Welfare and Employment in a United Europe: A Study for the Fondazione Rdolofo Debenedetti

Edited by Giuseppe Bertola Tito Boeri Giuseppe Nicoletti

Welfare and Employment in a United Europe

A Study for the Fondazione Rodolfo Debenedetti

Welfare and Employment in a United Europe

Welfare and Employment in a United Europe A Study for the Fondazione Rodolfo Debenedetti

edited by Giuseppe Bertola, Tito Boeri, and Giuseppe Nicoletti

The MIT Press Cambridge, Massachusetts London, England Fondazione Rodolfo Debenedetti

©2001 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. This book was set in Palatino by Best-set Typesetter Ltd., Hong Kong Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Welfare and employment in a united Europe : a study for the Fondazione Rodolfo Debenedetti / edited by Giuseppe Bertola, Tito Boeri, and Giuseppe Nicoletti. p. cm. Includes bibliographical references and index. ISBN 0-262-02483-7 (hc. : alk. paper) 1. Public welfare—European Union countries. 2. Labor market—European Union countries. I. Bertola, Giuseppe. II. Boeri, Tito. III. Nicoletti, Giuseppe. IV. Fondazione Rodolfo Debenedetti. HV238.W42 2000 361.6¢094—dc21

00-060070

To Lapo Anzillotti

Contents

Preface

ix

Introduction: Putting the Debate on a New Footing

1

Tito Boeri I EU Welfare Systems and Labor Markets: Diverse in the Past, Integrated in the Future? 23 Giuseppe Bertola, Juan Francisco Jimeno, Ramon Marimon, and Christopher Pissarides Comments

123

Charles Bean Comments

127

Gøsta Esping-Andersen II European Integration, Liberalization, and Labor-Market Performance 147 Giuseppe Nicoletti, Robert C. G. Haffner, Stephen Nickell, Stefano Scarpetta, and Gylfi Zoega Comments

237

Olivier Blanchard Comments André Sapir

245

viii

Contents

Conclusions: Is There a Role for Supranational Institutions?

251

Tito Boeri Appendix: Taking Stock of Social Policy Reforms in Europe Fondazione Rodolfo Debenedetti Index

287

257

Preface

The changes that have taken place in western Europe over the last twenty years are unprecedented. Fifteen national economies, with their own institutions and traditions, have removed most barriers to trade and migration and most forms of national discrimination in economic and social exchange. Many of them have also chosen to give up their national currency and their ability to conduct independent monetary and fiscal policies. How will this economic integration affect European social welfare systems and the regulatory environment in the labor and product markets? What will be the implications for labor-market performance in the European Union? Is there a potential for coordinating social policies, or should uncoordinated national policies continue unabated? These are the main issues addressed in this book. Unusual for an edited volume, it consists of two long studies, each written by a group of economists working in four different countries of the European Union. Part I reviews and describes the diversity of social welfare systems and recent reforms in the European Union (EU). It discusses the tensions that European integration is likely to introduce and suggests how EU-level and national policies could be structured to minimize such tensions. Any realistic policy reform in Europe has to respect the complexity of political-economic and social-economic interaction among national and supranational policymakers and market participants, and the study focuses on these issues. Part II shifts the emphasis to product markets and asks how the stronger competition that integration brings will affect labor markets. Will European unemployment increase or decrease? Are labor-market institutions likely to change as the removal of product-market regulations exposes them to European competition? The study draws on fresh

x

Preface

and still unpublished evidence on product-market regulations, recently assembled by the OECD, and brings it to bear on the influence that product-market regulation has on the performance of labor markets. Both studies were carried out for the first European conference of the Fondazione Rodolfo Debenedetti held in Genoa in July 1999. Fondazione Debenedetti is a new research institution, located at Bocconi University in Milan, focused on European labor-market and social policy reforms. In addition to organizing the conference and coordinating the two studies, Fondazione Debenedetti provided background material for the two research teams, producing an inventory of social welfare reforms in Europe summarized in the appendix. The main results of the work carried out at the Fondazione are summarized in the introductory chapter.

Introduction: Putting the Debate on a New Footing Tito Boeri

This book aims at putting the current debate on the future of (social) welfare and employment in a united Europe on a new footing.1 We need fewer apocalyptic statements, fewer Cassandras, more facts, and deeper theoretical perspectives. More balanced views and more careful ways to assess empirical evidence are also needed, as well as ways to carry out speculative thinking. Extreme views about the implications of European integration are not supported by evidence on past integration and social welfare reforms in the last fifteen years. Dramatic Perspectives The two most recurrent views of the future of employment and social welfare systems in a united Europe are rather extreme and dramatic. On the one hand, some argue that the single market and the monetary union (for the countries that belong to EMU) will make it more difficult to carry out badly needed structural reforms in Europe. The action of governments will be biased in favor of the status quo for a number of reasons. First, incentives to free-riding will increase as closer economic integration makes it easier for governments to shift the burden of their own structural inefficiencies onto other countries. The monetary union, in particular, will reduce incentives to reform labor-market regulations to cope with the inflationary bias associated with structural unemployment (Calmfors 1998). Since the European Central Bank (ECB) now determines monetary policy in the currency union as a whole, labor-market reforms in a given country will have only a small effect on the common rate of inflation.2 Second, Europe will be caught in a slow-growth, high-structural-rigidities equilibrium: to grow, structural rigidities and inefficiencies in European welfare systems should

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be removed, but structural reforms can be made only when macroeconomic conditions are favorable. Slow growth makes it more difficult, if not impossible, to reform because there is a stronger demand for social protection and job security—institutional features that structural reforms are supposed to reduce or, at least, make less automatic. Moreover, the benefits from structural reforms take more time to materialize when aggregate demand is weak (Minford 1994), and hence governments with relatively short time horizons may be discouraged from taking initiatives on this front. Tight macroeconomic policies imposed under the Stability Pact (for the members of EMU) and the Maastricht criteria (for the countries wishing to join the EMU) will not improve matters. On the other hand, some claim that closer market integration and the loss of monetary authority (for the countries that belong to the EMU) will force governments to deal with structural issues as there is hardly anything else to do. This is, in essence, a Thatcherian “there-is-noalternative” or TINA statement (the label comes from Calmfors 1998). Governments in the monetary union will have to concentrate their efforts on structural policies (Bean 1998). As monetary policy is decided elsewhere, countries will be able to cope with (asymmetric) shocks only if they increase the flexibility of their product and labor markets. This may be a desirable development since the rigidities of European markets, the so-called Eurosclerosis, often bears the blame for the dismal growth performance of the EU vis-à-vis the United States. However, the dismantling of European “social protections” will not be selective and may involve features of European welfare systems (for example, social assistance of the last resort) that remedy market failures and are essential to maintaining social cohesion. The removal of the remaining barriers to the mobility of goods and services and the greater price transparency involved by the adoption of a common currency in the core EU countries will increase competitive pressures on national fiscal systems, setting in motion a “race to the bottom” in social welfare provision (Sinn 1998) in an attempt to attract foreign direct investments (FDIs). The impossibility of adjusting parities vis-à-vis the main trading partners will also increase competitive pressures on employment protection and collective bargaining institutions.3 In a nutshell, European integration certainly will be bad for the unions (Burda 1999), but it is likely to be bad also for some features of the welfare state that should be kept in place.

