On the effects of reducing the government's role in the labour market: a stylished model for Egypt with some numerical policy examples

Risager, Ole; Yang, Chang-Po Working Paper On the effects of reducing the government's role in the labour market: a stylished model for Egypt with some numerical policy examples Working paper, No. 3-99 Provided in Cooperation with: Department of Economics, Copenhagen Business School (CBS) Suggested Citation: Risager, Ole; Yang, Chang-Po (1999) : On the effects of reducing the government's role in the labour market: a stylished model for Egypt with some numerical policy examples, Working paper, No. 3-99, Copenhagen Business School (CBS), Department of Economics, Frederiksberg, https://hdl.handle.net/10398/7659 This Version is available at: https://hdl.handle.net/10419/208414 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ Institut for Nationaløkonomi Handelshøjskolen i København Working paper 3-99 ON THE EFFECTS OF REDUCING THE GOVERNMENT`S ROLE IN THE LABOUR MARKET: A STYLIZED MODEL FOR EGYPT WITH SOME NUMERICAL POLICY EXAMPLES Ole Risager Chang-Po Yang Department of Economics - Copenhagen Business School Nansensgade 19, 5. DK - 1366 København K. ON THE EFFECTS OF REDUCING THE GOVERNMENT’s ROLE IN THE LABOUR MARKET: A STYLIZED MODEL FOR EGYPT WITH SOME NUMERICAL POLICY EXAMPLES by* Ole Risager Chang-Po Yang Institute of Economics/EPRU The World Bank Copenhagen Business School World Trade Center Nansensgade 19, 5. 1191 Corniche El Nil, 15th floor 1366 Copenhagen K. Cairo 11221 Fax +45 3815 2665 Fax +20 2 5741676 E-mail [email protected] E-mail [email protected] First draft August, 1998. This version February 1999 Keywords: Uncertain environment, job security, countercyclical government intervention with lifetime employment guarantees, wages, and employment. Abstract: This paper analyzes the consequences of pursuing a less activist Government employment stabilization policy strategy in Egypt. On the basis of a fairly stylized model we find that a reduction of the Government’s involvement in the economy along with an introduction of mild but binding firing regulations in the private sector may lead to a rise in total employment and to an improvement in Egypt’s trade balance vis-à-vis the rest of the world. *This paper has been written for the World Bank. We thank Jan Olesen and Guttorm Schelderup for helpful comments and Christoffer Kok Sørensen for competent research assistance. Finally, the views expressed in the paper are those of the authors’ and are not necessarily shared by the World Bank. 1 1. Introduction The point of departure of this paper is the high degree of uncertainty that characterizes Egypt and the Middle East in general. The highly volatile economic and political environment provides one reason why the government is so involved in the economy. In Egypt’s case the public sector, defined as the government plus the public establishments, now employs one third of the workforce. The relative importance of the public sector has furthermore increased in recent years. As noted by Fergany (1997), the public sector has been the only consistent employment generator in the period 1990-95, which is also characterized by shrinking private sector employment in the beginning of the period due to the recession. Moreover, the public sector has continued to expand also after the private sector has started to pick up. Besides having pursued an active stabilization policy, the government is also offering a high degree of job security like in many other countries. In Egypt’s case, the government is virtually offering lifetime employment security as noted by Assaad (1995). Unlike the public sector, the private sector offers very little job security partly because of lax enforcement of the labour law, see Assaad (1995). Hence, the private sector operates under a very liberal hiring-firing regime. As the unemployment benefit system is highly underdeveloped, jobs in the private sector are much more risky than in the public sector, which in turn is an impedient to a strengthening of the private sector, which accounts for most of the export-oriented firms, relative to the public sector. The extensive job creation in the public sector in combination with life time job security may lead to a relatively high wage level in the economy, which in turn may have made it more difficult for the private sector to compete at the international market place. An important purpose of this paper is to analyze an alternative policy regime that aims at increasing the role of the private sector and likewise reducing the role of the public sector. The regime we have in mind is still characterized by active government intervention in recessions but only in recessions. Hence, the government continues to offset adverse employment shocks, but in order to make the system more symmetric and balanced, the private sector is also supposed to bear part of the burden through mild but binding firing regulations. Hence, both the public sector and the private sector offer some protection against adverse shocks, which compared to the present state of affairs reduces the riskiness of being employed in the private sector. Another important 2 feature of