RDP 2007-04: Productivity Growth: The Effect of Market Regulations 5. Alternative Measures of Labour Market Regulation

This section discusses some alternative measures of labour market regulations and presents regression results where these are used in place of the working days lost (WDL) measure. A measure of labour market regulations is included to capture the degree of flexibility of a country's labour market at a given point in time, where we understand a ‘flexible’ labour market as one in which employees can be matched with jobs in an efficient manner. The rationale for using working days lost per 1,000 employees as a measure of labour market regulation is that there is likely to be an indirect, though perhaps imprecise, link between this variable and labour market flexibility.

There are several alternative measures, but each has its own problems. One alternative is union density, which measures the proportion of employees who are union members (Table 1). Again, while there may be an indirect relationship between union density and the rate of job matching, the linkages may be somewhat tenuous. This is partly because, regardless of the proportion of employees who are union members, it is the structure of wage bargaining prevailing in a given country that determines the proportion of employees actually covered by union-negotiated wage bargains (this proportion is called ‘union coverage’). Furthermore, because the gap between union density and union coverage differs across countries, union density is not a good proxy for coverage.^[20]

Both WDL and union density measure an outcome of the regulatory structure of the labour market rather than measuring that regulatory structure directly. While outcomes-based measures might reflect a broader range of structural features affecting the labour market than more direct measures do, measuring outcomes can lead to problems of endogeneity. Of course we have tried to address these, at least in part, by an appropriate lag structure in the regression analysis.

In contrast to these outcomes-based measures, the summary indicator of employment protection legislation (EPL) produced by the OECD measures one aspect of labour market regulation – the procedural and monetary costs associated with legislation governing dismissals. This index is comparable across countries and time,^[21] with a higher number indicating stricter legislation. To date, the indices are only available for three time periods: the late 1980s, the late 1990s and 2003. We therefore follow Blanchard and Wolfers' (1999) method of backcasting and interpolating an EPL to create a long time series for this indicator (see Appendix A for further details).

The theory that stricter EPL makes employment adjustment more costly for firms (and hence impedes matching) is fairly robust across the literature.^[22] However, as a proxy for labour market regulation more generally, EPL suffers from the fact that it may not be the most significant determinant of flexibility, so that changes in EPL strictness might not reflect changes in the overall degree of flexibility. For example, employment protection can be strengthened as other key features of the labour market – such as the structure of wage bargaining – are made more flexible. If the increased flexibility arising from the other changes more than offsets the fall in flexibility from increased EPL, using EPL as a proxy for labour market flexibility would mistakenly suggest flexibility had decreased.^[23] From an empirical perspective, there is less within-country variation in this EPL than in WDL (the average within-country coefficients of variation are 0.53 and 0.87 respectively), although this is only problematic if variation in the EPL understates the ‘true’ variation in the flexibility of the labour market.

The results of re-estimating Models 1 and 2 with union density and EPL appear in Table 3.^[24] When Model 1 is re-estimated using EPL as the LMR variable, the model is not significant overall and the p-value on EPL is very high (0.984). The model is generally robust to excluding individual countries, with the exception of the UK and the US. When EPL is replaced with union density (UD), the coefficient on UD is not significant; the model itself is also not significant overall, while the coefficient on PMR is not particularly robust to the exclusion of individual countries from the sample. The fit of the EPL and UD models is poorer than that based on WDL (as indicated by much lower R² values).

Model 2 with EPL is significant overall (at the 10 per cent level) but few coefficients are significant by themselves. The effects of product and labour market regulation on TFP are evident in the parsimonious specifications (Model 3) based on these alternative labour market variables. However, Model 3 based on EPL suggests that the net effect of a one unit decrease in EPL on TFP growth is positive only for countries that are closer to the technological frontier (that is, once TFP gaps are smaller than about –24). Model 3 based on UD implies that, for a country with an intermediate technology gap, a simultaneous move from a PMR of 5 and UD of 50 per cent to a PMR of 3 and UD of 20 per cent is associated with a rise in TFP growth of 1.2 percentage points, other things equal.

Overall, these results suggest that conclusions about the effects of product and labour market regulation on TFP growth are somewhat sensitive to the measure of labour market regulation included in the regression analysis.

Footnotes

For example, in France in 1990, about 10 per cent of employees were union members but union coverage was around 90 per cent. The figures for the US were 16 and 18 per cent, respectively (Nickell and Nunziata 2000). While data for union coverage are too sparse to be useful, the summary indicator of wage bargaining presented in Elmeskov, Martin and Scarpetta (1998) does measure a related concept for some countries over most of the 1980s and 1990s. [20]

The statistical techniques used to combine the raw data also yield cardinal indices. See Annex 2.A1 in OECD (2004) for a detailed description of the construction method. [21]

The existence and magnitude of these effects in practice has been a far more contentious issue. See OECD (2004) for a recent cross-country analysis of the effects of EPL on labour market outcomes. [22]

Indeed, for Australia, the EPL measure we use suggests that the labour market was more regulated in recent years compared with the 1980s, despite the significant reform over this period (see Dawkins 2000 for a discussion of these labour market reforms). [23]

We do not show results based on a fourth measure of LMR, the Economic Freedom of the World (EFW) Index of overall labour market regulation. While some of the individual components of this index may be useful, the composition of the index changes over time and yet the overall index for any year seems to be merely a simple average of that year's components. This means that within-country variation can reflect the addition of new components rather than a change in flexibility. [24]