Introduction

3

Lessons from European Integration Which of these two extreme views, if either, comes closest to reality? We may be able to learn something useful from the recent past. After all, product-market integration and monetary unions are not completely unknown in Europe. Countries like Austria, Belgium, and the Netherlands have maintained fixed parities with the D-mark, virtually sharing the same currency, for the last twenty years. The French franc has also been a “hard currency,” kept well within the narrow EMS bands since 1987. If these are not truly monetary unions, they are very close approximations. Thus the experience of the D-mark area and core EMS countries can be informative here. In particular, race-to-thebottom pressures on wages and bargaining institutions should have arisen within these “currency areas,” characterized from the very start by marked differences in unit labor costs and unemployment levels (hence also potential differences in the dynamics of wages). The countries that belong to such unions were also closely interconnected (e.g., one-third of Dutch exports go to Germany). Since the completion of the internal market in 1979, product-market regulations of current EU members have been significantly reformed, with the dismantling of many implicit barriers to the mobility of goods. Product-market regulations are commonly considered the most effective arena of operation for the European Commission. Policies like mutual recognition on case law have played a very important role in enforcing the single-market principles. Yet there are still product markets, notably services, in Europe that are relatively sheltered from competition, and these account for a significant component of EU GDP.4 Moreover, most of the sheltered sectors supply inputs to other products, for example, agriculture, energy, and automotive parts,5 which clearly reduces the scope of price competition in the industries heavily using these intermediate inputs. Yet price competition in manufacturing is relatively high and trade, notably of the intraindustry type, has been constantly increasing.6 FDIs have also increased: intra-EU foreign direct investment inflows currently account for more than 1 percent of the European Union GDP (from less than 0.25 percent of that in the late 1970s). Several measures of economic integration—for example, defined on the basis of clustering techniques over macroeconomic series and the structure of private consumption (OECD 1999)—point to increasing market integration within the EU. It follows that developments not only in the D-mark area and core EMS groups, but also

4

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Contributions as a percentage of gross wage

in the EU at large, are informative as to the likely consequences of integration on labor market and social welfare institutions. Figures I.1 to I.6 give some clues about the evolution of these institutions in the three areas listed above—D-mark zone, core EMS group, and EU as a whole—over the course of the last two decades. Top and bottom provisions in the mid–1980s and in the 1990s7 are highlighted to show the degree of convergence across countries and to better assess the presence of a race to the bottom. Figures I.1 and I.2 show the dynamics of statutory and actual social security contribution rates as a percentage of the gross wage bill. Actual social security contribution rates are obtained by taking the ratio of social security revenues to the total wage bill plus employers’ social security contributions. This measure is complementary to statutory contribution rates insofar as countries often grant some regions or lowskilled workers partial exemptions from social security payments in order to subsidize employment. For instance, in southern Italy employ-

45 Nld

TOP 97 TOP 85

40

Bel

Ita

35 30 25

1985 Aut

Grc

Ger

Es Por

Lux

20

1997

Irl Fra

15

Uk

Mex Jap

10 Den 5

Nor

Swe

Fin

Swi Tur

Usa

Can BOTTOM 97

Aus BOTTOM 85

0 D-mark Area

Other EU countries

Other non-EU countries

EMS Area Figure I.1 Compulsory social security contributions Note: Compulsory social security contributions paid by employees and employers as a percentage of the gross wage. The (Spearman) rank correlation coefficient between the initial and the final distributions is 0.91, which is statistically significant at 99 percent confidence levels. The standard deviation of the initial distribution is 14.74, and of the final distribution it is 10.43. Source: OECD, 1998a.

Contributions as a persentage of the labor tax base

Introduction

5

30

Nld TOP 85

25 20

TOP 97

Fra

Bel

Grc

Ger

Ita

Aut Lux

Swe

15

Por Fin

10 5 0

1985

Es

Irl

Nor

1997

Jap Uk Usa Can Swi Tur

BOTTOM 85 Den BOTTOM 97 D-mark Area

Other EU countries

Other non-EU countries

EMS Area Figure I.2 Actual social security contributions Note: Total contributions paid by employees and employers as a percentage of the labor tax base (total wage bill + employers’ contributions). Data for Belgium, Canada, and Japan refer to the years 1985–1996. Data for Germany refer to the years 1985–1994. The (Spearman) rank correlation coefficient between the initial and the final distributions is 0.91, which is statistically significant at 99 percent confidence levels. The standard deviation of the initial distribution is 6.62, and of the final distribution it is 6.89. Source: OECD, 1998a.

ers did not have to pay a wide array of contributions. Hence the sum of statutory payroll taxes earmarked to the various funds may well hide declines in the actual fiscal pressure on labor associated with the financing of social security provisions. The visual impression given by figure I.1 is not quite one of fiscal competition eroding the contribution base for social policies. Statutory contribution rates have indeed increased in most countries over time, and the fact that such a tendency has been particularly pronounced within the D-mark zone, with Germany and Austria leading the “race to the top,” is quite revealing. The relative positions of the various countries in the incidence of payroll taxation do not appear to change significantly over time. The (Spearman) rank-correlation coefficients, reported at the bottom of the figure, together with the standard deviations of the two distributions, confirm this visual impression. The picture does not change substantially when the focus is on actual contribution rates. Just a few arrows point downward, in spite of the fact that some countries have recently shifted social security financing away from payroll taxes to income or indirect taxation. Overall, there