the policy regime we analyze is the abolishment of lifetime job security for workers and civil servants. Thus, individuals who get hired by the public sector in recessions to be employed in regular jobs or enrolled in training activities should only be offered temporary state contingent contracts. Thus, when the economy moves from bust to boom, these manpower ressources are released such that the private sector easily can expand without competing for labour with the public sector and hence putting an upward pressure on labour costs. The idea is, of course, to facilitate the required reallocation of ressources from the public sector, which is mainly non-tradables, to the private sector that accounts for the export sector. In order to analyze this issue, section 2 constructs a stylished model that allows for an active government stabilization policy and for firing regulations in the private sector. The model is stochastic and hence allows for shocks and uncertainty in general. Indeed, it is the uncertain environment that provides the rationale for active government policies and for some job security in the private sector. Our model extends Bertola (1990) to an open economy framework with a state contingent government policy rule. Section 3 calibrates the model such that it fits the present state of affairs in Egypt. Section 4 goes on to compare the present situation (base run) with a policy reform that reduces the role of the government in upswings and increases the role of the private sector in downswings via the introduction of mild but enforced firing regulations. Besides focusing attention on private and public sector employment, the paper also looks at the trade balance effects of the various policy regimes. Section 5 concludes the paper. 2. The Model This section outlines a stylished model of Egypt’s economy with particular emphasis on the labour market and the labour market policies the government has pursued in order to cope with the persistent high unemployment problem. Following the presentation of the model and the characterization of the present state of affairs, the paper goes on to analyze the effects of pursuing a less activist policy. The main focus is on two classical themes in economics, namely, internal and external balance. The measure of internal balance is the overall employment situation, whereas external balance is defined by the trade account. 2.1 The Private Sector The point of departure of the model is the high degree of uncertainty that characterizes the 3 Middle East in general and therefore also Egypt. Indeed, it is this uncertain economic and political environment that is the prima facie reason for the high degree of government intervention in the economy. The volatile economic environment is incorporated into the model by the assumption that the demand for the economy’s output fluctuates, that is, the economy is sometimes facing high demand and sometimes low demand. As Egypt has only limited power to affect prices in international trade, the model assumes that the economy is a price taker. In this case, the uncertain demand situation can be captured by a stochastic process for the price of exports or tradables in general. The price for tradables p in period J is given as, (1) pZ ττ τ = , = G,B where Z is a state variable which equals ZG in good states and ZB in bad states; ZG > ZB such that there are periods with high demand/price and periods with low demand/price. The good state ZG persists with probability PG , whereas the state shifts from “good” to “bad” with probability 1-PG. The bad state ZB persists with probability PB , whereas the state shifts from “bad” to “good” with probability 1-PB. It is the uncertain demand that provides the rationale for job security policies and government intervention in general. The export sector produces output Y according to the following standard production function, where L is employment. (2) yL ττ α τα =<< −1 01 , = G,B, In the absence of labour shedding and recruitment of new workers , profit equals, (3) πτ τττττ =− py WL , = G,B where W is the wage. Due to labour market regulations, the model economy assumes that it is costly for firms to fire workers. The cost of firing a worker is given by F. It may also be costly to hire new workers on top of the direct wage cost. We take that possibility into account by assuming that the cost of hiring a new employee is given by H. Hence, firms operate under 4 1) The solution can be obtained on request to the authors; see also Bertola (1990). () () () L WHF P r rH r Z G G G G =++− +++ −             − 1 11 1 1 α α () () () L WHF P r rF r Z B B B B =−+− +−+ −             − 1 11 1 1 α α the following labour turnover costs, (4) () () AHL L L L FL L L L =−− −− −<    −− −− ττ ττ ττ ττ 11 11 0 if > 0 if The value of the firm is defined as the expected discounted cash flow, given as (5) () VE rA j jj j ττ τ τ πτ =+     − ∑      ++ = ∞ 1 1 0 ,=G,B where E is the expectation operator (given the available information in period J) and r is the constant discount rate. The goal of the firm is to maximize the discounted cash flow (5) subject to equations (1)-(4), and the assumption that firms take the interest rate r, the wage level W, and the labour