employment protection legislation (EPL) has evolved during the transition CEE economies that were approaching entry into the European Union have been more aggressive in liberalizing EPL than other transition countries, whose accession was further in the future (Bulgaria) or not foreseen in the short-run This hints at the fact that the prospect of closer integration to the EU market may have played as a discipline device in promoting reforms It should be stressed, however, that most of the EPL reforms were concentrated in liberalizing temporary contracts by extending maximum duration of fixed-term contracts or by legalizing temporary work agencies In other words, following the experience of many continental European countries, EU transition economies have liberalized at the margin, lowering the costs of temporary employment, with more modest reductions in the protection of regular workers This may have contributed to the observed duality in the labor market in which vulnerable groups, including the youths, women and the unskilled, churn from one job to another without being able to build a proper career, while those who maintain a regular contract still enjoy a significant degree of job protection 24 In CIS and Belarus, Russia and Ukraine, there is widespread evidence of weak enforcement of EPL This is supported by employer surveys For example in Moldova, despite strict EPL and consistently with the country s high job destruction rate and low incidence of over- 16

17 staffing, employer surveys identify labor regulations as their least important problem Table 2 shows a tentative characterization of ECA countries according to the strictness of EPL and its enforcement It is indicative only, but illustrates that the effective impact of strict EPL in ECA may be less than comparisons of labor legislation would suggest, with only Slovenia having both strict EPL and strict enforcement While the characterization is crude, it indicates that countries in the top right of the table need to focus more on credibly enforceable laws as opposed to paper protections which at best protect a limited share of formal sector workers Figure 9 ECA countries have more stringent regulations on hiring and firings than OECD countries Temporary and Regular Employment Protection Indexes South Asia Eastern and Central Europe Sub-Saharan Africa Middle East and North Africa East Asia and Pacific Latin America Industrial Countries Temporary employment regulations Regular employment regulations Source: Bank staff calculations based on Doing Business Database (2005) 25 Taxes on labor use are high, in many cases very high At the same time, like most labor market institutions, it exhibits considerable variation among sub-regions, both in aggregate levels and composition The tax wedge on labor in CEE and Turkey is very high by any standard, while labor taxation in former Soviet Union countries is lower on average South East European countries represent an intermediate tax burden on labor, but remain high by international standards The surge in social expenditures, predominantly pensions, has led to further increases in the fiscal burden on the use of labor in CEE countries over the 1990s In this context, it is not surprising that many employers in the region found the tax burden to be one of the most serious constraints to operating their firm 26 While the high tax wedge in ECA is important, there is also considerable evidence particularly in the earlier part of the transition, prior to reforms of tax administration in a number of countries of partial tax compliance, particularly in low-income countries and those affected by conflict The twin effects of high taxes on labor and low capacity of the public sector to enforce compliance point towards ambiguous effects on aggregate (un)employment However, the relatively stronger enforcement capacity of CEE countries, combined with their very high labor taxation, could raise labor costs and affect employment at least for those with low productivity potentials whose wage has limited downward flexibility because of minimum wages 27 There has also been progress in transition countries on the wage setting systems In CEE countries, there has been a substantial decentralization in formal private sector wage setting The most notable exception is Slovenia, which retains highly centralized wage setting But there are 17