6

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is no visible sign that social security taxes were put under strain by European integration. Although the past offers a highly imperfect guide to the radical transformations about to occur, like the build-up of EMU, the fact that social security contributions have increased in the quasi-monetary unions of central Europe does not lend support to the race-to-the-bottom scenario. Figures I.3 to I.6 are on social expenditure, namely, on the generosity of the three basic components of social security: pensions, unemployment benefits, and social assistance. Figure I.3 shows the ratio between the (public) pensions received by people aged 65 to 74 and the disposable income of 55- to 64-year-old individuals. This is a summary measure of the contribution offered by public pensions to the replacement of preretirement earnings. Data come from national sources and have been assembled (in a way satisfying cross-country comparability requirements) by the OECD. If anything, the figure points to a mild degree of convergence in the generosity of public pension systems as the range of actual replacement rates narrows significantly (the 80

TOP 80s Fra TOP 90s

70

Contribution

60

Hun

Swe

Bel Ger

Mid-80s

Ita

Mid-90s

Grc

50

Uk 40

Nld

Aus

Den

Nor

Swi

30

Usa

20

Fin

10

BOTTOM 90s BOTTOM 80s Can

0 D-mark Area

Other EU countries

Mex

Other non-EU countries

EMS Area Figure I.3 Contributions of public pensions to the maintenance of income after retirement Note: Pensions received by persons aged 65 to 74 as a percentage of the total disposable income of persons aged 55 to 64. The (Spearman) rank correlation coefficient between the initial and the final distributions is 0.97 which is statistically significant at 99 percent confidence levels. The standard deviation of the initial distribution is 20.56, and of the final distribution it is 19. Source: OECD, 1998a.

Introduction

7

standard deviation of the distribution is lower in the final rather than in the initial years), and the countries with the more (less) generous arrangements are visibly cutting down (increasing) provisions vis-àvis earnings before retirement. This impression is conveyed by simple regressions of rates of changes in pension expenditure to GDP ratios against the initial levels.8 Note that this mild convergence does not appear to occur at the bottom of the distribution but toward its middle, for example, in the position initially occupied by the United Kingdom. This trend was paralleled by the increase in statutory and actual contribution rates documented above. Hence, rising replacement rates are not necessarily associated with higher returns from public pensions. Microsimulation studies9 suggest that rates of returns of public pensions are declining in all countries for which data are available. Figure I.4 offers a summary measure of generosity of unemployment benefits. Typically the OECD (e.g., in the context of the OECD Jobs Study10) produces such measures by taking simple averages of nominal

Figure I.4 Generosity of unemployment benefits Note: Average of gross replacement rates (gross unemployment benefits as a percentage of the gross wage) at two income levels (100 and 67 percent of average wage) for a single person during the first two years of unemployment. The (Spearman) rank correlation coefficient between the initial and the final distributions is 0.87 which is statistically significant at 99 percent confidence levels. The standard deviation of the initial distribution is 20.21, and of the final distribution it is 17.46. Source: Fondazione RDB estimates based on OECD, 1998b.

8

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replacement rates at different durations of unemployment. This is inaccurate, however, as the replacement rates offered in the second year of joblessness are clearly more important than, say, the benefits provided in the fifth year of unemployment. Moreover, no account is made by the OECD summary generosity measure of the actual coverage of benefits, which means that a very generous benefit given to 10 percent of the unemployed is accorded the same score in generosity as a lower subsidy offered to a larger fraction of the jobless population. The two biases work in the same direction insofar as coverage is decreasing with unemployment duration (not least because eligibility for benefits for long unemployment duration becomes conditional to passing an income and asset test). Hence in figure I.4 we have corrected the OECD measures in two ways. First, we focus only on the first two years of unemployment (in most countries, individuals with unemployment durations longer than twenty-four months are eligible only for meanstested social assistance, whose coverage and level are assessed in figure I.5). Second, we have weighted replacement rates for the second year of unemployment by the incidence of long-term unemployment. Thus in a country where 50 percent of unemployment is long term (lasts more than twelve months), a weight of 0.5 is given to replacement rates offered in the second year of joblessness.11 Figure I.4 suggests that there has been some tendency toward reducing the generosity of benefits, but this trend has not been uniform. Declines in the generosity are visible in the D-mark zone, but these are rather marginal; generosity is reduced by less than five percentage points on average. Figure I.5 provides information on trends in social assistance provision—cash transfer schemes aimed at satisfying the primary goal of social welfare, namely guaranteeing subsistence to people in need. This key function of welfare systems is often pointed out as being in danger of being dismantled by those who fear the consequences of a race to the bottom. The generosity measures are in this case provided by the ratio of social assistance expenditure12 to the number of people with incomes lower or equal to 50 percent of the average wage. Many arrows in this chart are oriented northward and the top of the distribution itself is shifting upward. Thus, in this primary field of social protection the visual impression is one of a race to the top rather than of a race to the bottom13. Social assistance is usually funded out of general government revenues, hence it will not be affected by possible reductions in statu-

Introduction

9

TOP 95 Social assistance to the unemployed as a percentage of previous wage

80 70

Den TOP 85 1985

60 50 40 30

1995

Nld

Fin

Bel Aut

Ger

20

Aus

Fra

Irl

Es

UK

Nzl Nor

Can

10 0

BOTTOM 85–95 D-mark Area

Grc Ita Por

Other EU countries

Swe

Jap

Swi

USA

Other non-EU countries

EMS Area Figure I.5 Generosity of social assistance programs Note: Average of the gross replacement rates offered by social assistance at two income levels (100 and 67 percent of average gross wage) for three family types (single person, couple with only one worker, couple with one worker and children) from the second to the fifth year of unemployment. The (Spearman) rank correlation coefficient between the initial and the final distribution is 0.82 which is statistically significant at 95 percent confidence levels. The standard deviation of the initial distribution is 6.26, and of the final distribution is 9.59. Source: Fondazione RDB estimates based on OECD, 1998b.

tory and effective social security contributions paid for by employers on top of their wage bills. Finally, figure I.6 deals with employment protection regulations—the set of rules governing unfair dismissals, layoffs for economic reasons, severance payments, minimum notice periods, administrative authorization for dismissals as well as prior discussion with representatives of unions and/or labor market administrations. The measures provided in the figure are increasing in the guarantees offered to employees and have been recently revised (and updated) by the OECD14 in an attempt to capture the spread in many EU countries of temporary contracts. A number of caveats apply to these measures15; nonetheless they offer an overview of trends in barriers to dismissals, trends that are now, unambiguous. Almost all European countries show a decline in the extent of employment protection, while no changes are visible

