May2002 No.1 A regular series of notes highlighting recent lessons emerging from the operational and analytical program of the World Bank's Latin America and Caribbean Region ON LATON &MBERO&AND'THU )E CAFE@zBBEAB( ONuTE (g)9i Indermit S. Gill, William F Maloney and Carolina Sanchez-Paramo' Labor Reform at a Crossroads 24498 Latin American labor markets performed below ex- The third explanations emphasizes the role of labor market pectations during the 1990s in terms of both formal rigidities in preventing the economic growth induced by the employment creation and poverty reduction. Three reforms from translating into higher employment creation different explanations have been proposed for this in the formal sector underperformance (these explanations need not be mutually exclusive): (i) trade liberalization; (ii) macro- This note synthesizes the findings of research on trade and restructuring; and (iii) labor market rigidities. labor in the region, including World Bank studies on: (i) trade and job quality (De Ferranti, Perry, Lederman and The first explanation considers increases in unemploy- Maloney, 2001), (ii) informality (Maloney 2001) and (iii) ment and informality as a product of the globalization labor policies in the region (Gill, Montenegro and process, and is concerned about the 'low quality' of the Domeland, 2001). First, the evidence on the relationship new jobs generated in the trade-fueled sectors, such as between trade liberalization, macro-restructuring and labor 'maquilas' and tourism. As a result, proponents of this market outcomes during the 1 990s is reviewed. Second, la- view contend that the poor have not benefited from bor market rigidities will be analyzed and the extent to trade openness as much as the rich and that this has led which reform efforts facilitated formal employment creation. to increasing income inequality in the region. Finally, based on lessons learned from the 1990s, a new The second explanation attributes the observed in- agenda for labor market reform is proposed which reflects creases in unemployment to the labor reallocation as- more closely the new environment in which Latin American sociated with macro restructuring, macro-stabilization governments now operate. and to other crises unrelated to trade liberalization. This year's flagship report for the Latin American and Caribbean Region, From Natural Resources to the Knowledge Economy Trade and Job Quality, addresses three concerns about the structure of trade in Latin American and Caribbean economies. The first is whether natural wealth and exports of natural resource- intensive commodities hampers economic development. The second concern is that natural resources create a concentrated export structure which exacerbates economic volatility and thus reduces growth. The third concern is that international trade might Ge eliminate jobs. The wide-ranging report cites the experience of Australia, Canada, Finland; Sweden, and the United States, as well as some Latin American countries, to show how successful economies have been built on the basis of primary commodity exports. Links between Trade, Market Restructuring In many countries, increases in informality at the beginning and Employment of the 1990s were driven partly by the expansion of opportunities in non-tradeable sectors, such as construction and services, which tend to be informal (e.g. Argentina, There is no clear link between the effects of trade Brazil and Mexico). liberalization and increases in unemployment or informality. Although several countries in the region Macro-adjustments and labor legislation are much more experienced low employment creation and growing closely related to the increase in informality than trade unemployment during the 1990s, over the long run there liberalization. Although in other countries there was seems to be no relation between these developments and evidence of labor market segmentation, with employment trade openness. Considering long-term trends, in the informal sector being a fall back option rather than unemployment levels were not substantially higher in the an attractive opportunity, this segmentation could not be 1990s than in the 1980s and 1970s, which cannot be attributed to trade reforms in most cases. For instance, in characterized as periods of substantial trade liberalization Colombia it was the combination of rising minimum wages (Figure 1). with the economic downturn that rationed many workers out of formal sector employment. Similarly in Argentina Empirical evidence suggests that high levels of labor market segmentation had begun in the early 1980s, unemployment in the last decade reflect the long transition long before trade liberalization, probably as a result of the periods associated with macroeconomic reforms, rather than existing rigidities that plagued the economy and their final outcomes. Chile required ten years to achieve encouraged workers to go off the books. sustained employment and wage growth after reforming, but since 1985 has been the best performer. in the region In addition, the jobs created in the emerging sectors (i.e. with the lowest unemployment rate, together with appeared to be better than similar jobs in other sectors. In Mexico - another early reformer). Similarly, it was the particular, jobs in