turnover costs F and H for given. By solving this problem, we obtain firms’ desired labour demand in the two states.1 (6) Below we outline the characteristics of the employment equations. An increase in the cost of hiring a new employee H reduces employment in both the good and bad state as expected. The role of firing regulations is more tricky. An increase in the cost of firing F reduces employment 5 () $ GLL GB =− ≤≤ ζζ , where 0 1 in good states because firms are forward looking and hence take into account that there is a risk that the economy moves into a recession in which case firms would like to layoff workers. Hence, firing regulations that are intended to prevent workers from being fired in bad times have a clear negative effect on job creation in good times. However, it remains correct that firing regulations do protect the employed workers in recessions insofar as firms get an incentive to hoard labour. Due to the positive employment effect in recessions and the negative effect when the economy is doing well, firing regulations have an ambiguous effect on the average employment level in the private sector, see also Bentolila and Bertola (1990). It is therefore desirable to try to quantify the effects of firing regulations on average employment, cf. below. Private sector employment of course also depends on the wage level and the goods price, and as usual private sector employment declines when wages increase, ceteris paribus. Similarly, employment will of course be lower in periods with a low goods price. The sensitivity of employment with respect to the movement of the price of tradables and, in general, the prosperity of the region motivates the introduction of the government and its attempt to offset the negative shocks that hit the economy. 2.2 The Government and the Policy Regime The government is assumed to pursue a countercyclical employment policy. Thus, when the private sector is hit by an adverse shock, the government expands public sector employment according to the following policy rule, (7) where the parameter . is a measure of the extent to which the Government intervenes. In the extreme case where .=1, the Government completely offsets any fall in private sector employment. In case .=0, the Government pursues a pure hands off policy, which may be of interest to consider in contrast to Egypt’s more activist policies. The public sector employment level in the bad state is therefore given as, 6 GGG B =+ 0 $ GGG G =+ ≤≤ 0 01 γγ $ , where (8) where G0 denotes a fixed level of public sector employment. In good states, the employment level is defined as, (9) where the parameter ( is a measure of the extent to which those workers who were hired by the public sector in recessions also hang on to the public sector in good times. In case workers enjoy lifetime employment guarantees within the public sector, ( equals 1. In the opposite case where public sector employment is reduced when the private sector again is prosperous, the parameter ( equals 0. In the latter case the policy is purely countercyclical, whereas in the first case the expansionary policy has built in an element of irreversibility. 2.3 Wage Determination Supply and demand for labour are crucial determinants of wages in any labour market theory. Below we assume that wages are entirely determined by those two factors. Issues of monopolization of the labour force in the form of trade union organizations are left out of the formal model; one reason for this is that it is not really clear whether labour unions in Egypt have much power in influencing wages. Several authors argue that trade union leaders restrain themselves from asking for large wage increases as long as the government admits them influence in the labour market legislation process and as long as job security has high priority in particular in the public sector, see Assaad (1994) and his references. However, we will briefly comment on how an introduction of a formal trade union wage model will influence the results. Labour supply is assumed to be an increasing function of the real consumption wage defined as the nominal wage deflated by the consumer price index. As we focus mainly on shifts in the price of tradables and how this affects employment we take a partial approach to the determination of the price of non-tradables and assume that this price is constant and equal to one for simplicity. Labour supply is therefore given by, 13 intervention gives the private sector a strong incentive to fire, and this incentive is much stronger than the labour hoarding incentive that follows from the binding firing costs. In this particular case, severance payments as a proportion of the annual wage amounts to 0.06/0.28 or 21 %. These costs correspond to paying wages in 10 weeks after the individual has been made redundant. The above case raises at least two questions. First, what would happen if the government was less active in stabilizing the economy in which case there will be less upward pressure on wages in recessions. Would it then be possible also to achieve an increase in total employment as in the above example or at least maintaining status que without inducing an increase in the trade deficit? Second, what are the consequences of making it slightly more costly to fire - are there any desirable effects associated with such a strategy? These questions are adressed in section 5 and 6 below. 