Strictness of protection

10

Boeri

Ita Por Es Grc Swe

Bel Ger Nld

Fra

TOP 80s TOP 90s

Japan Den Fin

Aut Australia

Irl Uk

D-mark Area

Other EU countries

BOTTOM 80s and 90s

United States Canada

Other non-EU countries

EMS Area Figure I.6 Employment protection legislation Note: OECD summary indicator of the strictness of employment protection legislation (weighted average of indicators for regular contracts and temporary contracts. The (Spearman) rank correlation coefficient between the initial and the final distribution is 0.92 which is statistically significant at 99 percent confidence levels. The standard deviation of the initial distribution is 1.23, and of the final it is 1.05. Source: OECD, 1999b.

outside the EU. Although this higher flexibility in employment adjustment is often the by-product of new contractual types rather than of reforms of regulations permanent workers, the tendency toward reductions in the degree of employment protection is noticeable and the standard deviation of the distribution is declining over time. Overall, there does not appear to be a uniform tendency toward reducing social welfare provisions across Europe. Some schemes, such as unemployment benefits, are becoming less generous, and there is a marked tendency toward the reduction of the system of job guarantees offered in the past to employees. In other fields, such as social assistance, the trend goes in the other direction: the generosity of provisions is increasing over time. More important, being in a quasicurrency union does not appear to matter much. Evolutions in social spending and social security taxation are, in most cases, broadly the same among D-mark area or core EMS countries and the remaining EU members. What can we conclude from this? Experience does not lend support to the view that European social welfare systems are challenged and at serious risk of being dismantled because of the competitive pressures

Introduction

11

associated with closer market integration and the EMU. Cuts to social spending are not uniform but selective, and they do not appear to be confined to currency unions. This may suggest that some rationalization is going on, but governments have some leverage in deciding which institutional features should be kept in place and which should be downscaled. Governments can, as in the case of income support of the last resort, even make existing provisions more generous over time. Needless to say, more careful analyses of the changes in the composition of social spending (as those carried out in the first part of this book) will shed more light on these selective interventions concerning the generosity of social welfare systems. Learning from Social Welfare Reforms How should one address the rather gloomy view that Europe will not be able to reform its welfare systems because it does not grow fast enough (and does not grow because it does not reform labor and social welfare institutions)? Based on a variety of sources (including country economic reviews carried out by the OECD, Income Data Source studies, EC-MISSOC reports, etc.), we have taken stock of reforms carried out in Europe in the field of nonemployment benefits (encompassing not only unemployment benefits but also the various cash transfers provided to individuals of working age16), pensions, and employment protection. Details on the inventory of social policy reforms produced at the Fondazione Rodolfo Debenedetti and on the single regulatory changes are offered in the appendix. Hence, we confine ourselves here to providing information on the criteria followed in the classification of the various reforms which is organized along two main dimensions. First, we distinguish reforms on the basis of their broad orientation, that is, whether they tend to reduce or increase the generosity of public pensions and nonemployment benefits and make employment protection more or less stringent. This is the same dimension along which figures I.1–I.6 have been organized. Second, we distinguish reforms depending on whether they are marginal or radical. This procedure is done in two stages. First, we rely on qualitative assessments, which are based on an evaluation of the scope of the various reforms. In particular, we classify as radical those reforms that satisfy at least one of the following criteria:

12

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reduce replacement rates at the average production worker (APW17) level by at least 10 percent; •

are comprehensive, that is, do not address just minor features of the cash transfer schemes (e.g., the minimum employment record required to qualify for unemployment benefits) but rather reform their broader design; and •

involve existing entitlements rather than being simply phased-in for the new beneficiaries of the various schemes (e.g., reforms of employment protection also should concern workers under permanent contracts). •

The second stage of the classification procedure looks at the actual behavior of the series that should be most affected by the reforms; only if we observe a change in the underlying trend of these series do we confirm our qualitative assessment. Clearly the second stage of this procedure can be implemented only for the reforms carried out before 1993, as a minimum number of observations are necessary establish whether a change in the underlying trend has occurred. Sometimes, even in the case of reforms carried out before 1993, the second-stage validation procedure cannot be implemented, as some reforms are followed just a few years later by regulatory changes moving in the opposite direction, thus undoing part of the initial institutional changes. In all the cases where the second-stage procedure cannot be implemented, only the first-stage assessment is used. The latter was validated in 85 percent of the cases. Which series was used in the empirical validation procedures? It clearly depends on the institutional features subject to reform. In the case of employment protection, we looked at labor-market flows, notably unemployment inflows, as previous work has found a strong negative correlation between employment protection and the incidence of unemployment.18 The impact of reforms on stocks (e.g., employment and unemployment levels or labor force participation rates) can only be appreciated when working with long series, something that is not within our feasibility set. In the case of pension reforms, we looked at the dynamics of pension expenditures and revenues earmarked for public pension funds: we expect radical reforms to significantly affect at least one of the two. Finally, in the case of nonemployment benefits, we used proxy outflows from unemployment19 (or outflows from the live registers to jobs in the countries for which such data are available): we expect radical reforms to significantly affect exit flows

Introduction

13

from unemployment (unfortunately we have no data on outflows from nonemployment). The main results of this exercise are summarized in table I.1. The first fact to notice here is that, contrary to popular wisdom and to the belief that labor-market and social welfare institutions cannot be modified, many changes have occurred over the observation period of twelve years. We counted almost 200 reforms; however, the changes have often been marginal (172 out 198 reforms, that is, roughly 85 percent of the regulatory changes did not pass the two-stage procedure identifying radical reforms). Moreover the reforms are almost evenly split between those reducing generosity and employment protection (107 out of 198, about 55 percent) and those increasing generosity and protection. It is also not infrequent to find reforms going against each other over a few years. These inconsistencies—which can be better appreciated by looking at the arrow charts in the appendix—and the marginal nature of most reforms have significantly increased the institutional complexity of the European social welfare landscape. In the field of employment protection, for instance, we have found a growing mumber of contractual types, with a number of fixed-term and unstable jobs going hand-in-hand with permanent and still heavily protected positions. All of this has increased the dualism of European labor markets, making them more segmented not only between insiders and outsiders but also among various types of outsiders. Another important fact revealed by table I.1 is that, among the seventy reforms that have tightened benefits or reduced employment protection, fifteen have been carried out during recessionary periods (negative GDP growth) and twenty-two under slow growth (zero to 1.5 percent GDP growth). During recessions or under slow growth it appears that it is more common to tighten generosity and reduce protection (37 reforms) than to proceed the other way (23 reforms), while strong pressure to increase generosity exists during relatively strong growth scenarios (GDP growing at more than 1.5 percent per year). Only four of the “unpopular” reforms, however, were radical among those carried out when GDP was growing less than 1.5 percent per year. Overall, the view that slow growth prevents reforms does not find support from this analysis. It is true that radical and unpopular reforms are difficult under these circumstances, but when macroeconomic conditions are not favorable it is more likely that regulatory changes will move toward reducing the generosity of benefits and employment protection rather than in the other direction. A tentative explanation for