Export Promotion Zones, new countries which failed to fully tackle the issues of macro- agricultural sectors, tourism and tele-services compared economic stabilization and labor market rigidities (e.g. favorably to work in more traditional sectors in terms of Argentina and Colombia), rather than those that opened up pay and benefits. Statistical comparisons and interviews the most, that did not succeed in bringing unemployment with Mexican workers suggest that those employed in the down and fostering employment creation. maquila and the new agricultural sectors do at least as well in these sectors as in alternative ones. Moreover female Paired with poor formal employment creation most labor force participation and relative wages were also high countries experienced substantial increases in informality in these sectors, thus giving women more leverage in over the 1990s2. However, there is no evidence that this was household. due to subcontracting in global production chains and little evidence that it was more generally due to trade liberalization. Figure 1: Average Unemployment Rate in Latin America Caribbean Region 15 - 12 9 6 3 0~~~ 1990s J 1980s 1970sSoreSMADtbsfr the 1970s and 1980s, andU and ECLAC for the 1990s. 2 Finally, although wage inequality did worsen in several that job security and severance pay have on employment. countries, numerous studies failed to find direct links to The evidence on job security is somewhat mixed at both the trade liberalization. Rather these studies suggest this trend regional and country levels, although it suggests that job results from skill-biased technological change as well as security has a generally negative effect on employment from insufficient growth in the supply of skilled workers creation. relative to their demand (technological progress). In fact, average wages in the region rose at historically high levels Overall, severance pay reforms seemed to favor more during the 1990s and more open sectors appeared to pay disadvantaged workers. This contrasts to situations where higher than average wages. Moreover increases in severance pay was increased, or where tenured workers inequality reflected the fact that the new jobs being created- were made better off relative to untenured workers. For are demanding more from the region's workers in terms of instance, workers with higher tenure benefited relatively skills and were neither permanent (i.e. inequality rose and more from a ceiling increases in Chile, and from steeper then fell in Chile and Mexi.co), nor did they translate into severance pay-tenure profiles in Colombia, the Dominican higher overall inequality at the household level. Republic and Peru. However, these changes increased the cost of formal employment relative to informal employment. Labor Market Rigidities B. Unemployment Insurance and Compensation Funds Severance pay systems do not seem to be an adequate way As a result of market developments, Latin American o rvdn nmlyetisrnedet h itrin governments turned their attention more directly to the of providing unemployment insurance due to the distortions functioning of labor markets in the region, in an attempt to and high costs associated with them. These problems can understand why economic growth induced by be partly avoided by relying on a system where workers mnderstacro why.economic sbta tr iber a nforego a small share of their earnings while employed and macroeconomic stability and trade liberalization had not te s hs tnsi aeo nmlyet needn translated into higher employment creation in the formal then use those funds in case of unemployment, independent sector. Although part of these developments were simply of the cause ofmjob separation. However, adoption of due to the costs of transition, a closer look into the labor alternative compensation systems did not tend to come market suggested that excessively rigid legislation could hand i hand with a reduction in severance pay. Rather also have contributed to poor formal employment creation these new systems were generally Introduced on top of existing labor legislation, thus putting additional stress on Increasing labor market flexibility became the main goal of labor taxes and introducing substantial inefficiencies. In any labor reform, based on the belief that deregulating general, alternative compensation systems were labor markets would lower laborjcosts and enhance characterized by strict eligibility criteria and poor coverage compliance, resulting in more labor-intensive production, of the overall unemployed population. Access to funds is hopigher , creaution in t ormalor,indensoverall, often conditional on the cause of dismissal or requires a higher job creation in the formnal sector, and an overall crannme fmnh fcnrbtost h improvement in the quality of jobs. However, proposals to certai number of months of contributions to the increase labor market flexibility often faced substantial unemployment fund. As a result coverage is low and opposition, making them difficult to implement. In fact, sometimes poorly targeted. while most countries in the region had carried out profound trade and financial reforms, only a few actually introduced C. Temporary Contracts substantial changes to their labor legislation during the 1990s. Some reforms were indeed implemented