18 still constrains in the aggregate and especially relative wage adaptability Evidence for the manufacturing sector suggests that industry wages adjust weakly to productivity growth and many CEE countries are gaining comparative advantages in relatively high-tech industries with strong productivity growth, while labor intensive industries are facing rising unit labor costs 28 In contrast, in Belarus, Russia and Ukraine as well as in CIS countries, the government plays a more prominent role in formal sector wage determination Unions have not fully evolved into independent forces in the bargaining process and employers often continue to place employment retention above productivity gains This leads to private sector wages often mimicking public sector wage While the situation varies across countries (eg Russia and Kazakhstan have active independent unions), the weakness of unions and employers is a shared feature of these countries As a result, firms often remain price takers from government with respect to wages, and focus their efforts on negotiating soft budget constraints At the same time, a large informal sector (accounting for over 40 percent of employment) has provided very flexible wage determination for a large share of the workforce Table 2 A typology of employment protection legislation and enforcement in ECA countries Flexible EPL More restrictive EPL Very rigid EPL Weaker enforcement Intermediate enforcement Stronger enforcement Albania, SAM, Russia, Kazakhstan Czech Republic, Hungary, Slovakia, Poland Armenia, Georgia, Turkey Bulgaria Lithuania, Estonia, Latvia, Slovenia Azerbaijan, Belarus, Bosnia and Herzegovina, Kyrgyz, Moldova, Ukraine, Uzbekistan Croatia, Macedonia Romania Note: (i) Strictness defined as whether country EPL index below world average EPL index in Doing Business 2005, up to 20% higher and more than 20% higher; (ii) strength of enforcement based on share of informal sector 29 The minimum wage is an important element of wage determination, in particular given its possible impact at the low-end of the wage distribution in providing a floor to wages and hence a constraint on hiring of low-skilled, often young, workers Minimum wages in ECA countries exhibit a clear divide between CEE and SEE on the one hand, and CIS (except Ukraine) on the other, with minimum wages in CEE and SEE averaging close to 40 percent of the average wage in 2002, but in CIS only around 20 percent, and for several countries less than 10 percent of the average wage The ratios place CEE at the high end of the range of minimum wages by international standards, and CIS at the low to modest end In SEE, both BiH and Macedonia have high MW/AW ratios In addition, available evidence indicates much weaker enforcement of minimum wages in BRU and CIS during the 1990s, though this appears to have improved postcrisis 30 While the minimum wage is generally relatively low compared to the nation-wide average, it often represents a larger proportion of the market wage in backward areas in many transition countries For example, in Poland the minimum wage accounts for over 80 percent of the wage received by low-skilled workers in high unemployment regions As such, it is likely to affect negatively the creation of low-paid jobs and price some low-skilled workers out of employment 18

19 31 Unemployment benefits have been reformed in many CEE countries and are currently relatively low The main challenge is to strengthen the (re)activation of the long-term unemployed, both through incentives in the benefits and tax systems (eg, back-to-work allowances; tax credits for low-income working households), and through targeting active programs on those with low skills and in depressed regions where net impacts of intervention can be positive There is also a need to improve monitoring and evaluation of the effectiveness of different active labor market programs and to examine social assistance benefits in depressed regions to ensure that eligibility thresholds and benefits levels do not contribute to localized work disincentives 32 Unemployment benefits, albeit present in all countries, have lower coverage of the unemployed in South East Europe and in CIS and provide a low level of income support The very low generosity of unemployment benefits in CIS countries has made this form of income support increasingly irrelevant, contributing to low registered unemployment rates Moreover, the lack of adequate income support implies that workers prefer to stick to their job, even in the face of large declines in wages, rather than facing a job search without some support Given the limited administrative capacity, large under-reporting of activities and limited financial resources, especially in the low-income CIS the issue could be raised as to whether a move to flat-rate unemployment assistance is appropriate and whether this might be general revenues rather than payroll tax financed Moreover, given widespread informality, the need to reinforce social protection for those without access to formal insurance mechanisms should be considered Similar challenges are faced by many countries in South East Europe PACKAGING REFORMS TO BOOST LABOR DEMAND AND PROTECT WORKERS AFFECTED BY LABOR ADJUSTMENT 33 There is by now little doubt that the journey from central planning to a market economy that former socialist economies have embarked on in the early 1990s was not smooth and quick as some were hoping The process has profoundly changed the social and economic fabric of all countries More than a decade down the road, many transition economies have achieved impressive results, but economic and structural conditions differ substantially across them And most of them are still facing the daunting challenge of significant labor market slack Further reforms are needed in most areas, but priorities differ depending on the most severe bottlenecks for firms operation and expansion, as well as for the functioning of the labor market 34 In less advanced transition economies such as those in the CIS, the main challenge for growth and job creation is to reinforce key institutions of a market economy, including better protection of property rights, effective contract enforcement, efficient market regulations and less corruption Labor market reforms can contribute to a better environment for firm expansion and job creation Social partners should gain a greater independent role in wage bargaining And policy should be reformed so as to strike a better balance between protecting existing jobs often only on paper given weak enforcement and protecting workers affected by labor mobility With a rapidly expanding informal sector, how to reach out to those left out of the traditional welfare system is a major challenge, similar to that facing many low-income countries in other areas of the world 35 In ECA s more advanced transition economies including the new members of the European Union the formal private sector has flourished with the creation of many new firms and many jobs Yet unemployment remains high and persistent and many workers have left the labor market altogether because of the bleak job prospects Fostering a shift from defensive restructuring to strategic restructuring with new investment and job creation requires lowering the burden of taxation which however collides with growing expenses for old-age pension and 19