Marginal Radical

Marginal Radical

Nonemployment benefits

Public pensions

15

6 1

6 0

2 0

22

6 1

8 2

5 0

70

18 5

23 5

13 6

10

13

4 0

5 0

5 0

3 0

4 0

0 2

GDP growth 0–1.5%

68

2

28

2

24

0

12

GDP growth >1.5%

GDP growth <0%

GDP growth >1.5%

GDP growth <0% GDP growth 0–1.5%

Increasing generosity and protection

Decreasing generosity and protection

Source: Fondazione Rodolfo Debenedetti.

Total per column

Marginal Radical

Employment protection legislation

Table I.1

198

67 9

69 9

36 8

Total per row

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Introduction

15

this rather surprising result is that public authorities and social partners may have a stronger sense of urgency when macroeconomic conditions are less favorable—recessions are often times of “extraordinary politics”—than during upturns. Thus, neither of the two extreme views is supported as such by our investigations. This is reassuring as neither of the two extreme scenarios (the dismantling of social Europe and its paralysis) appear to be particularly appealing, but it also leaves many other questions on employment and welfare in the united Europe unanswered. A vast array of intermediate scenarios need to be explored and empirically assessed. The only thing we can be sure of is that institutions are not static. The overall impression is one of changes taking place in rather complex and disordered ways with country-specific reform trajectories and little, if any, convergence in outcomes. The contributions in this book shed light on this complexity. Understanding Complexity One may argue that the answer provided by the data does not come as a surprise at all. European social welfare is so articulated (even more so after the marginal and inconsistent reforms of the last fifteen years) and institutions are so diverse that it would be hard to imagine that they could converge or be subject to the same trends. Not only the institutions themselves but also the combinations or clusters of institutions are country-specific. Moreover, the various regulations in the social and labor spheres are often complementary and provide support to one another.20 For these reasons, it would be foolish to expect common trends to arise in a united Europe. By the same token, there is no reason why the current countryspecific evolutions should be blocked under closer European integration. Regulations will continue to evolve and reforms will be made. Institutional heterogeneity means that there is not just one arbitrage condition to be met and just one factor, namely capital, that moves around.21 Another possible reaction to the results presented here is that past experience is actually not informative as to the future course of events. What we are experiencing here is a radical transformation, something that challenges any extrapolation from past behavior and makes the future highly unpredictable.

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Whatever one’s reaction is to the evidence presented here, we need hard evidence and more analytical thinking to understand what is going on and what will likely occur in the field of social welfare institutions and employment regulations. For this reason, the facts and theoretical perspectives reviewed in this book are essential as a new footing for the debate. What are the main trends emerging behind the institutional complexity outlined above? Are clear country- or region-specific patterns emerging? How will these trends be affected by stronger European integration? Is there any scope for coordination of social policies (and social policy reform) at the European level? These are the main issues addressed in the first part of this book, presenting the results of research carried out by a group of leading European economists. Their work reviews the heterogeneity of welfare systems and reforms in the EU, discusses theoretical and empirical perspectives on the race-to-thebottom tensions, and outlines how EU-level and national policies could be structured to minimize such tensions while preserving appropriate mobility incentives and recognizing the complexity of the politicoeconomic interactions among national and supranational actors. Analytical thinking, more than casual empiricism, is needed to understand the fate of European labor and social policy institutions. Empirical evidence can be of help, however, especially for those institutional features and implications of economic and monetary integration about which we can be most sure. The fact is that EMU has already had an impact on European institutions. In particular, EMU has de facto decentralized even the most centralized collective bargaining institutions since national unions no longer interact with domestic monetary authorities to decide on target inflation rates. Another important effect of EMU is the presence of greater price transparency, hence more competition in product markets. Indications of the future course of events on labor market and social policy reforms in a united Europe can come from analyses of the interactions among product and labor market institutions. The second part of this book draws on an extremely rich data set assembled at OECD on product-market and labor-market regulations. The aggregate indicators displayed therein suggest that countries tend to adopt similar approaches in these two markets: where product markets are adverse to competition and state interference in the business sector is high, labor markets tend to have tight legislation that protects insiders. This does not mean that furthering product-market liberalization

Introduction

17

will foster the liberalization of labor markets as well, but rather that we cannot speculate on the future of European (un)employment after EMU by considering product- and labor-market institutions in isolation. What can we expect to come from the effects of EMU on productmarket competition? How will stronger competition in product markets interact with the main labor-market aggregates? Are labormarket institutions likely to change along with product-market regulations? These basic questions are addressed in the second part of this book, which presents a study by a group of eminent professional economists and academicians. Thus the two parts of this book address different but interrelated issues; taken together, they provide a balanced scenario. The first part focuses on matters of principle and on long-run issues; it relies on theoretical insights when hard evidence is not available. The second part exploits fresh and so far unpublished evidence on the extent of product-market and labor-market regulations. Hence, more description and the presentation of data are required there. Acknowledgments Both contributions were originally prepared for the first European conference of the Fondazione Rodolfo Debenedetti, held in Genoa in July 1999. This book draws on the discussion in Genoa, which involved an audience of academicians, professional economists, industrialists, representatives of unions and employers associations, and policymakers. We are most grateful to Carlo De Benedetti, who conceived of a foundation with a “core business”—a research institution focused on European labor-market and social policy reforms, rather than dispersing intellectual energies among a wide array of topics. We are also indebted to all those who attended the Genoa conference and contributed actively to the discussion. In particular, we wish to express our gratitude to Jürgen Von Hagen, who agreed to chair the final policy panel, and David Coe, Georg Fischer, and John Martin, who contributed to it. Their insightful remarks were helpful in revising the material for this book. Special thanks go to Sarah Castoldi, Giacomo De Giorgi, Mattia Makovec, Roberta Marcaletti, and Michele Pellizzari, who assisted in the organization of the Genoa conference and worked skillfully in preparing the background material for this book.