and these Prior to the 1990s labor legislation in the region prohibited were reviewed paying special attention to their effect on the use of temporary contracts for permanent activities, employment, unemployment and informality. restricting their use to work that was temporary in nature, such as harvesting or construction. These contracts A. Cost and Cause of Dismissal frequently involved high administrative costs (e.g. labor union consent on a case-by-case basis). The restrictions had negative effects on formal employment creation and Latin American labor legislation traditionally imposed high encouraged low compliance and informality, especially firing costs on employers to achieve job security and among small businesses that depend on flexible employment stability. These costs included the stipulated arrangements. Although each country's experience was severance pay and possibly other forms of compensation somewhat different, the adoption of temporary contracts depending on the cause of dismissal. However, in practice generally translated into higher employment creation. These employers also needed to take into account transaction reforms however were often accompanied by higher worker costs associated with workers' appeals and lengthy court turnover. procedures. While legislative changes implemented to increase High firing costs are considered a barrier to job creation in flexibltyw e fairly similac ontre t herea wa Latin America, and empirical work has explored the effect substantial variation in the way these same countries paper suggests new directions for labor reform efforts, tackled the worker protection issue. In particular, some emphasizing the need to create dynamic labor markets and continued to rely on severance pay systems to protect effective safety nets to fight vulnerability and foster workers in case of unemployment, whereas others productivity, rather than to perpetuate a culture of job experimented with alternative compensation systems. These stability and protection of the employed. Although a alternative compensation systems were an improvement on substantial change of direction has been suggested, a severance pay-based systems. Despite the economic second round of reforms would not be possible without the benefits associated with some of the reforms, they were changes that took place in the 1990s. generally unpopular; sometimes so much so that certain governments were forced to backtrack on some of the changes (e.g. Argentina in 1998). References Policy Prescriptions Gill, Indermit S., Claudio E. Montenegro and Dorte Domeland, editors (2001) Crafting Labor Policy: Techniques and Lessons Learned from Latin America. The Based on the findings regarding trade liberalization effects World Bank, Washington, DC. and labor market rigidities, several changes in policies and in designing operations are suggested to enhance the Heckman, James and Carmen Pages (2000) "The Cost of Job efficiency of labor markets in the region. The first is a Security Regulation: Evidence from Latin American Labor move from reducing stipulated firing costs to reducing Markets". NBER Working Paper No. 7773, National Bureau transaction costs associated with firing. The second of Economic Research, Cambridge, MA. recommendation is a transformation of the compensation systems to emphasize portable benefits and effective safety Maloney, William (2001) "Informality Revisited". Mimeo, nets rather than market-based mechanisms. A third proposal The World Bank, Washington, DC. for designing interventions is a change in approach from seeking to foster labor market flexibility to conceptualizing Weller, Jilrgen (2001) Economic Reforms, Growth and labor as a flexible production input. Finally, the review Employment: Labour Markets in Latin America and The calls for a change in regarding 'informality' as a Caribbean. CEPAL, Santiago (Chile). disadvantage to viewing it as largely voluntary and heterogeneous phenomenon. David De Ferranti, Guillermo Perry, Daniel Lederman and heterogene6. phenomen6n. William Maloney (2001). From Natural Resources to the Knowledge Economy: Trade and Job Quality. PREM/LAC, The World Bank, Washington, DC. New Opportunities After Liberalization , , Notes In the early 1990s it would not have been an exaggeration to characterize labor reforn as the forgotten reform. As 'Indermit Gill and William Maloney are Lead Economists mentioned above, most countries had by then put in place in the Latin America and the Caribbean Region of the World successful macroeconomic stabilization programs, and Bank. Ms Sanchez-Paramo is an Economist in the Poverty many had already launched. financial sector reforms. By the Unit of the Region. middle of the decade, however, the labor policy agenda 2 CEPAL estimates that 6 of every 10 new jobs were created could be upgraded from forgotten to unfinished, and in the informal sector. governments in the region seem committed to continue Learn more about our work working on labor reform during this new decade. This http://www.worldbank.org/Iac To Subscribe to "en breve" ple,ase send an "en breve" might also be of interest to: email t6" ?_breve@worldbank.org" or write to: . ~~~~~~~Name:- Editor, En breve lnstit'.tiion MSN. 16-604_ Add res!$ - The World Bank 1818 H Stret NW-' Washingto.n D.C. E-mail: 4