5. Partial Stabilization with some Job Security in the Private Sector. Consider now the case where the government only partially stabilizes the economy. The stabilization degree is assumed to be 50%, which means that the government absorbs half of those who get fired in the private sector when the economy moves into recession. In upswings, these ressources are released to the private sector reflecting that the government no longer offers lifetime employment guarantees. The results are presented in Table 4. 14 Table 4: Variables Simulations: Base Run1) No employment guarantee, partial stabilization, private firing costs2) Private Employment Good state 0,48 0,55 Bad state 0,36 0,45 Government Employment Good state 0,22 0,10 Bad state 0,22 0,15 Total Average Employment 0,63 0,62 Nominal Wages Good state 0,40 0,34 Bad state 0,23 0,23 Real Product Wages Good state 0,80 0,69 Bad state 0,90 0,95 Real Cons.Wages Good state 0,49 0,42 Bad state 0,34 0,36 Average Trade Balance -0,025 0,081 in % of GDP Notes: 1) ('.'1,F'0 2) ('0,.'0,5,F'0,06 As there is less stabilization in recessions, wages are lower as compared to the previous case with full stabilization. Hence, the private sector is a much larger employer in this case. As employment in the private sector in upswings is identical to the level in the previous case, the private sector is now on average a more important player in the economy. Due to the rise in the private sector, the trade balance improves quite considerably in the model, which is likely to be an exaggeration as there are many activities in the private sector that are non-tradables. However, underlying the very considerable improvement in the trade balance is of course also the reduction in government absorbtion. The fall in public sector activities reduces employment, whereas the rise in private sector activities increases employment. It is interesting to note that total average employment only falls very little as compared to the base simulation. With a modest increase in the degree of government stabilization, it is possible to get both an increase in employment in the private sector and an improvement of the trade balance without hurting total employment in the economy, see Table 5. In this example the degree of stabilization 15 . is 0.7. The main point is that with some firing regulations, there is less need for government intervention. Moreover, when the government moves from complete to partial stabilization of the economy, the government releases a downward pressure on wages that gives the private firms an incentive to hire more workers even though there are now some costs associated with reducing the payroll in recessions. The rise in the private tradables sector is big enough to exactly offset the fall in public sector employment. As a result of the increased role for the tradables sector and the reduced role for the public sector, the trade balance is bound to improve and this tendency is also clear in Table 5. We believe that this regime is an interesting challenge to the present policy regime because it delivers the same average employment level in the economy while at the same time the tradables sector is strengthened. Table 5: Variables Simulations: Base Run1) No employment guarantee, partial stabilization, private firing costs2) Private Employment Good state 0,48 0,54 Bad state 0,36 0,42 Government Employment Good state 0,22 0,10 Bad state 0,22 0,19 Total Average Employment 0,63 0,63 Nominal Wages Good state 0,40 0,34 Bad state 0,23 0,25 Real Product Wages Good state 0,80 0,69 Bad state 0,90 0,98 Real Cons. Wages Good state 0,49 0,42 Bad state 0,34 0,37 Average Trade Balance -0,025 0,04 in % of GDP Notes: 1) ('.'1,F'0 2) ('0,.'0,7,F'0,06 16 6. Partial Stabilization with Much More Private Sector Job Security. Let us now keep the degree of stabilization at the level just considered, that is, . = 0.7. Suppose the costs of firing increases to F = 0.10, which means that the cost of firing equals 40 % of the annual wage. Due to this increase in labour turnover costs, firms hire fewer workers in upturns; in recessions labour hoarding is more pronounced. Hence, the employment difference between the two states is reduced. Therefore, there is less government intervention in recessions. As compared to the previous case with less restrictive firing regulations total average employment goes down; in this regime average employment equals 0.62 as compared to 0.63 in the previous regime. Hence, the fall is modest, but the firing regulation regime is now so restrictive that there may be negative side-effects that are not incorporated into the model. Risager and Soerensen (1997) investigate the relationship between firing costs, firms’ profitability and optimal investments, and show that firing costs under some conditions may have negative investment effects in spite of the incentive to substitute labour with capital. 