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Notes 1. The author wishes to thank Giuseppe Bertola, Alan Krueger, Giuseppe Nicoletti, and two anonymous referees for useful comments on an initial draft. 2. Cukierman and Lippi (1999) have a model in which centralized wage setting is decentralized under EMU, thus reducing incentives of unions to restrain real wages. 3. “Comme il n’est plus possible d’utiliser les parités monétaires pour ajuster les écarts de compétitivité, les autres économies ne pourraient réagir qu’en se lançant à leur tour dans une course à la baisse de leur couts salariaux” (from the interview with Oskar Lafontaine appeared in Le Monde on February 10, 1999). 4. Up to 50 percent according to EC (1998). 5. Cf. EC (1998a, 1998b). 6. Cf. OECD (1999a). 7. Whenever possible (we do not have time-series for all measures), three-year averages were taken for both the initial and the final observations. This reduces the scope of measurement errors in the initial levels, which would be negatively correlated with changes (the arrows) giving a wrong impression of convergence. 8. The correlation coefficients between change and initial levels is -0.75 which is significant at 99 percent. 9. Disney Palacios and Whitehouse (1999) for the United Kingdom, Castellino (1995) for Italy, and Leimer and Richardson (1992) for the United States. 10. Cf. OECD (1994). 11. We are aware of the fact that the duration of unemployment may be affected by the duration of benefits. Yet, this “endogeneity” problem of our measure appears to pose less serious problems than attributing the same weight to all years of unemployment. 12. Social assistance expenditure is measured by the OECD social expenditure database. 13. Notice that arrows in the D-mark area are all oriented downward. Yet, these changes are small and D-mark countries in 1995 were still providing more generous income of the last resort schemes than other EU countries. 14. Cf. OECD (1999b). 15. See Bertola et al. (1999) for a discussion of problems with existing measures of employment protection. 16. Social assistance to persons in working-age, disability pensions, and sickness benefits belong to these categories. 17. See OECD (1998a). 18. See, for instance, Boeri 1999. 19. Proxy outflow rates are computed as follows: Ot ,t+1 = I t ,t+1 - (U t+1 - U t ), where O denotes proxy outflows, I inflows, and U unemployment levels. All primary data come from the OECD unemployment duration database.

Introduction

19

20. Institutional complementarities are characterised, inter alia, by Coe and Snower (1997), Orszag and Snower (1998), as well as Blanchard and Wolfers (1999). 21. Alan Krueger (1999) provides a number of valid reasons not to expect intra-EU migration to significantly pick up under stronger economic integration.

References Bean, C. 1998. “The Interaction of Aggregate-Demand Policies and Labor Market Reform.” Swedish Economic Policy Review 5, no. 2 (autumn 1998). Bertola, G., T. Boeri, and S. Cazes. 1999. “Employment Protection and Labor Market Adjustment in OECD Countries: Evolving Institutions and Variable Enforcement.” ILO employment and training papers no. 48. Blanchard, O., and J. Wolfers. 1999. “The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence.” Mimeo, MIT. Boeri, T. 1999. “Enforcement of Employment Security Regulations, On-the-Job Search and Unemployment Duration.” European Economic Review 43: 65–89. Burda, M. 1999. “European Labor Markets and the Euro: How Much Flexibility Do We Really Need?” Forthcoming in Deutsche Bundesbank, ed. The Monetary Transmission Process.” London: Macmillan. Calmfors, L. 1998. “Macroeconomic Policy, Wage Setting, and Employment—What Difference Does the EMU Make?” IIES seminar paper, no. 657. Castellino, O. 1995. “Redistribution between and within Generations in the Italian Social Security System.” Richerche Economiche 49: 317–327. Coe, D., and D. Snower. 1997. “Policy Complementarities: The Case for Fundamental Labor Market Reform.” CEPR discussion papers, no. 1585. Cukierman, A., and F. Lippi. 1999. “Central Bank Independence, Centralisation of Wage Bargaining, Inflation, and Unemployment: Theory and Some Evidence.” European Economic Review 43: 1395–1434. Disney, R., R. Palacios, and E. Whitehouse. 1999. “Individual Choice of Pension Arrangement as a Pension Reform Strategy.” The Institute for Fiscal Studies working paper series W99/18. EC. 1998. The Competitiveness of European Industry, Brussels. EC. 1998. Commission’s Recommendations for the Broad Guidelines of the Economic Policies of Member States and the Community, May, Brussels. Krueger, A. 1999. “From Bismark to Maastrich: The March to European Union and the Labor Compact.” Adam Smith lecture at the European Association of Labor Economists in Regensburg, Germany September 25, 1999. Le Monde. February 10, 1999. “M. Lafontaine preconise une coordination des politiques salariales en Europe.” Leimer, D., and D. Richardson. 1992. “Social Security, Uncertainty Adjustments, and the Consumption Decision.” Economica 59, no. 235 (August 1992): 311–335.

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Minford, P. 1994. “Deregulation and Unemployment: The UK Experience.” Swedish Economic Policy Review 1: 113–142. OECD. 1994. The OECD Jobs Study. Paris: Organization for Economic Cooperation and Development. OECD. 1998a. The Tax/Benefit Position of Employees 1997: La situation des salariés au regard de l’impôt et des transferts sociaux. Paris: Organization for Economic Cooperation and Development. OECD. 1998b. Benefit Systems and Work Incentives. Paris: Organization for Economic Cooperation and Development. OECD. 1999a. EMU: Facts, Challenges and Policies. Paris: Organization for Economic Cooperation and Development. OECD. 1999b. Employment Outlook. Paris: Organization for Economic Cooperation and Development. Orszag, M., and D. Snower. 1998. “Anatomy of Policy Complementarities.” Swedish Economic Policy Review 5: 303–343.