20 other social programs -- and improving access to credit Most of the CEE countries have also promoted adjustment in the labor market by easing regulations on temporary employment Whether the expansion of temporary contracts would be enough to generate enough flexibility in the labor market remains to be seen, but the experience in Western Europe suggests that this may lead to segmentation in the labor market Labor market slack also has a clear geographical dimension in many transition countries, with pockets of high and very persistent unemployment in backward areas once dominated by large industrial complex Since labor mobility is limited, tackling unemployment problems in these areas requires the development, often from scratch, of a business environment in which new private activities could emerge All in all, even if the macro and institutional framework is more favorable than in the poorer CIS, there remain major policy challenges in CEE countries to promote the creation of more and better jobs 36 Countries of South East Europe (with the exception of Albania) share a unique legacy of Yugoslav labor relations, which included labor self-management and strict employment protection At the same times structural reforms in these countries have been delayed by the regional conflict and associated institutional disruption Achieving stability is thus a major condition for a better job prospect But SEE countries also need to purse structural reforms to catch up with CEE They have already gone a long way in this direction Croatia, which recently become the EU accession country is the best example It significantly improved its business environment and reformed labor regulations to improve labor flexibility Labor market and other structural reforms have been also carried out in other countries in the region Still there is substantial room for further reforms Anticompetitive practices, lax contract enforcement, crime and corruption still impede firm entry and growth Wage setting in the public sector and in the privatized firms needs to better reflect the evolution of productivity across sectors and firms Moreover, there is probably room for further adjustment in employment protection legislation to facilitate labor reallocation and lessen the incentives for moving into the grey or informal economy 20

21 2 Labor market development during the transition 21 The dynamics of employment and unemployment 37 By its very nature, the transition from a centrally planned to a market economy that started in ECA countries in the early 1990s implied changes in the basic institutions of the economy It decentralized economic decision-making processes, liberalized price and wage setting, and exposed enterprises to competition Profitability and competitiveness have increasingly become the major criteria of firm survival and growth These major changes in the rules of the game, along with disintegration of traditional economic links, resulted in a substantial fall in output This in turn led to a fall in labor demand, which forced firms to reduce employment, or wages, or in practice - some combination of the two Unprofitable firms went out of business or were transformed through restructuring and changes in governance and ownership At the same time, new private firms began to enter the market This process has occurred in virtually all transition economies, although in different countries it has preceded at varying speeds Some countries, mainly in CEE, implemented key market-oriented reforms early in the transition and were determined to continue economic restructuring, while others, mainly in SEE, CIS-7 and Belarus, Russia and Ukraine (BRU), have adopted a more gradual and less decisive transition approach Labor market development during the transition largely reflects economic structures and efforts to reform 38 Economies of ECA vary vastly in terms of the level of economic development, which influences the functioning of the labor market (see Box 21) On the one end of the spectrum are emerging economies which are now members of the European Union, on the other end are low-income countries of Central Asia The first group is characterized by advanced market institutions, relatively more advanced economic structures and, correspondingly, high levels of labor productivity By contrast, transition economies of Central Asia are much closer to low-income developing countries in terms of their economic infrastructures Market-based institutions are relatively less developed or not effective on the ground, the economic structure is dominated by agriculture and labor productivity tends to be low Other ECA economies, such as those of South East Europe, Turkey, Russia and Ukraine, fall somewhere in-between these two polar cases 39 The differences in the level of economic development across ECA are associated with significant differences in the key features of labor markets Largely urban, service oriented and formal labor markets of EU transition economies perform differently than mainly rural, agricultural and informal labor markets of Central Asia For example, the predominantly rural and informal labor markets in Tajikistan or Uzbekistan are very much different from the mostly urban and formal labor market of Hungary or the Czech Republic Similarly, the labor markets in Belarus or Ukraine, where market oriented reforms are less advanced, differ from the labor market in the Baltic states, which have a well functioning market economy and are members of the European Union 40 Labor market adjustment to the transition shock has been different in transition 21