7. Conclusions Due to the high degree of instability in the Middle East, Egypt’s economy will be highly volatile without government intervention. This paper has also argued that the mean employment level is likely to be lower in comparison to a situation where the government pursues sensible stabilization and regulation policies. At present, Egypt has a very large public sector that accounts for one third of total employment. The public sector has expanded in particular during recessions as noted by e.g. Fergany (1997). An important feature of the public sector’s employment policy is the high degree of job security; as soon as individuals become public sector employees they are virtually impossible to lay off, which means that individuals only leave the public sector if they want to do so. Employment in the public sector is thus highly irreversible. By contrast, the private sector offers very little job security because the private sector is able to get around the formal labour market regulation policies as noted by Assaad (1995). Due to this asymmetry, it is entirely the public sector that dampens the fluctuations in the economy, and provides insurance against adverse shocks. On the basis of a stylished model that captures some of the institutional features characterizing Egypt’s economy and labour market, this paper has argued that the present policy regime may very well lead to relatively high wages that make it difficult for the private sector to compete at the international market place. In this context it is important to note that we have assumed a competitive labour market, which means that it is purely as an absorber of labour that the public sector pushes up wages. If there are strategic effects in the determination of wages in the sense that trade unions take advantage of the public sector’s stabilization policy and the lifetime employment guarantees, wages will be even higher, and the crowding out of the private sector will be more pervasive. Also, the paper has ignored another factor 17 that may lead to additional crowding out, namely, the effect on financial funds and borrowing conditions in general. It is therefore likely that the paper understates the crowding out effects associated with the large public sector in Egypt. Instead of offering lifetime employment guarantees, the paper has looked at alternative policies. One possibility is that the government continues to undertake some stabilization in bad times, but reduces employment in good times such that the tradables sector can more easily expand. Such a situation can be achieved by offering state contingent temporary employment contracts. As the private sector is known for circumventing many of the existing firing regulations, there is a need for making these constraints more binding without getting into the extreme where the private sector cannot reduce its workforce. We have simulated the effects of reducing government job security and increasing private job security such that both the private and public sector offer some protection against adverse shocks. It is important to stress that we have looked for mild firing regulations to be imposed on the private sector; in one example we consider the case where it costs a private firm the equivalent of 21 percent of the annual wage (equivalent to 10 weeks pay) to fire an employee. In this particular case, the results show that this regime outperforms the present unbalanced regime. Thus, the numerical simulations show that this regime leads to an average employment level that is around the level in the base simulation reflecting the present situation. Equally important, the private-tradables-producing-sector increases. Due to the expansion of the private sector, this policy shift is associated with an improvement of the trade balance. The most important reason that we get these desirable effects is that firing costs are not nearly as important for the private sector as the reduction in wage costs that are a result of reduced government intervention in upturns. Finally, it is important to emphasize that the results we have arrived at are tentative and based on a stylished model, but we believe that they are worth considering in more detail. References Assaad, R. (1995), ‘Structural Adjustment and Labor Market Reform in Egypt,’ paper presented at the 1993 Conference of the Middle East Studies Association, November 11-14, 1993. Bentolila, S. and G. Bertola (1990), ‘Firing Costs and Labor Demand: How Bad is Euroschlerosis?,’ Review of Economic Studies 57, 381-402. Bertola, G. (1990), ‘Job Security, Employment and Wages,’ European Economic Review 34, 851-86. Dixit, A. (1989), ‘Entry and Exit Decisions under Uncertainty,’ Journal of Political Economy 97, 62038. 18 Fergany, N. (1997), ‘Dynamics of Employment Creation and Destruction,’ Working Paper. Galeazzi, G. and D.S. Hamermesh (1992), Introduction, in G. Galeazzi and D.S. Hamermesh (eds.), Dynamic Labor Demand and Adjustment Costs (Edward Elgar Publishing Ltd.), IX-XXV. Lazear, E.P. (1990), ‘Job Security Provisions and Employment,’ Quarterly Journal of Economics 105, 699-726. Risager, O. and J.R. Sørensen (1997), ‘On the Effects of Firing Costs when Investment is Endogenous: An extension of a model by Bertola,’ European Economic Review 41, 1343-53. World Bank (1997), ‘Egypt: Employment and Labor Market,’ Issues Paper.