I

EU Welfare Systems and Labor Markets: Diverse in the Past, Integrated in the Future? Giuseppe Bertola, Juan Francisco Jimeno, Ramon Marimon, and Christopher Pissarides All these objectives are inextricably linked: the large market, technological cooperation, strengthening the European monetary system, economic and social cohesion and the social aspects of collective action. —Jacques Delors, 9th Jean Monnet Lecture at the European University Institute The internal effects of a mutable policy are [. . .] calamitous. It poisons the blessing of liberty itself. It will be of little avail to the people that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man that knows what the law is today can guess what it will be tomorrow. Law is defined as a rule of action; but how can be a rule, which is little known and less fixed? —James Madison: The Federalist Papers #62

The above quotations are clear statements of principle by pioneers working on similar issues in different times and locations.1 The mix of social policies in Europe today, however, fails on several criteria: they are uncoordinated, often conflicting, and far from simple to understand or implement.2 Despite obvious interactions between economic integration and social-welfare provision, little is done at the central European Union (EU) level to bring together social policies and address country-specific crises and integration challenges. The failure to provide guidance on the challenges facing social provision at the country level, in light of the removal of economic borders across the EU, exposes European policies to the twin risk of inertia and uncoordinated and unsustainable reforms. Here we document the current situation and analyze the reform pressures in the new united Europe. We argue that current EU decision-making procedures lead to slow and

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inefficient action at the central level. There is a pressing need for reform of European welfare policies, not necessarily of centralization, but certainly of more appropriate allocation at different levels of government. The review of institutional information in section 1 characterizes social-policy intervention in Europe with a few simple goals and a wide variety of policy instruments. We focus rather narrowly on the redistribution-oriented policies of traditional welfare states, neglecting many important forms of collective action that also pursue “social” objectives (in particular, we do not study education policy). There are significant differences across the EU in the relative importance attached to redistributive social-policy goals, in the instruments used, and in the extent to which social policy performs its stated duties. We document the heterogeneity of EU countries in these respects, highlighting in particular the relationship among welfare state configurations, average income levels, and historical patterns of social-policy intervention. Within the EU, the Scandinavian model of universal social protection as a right of citizenship coexists with the Anglo-Saxon model of the United Kingdom and Ireland; with the “Bismarckian” employmentbased model of Germany, France, Austria, and the Benelux countries; and with the much less mature, more fragmented, and highly idiosyncratic arrangements in the remaining southern EU members. We document these patterns and, examining recent indicators, find no evidence that systems of welfare provision are either shrinking within countries or converging with one another. Section 2 steps back from the complex configuration of EU social policies to examine briefly their motivation and effectiveness. As in the first section, we adopt an admittedly narrow view of “social policy.” The policies considered are those meant to improve on laissez faire economic outcomes by providing collective insurance against individual misfortune; and those meant to ease social tension by redistributing resources to individuals who could never purchase insurance even if the relevant markets existed and functioned well. In principle, neither class of redistributive policies need reduce economic efficiency (and many policy instruments we do not consider explicitly, such as public education, aim at increasing it). In practice, however, extensive socialpolicy intervention may reduce incentives to work in the marketplace. We analyze in some detail the effects of social-policy instruments, discussing briefly the evidence available on a wide variety of policy configurations on a global scale and focusing in particular on how recent

EU Welfare Systems and Labor Markets

25

macroeconomic developments have magnified the undesirable labormarket effects of European welfare states. The Anglo-Saxon model, based on means-tested and in-work benefits, has proven unable to stem the tide of increasing wage inequality. The continental model of employment-based instruments and wage compression, while motivated by a desire to make employment more attractive, has led to longterm unemployment. And the Scandinavian model, which tries to break out of the trade-off between social protection and employment by public job creation and “active” labor market policies, has proven expensive in the face of recent developments. Each welfare state faces its own challenges, and country-specific features of welfare provision imply different reactions to similar exogenous events. A further potential crisis is represented by economic integration, both within the EU and on the wider global scale. We briefly review some relevant evidence, but we do not analyze in detail the mechanics of such challenges to the welfare state (in particular, the important implications of an eastern enlargement of the EU are not considered). The focus is on the underlying theoretical and design issues. Integration reduces the effectiveness of social policies by giving more opportunities to individuals to opt out of supposedly mandatory redistributive schemes (e.g., through migration) and through tax competition generates races to the bottom in the provision of social policy. Section 3 considers the importance of such tensions in the EU. No large-scale race-to-thebottom tensions are apparent in the recent European experience; national policies display remarkable stability, stemming from wellrooted welfare state traditions. EU institutions, however, do interfere with national policies, chiefly by enforcing deregulation when existing policies are deemed incompatible with the single market and by extending social-policy coverage in each country to all EU citizens. This can enhance opportunities for personal mobility, but the current framework does not take into account the implications of such interference with national social policies. For example, while the European Court of Justice emphasizes European citizenship rights in the social field, the relevant costs are usually borne by local constituencies. Some recent policies also reduce the discretion of national policymakers; for example, the fiscal policy constraints imposed by the Growth and Stability Pact reduce the member states’ degrees of freedom in the implementation and reform of social policies. Explicit coordination of social policies at the EU level, however, does not go beyond declarations of principle. EU-wide action would require unanimous

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Bertola, Jimeno, Marimon, and Pissarides

agreement in policy areas that affect redistribution and labor-market outcomes, which is not forthcoming. Although more extensive use of majority-voting rules is advisable (and, indeed, is being implemented) in many policy areas, it is a delicate issue in the social-policy field. Due to the substantial heterogeneity documented in section 1, majority decisions may result in a subset of countries always being in the minority, a clearly unsustainable situation. If EU policies were decided centrally by a democratically elected European executive power, as in a traditional federalist entity, then it would make sense to centralize more decision-making powers in this area (as in the United States). The EU is, however, at most a cooperative federal entity: a supranational layer of institutions is laid over welldefined and heterogeneous national decision-making bodies. In such a situation, social-policy intervention at the central level would be distorted by strategic interactions among policymakers who represent national or regional constituencies. In the cooperative-federalist structure of the EU, the very limited budget of EU social-policy expenditures is a self-restraining device. Had there been a larger budget, national interests would encourage “log-rolling”—that is, approval of each others’ favorite redistributive policies while failing to internalize their systemwide financial implications. And unanimity requirements are equally rational, inasmuch as they prevent majorities of national representatives from pursuing their own ends rather than the collective interest. Thus, the weaknesses of the current configuration of EU decision-making in the social-policy area are rooted in the nation-based and very heterogeneous character of its constituency. It would be futile to blame them on unanimity requirements and budgetary limits per se, which may instead prevent distortions in the very complex central decision process engendered by heterogeneous objectives. Even though different decision-making arrangements might possibly better pursue collective interests within the EU, our discussion of desirable social-policy developments in section 4 takes the cooperativefederalist nature of current EU institutions as a given. The policy framework outlined does not rely on the emergence of strong supranational decision powers. Rather, it recognizes that heterogeneity is an essential and persistent characteristic of the EU and that increased economic integration and the character of intergovernmental interactions within the EU must be taken into account by any redesign of current socialpolicy practices. Social-policy instruments may enhance or reduce incentives for personal mobility. It is crucial to configure social-policy

EU Welfare Systems and Labor Markets

27

interventions to preserve economic mobility incentives; even though mobility is currently limited within the EU, its development is an essential component of its design. Desirable features of a framework for social-policy choices are discussed within the current institutional constraints, and the general economic insights illustrated by EU-specific examples in the previous sections are brought to bear on the allocation of social-policy choices to different layers of government: Solidarity-based transfers, guaranteeing a minimum welfare level, should be coordinated at the central level to prevent competition among subsidiary levels of government from resulting in either unacceptably low levels of welfare provision, or in more or less implicit limits to economic integration. Standards should be specified carefully, taking into account local conditions, to ensure that labor mobility is not driven by “welfare shopping” motives. Although such motives are not strong, it is essential to take into account potential (and very desirable) mobility of people when designing EU institutions. In light of the heterogeneous levels of developments within the EU, some interjurisdictional redistribution is hardly avoidable. Hence, minimum-welfare transfers and services should be cofinanced by a specific budget line item at the EU level. To ensure that the relevant issues are addressed clearly and to minimize political distortions, the relevant funds should be clearly isolated in the EU budget. Central cofinancing of social assistance programs would also provide means for enforcement of EU-wide guidelines: clearly, the minimum-welfare guidelines envisioned here, however carefully crafted from a technical viewpoint, could otherwise remain only on paper. •

Quasi-market arrangements meant to provide insurance, such as unemployment benefits and pension schemes, should not redistribute resources ex ante and should not be funded at the federal level, because economic incentives for factor mobility and allocation are best preserved when benefits and contributions balance each other within appropriately defined local markets. Inasmuch as laissez faire markets fail to provide adequate levels of insurance, however, participation in such schemes needs to be mandatory and comprehensive. Hence, minimum contribution rates and standard configurations should be agreed upon centrally to eliminate opportunities to opt out by individuals and by local constituencies. •

To fully exploit the advantages of heterogeneity and decentralized decision-making within the EU, central institutions should not •

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Bertola, Jimeno, Marimon, and Pissarides

specify uniform guidelines for other aspects of social policy. Rather, experimentation should be encouraged and closely monitored by EU institutions, which should play an active role in disseminating clear information as to the character and performance of locally financed policies and enable individuals to select the configuration of local social policies and labor-market institutions that best conform to their preferences, resources, and comparative advantage. 1 Status Quo and Recent Reforms: The Social Policy of EU Member Countries Our study of possible future developments in the EU social-policy field begins with a review of comparative information on the current situation. Social policy is the main pillar of the modern welfare state. Since countries put different emphasis on the goals of the welfare state, social policies differ in such respects as the size and composition of expenditures on social protection, institutional arrangements, benefits and taxation, and the impact on redistribution. As to regulation, labor market institutions are particularly relevant; wage setting mechanisms, job security provisions, the treatment of the unemployed by the nonemployment benefit system, and active labor market policies are all important elements of a welfare system’s efficacy and efficiency in combating poverty and inequality. The various aspects of social-policy intervention may complement each other, or substitute for each other. For example, similar levels of income support and insurance can be provided either by social transfers or by regulation of the employment relationship. Thus, policies and institutions vary considerably along many dimensions, and many of the relevant differences are rooted in political-historical circumstances and cultural traditions. In section 1.1 we review the contents and instruments of social policies as they are currently conducted in EU countries. Although all national welfare systems have similar goals and face some similar challenges (which we discuss in section 2), the extent and character of social policies is quite heterogeneous across EU countries; we also discuss briefly how European welfare systems differ from that of the United States. In section 1.2 we summarize the main differences in “welfare regimes” across EU countries and comment on the patterns of recent reforms (or lack thereof), assessing whether reforms are reducing or increasing the disparities in social policies across EU countries.

EU Welfare Systems and Labor Markets

29

1.1 Social Policy Instruments and Their Stated Goals Governmental policies in the social field pursue a variety of economic and political objectives. This section characterizes the status quo configuration of EU welfare states according to the instruments used and the intermediate goals targeted by each instrument. The primary goal of the welfare state is to insure the population against “social risks” as a way to increase social cohesion and equality.3 Increased “social cohesion” and better equality of resources and opportunities may be achieved via transfers, either in cash or in kind (through public provision of goods and services), funded by progressive taxation. How the different instruments of social policies are conducted have consequences for poverty, income distribution, and the functioning of the labor market, as governments may try to achieve more equitable distribution through regulation of economic relationships, particularly those in the labor market. Social-policy instruments are classified here according to their immediate goals: 1. combating social exclusion, that is, extreme poverty; 2. reducing overall inequality, and 3. increasing rewards from labor market participation. Each of these goals is an intermediate target in pursuit of deeper ones, and the proposed classification is not meant to be exhaustive or exclusive. In particular, a welfare system may appear to give little weight to alleviation of poverty (goal 1) because the more general instruments we classify under goal 2 effectively eradicate poverty. The three goals historically were and still are advocated in principle as a basis of welfare state policies, however, and the simple classification above offers a useful viewpoint of the current EU landscape. In the Beveredgian tradition, the first goal is the most relevant, while Scandinavian countries’ welfare systems aim at reducing overall inequality. The earliest social interventions, in the Bismarckian tradition, stressed workrelated benefits as the basis for administration of transfers. In practice, however, each policy instrument within the two broad “transfer” and “regulation” classes effectively targets more than one of the three social-policy intermediate goals. Moreover, each policy instrument entails costs. The cost of regulation is implicit rather than explicit and stems from its interference with the operation of laissez-faire markets. Resources directly transferred to individuals need to be collected

30

Bertola, Jimeno, Marimon, and Pissarides

explicitly, however, and the means of funding social policies is an important element of each welfare system. In summary, national welfare systems differ not only in the weight attributed to the three goals by their designers but also in the amount of resources and regulation effort devoted to achievement of specific objectives, and the detailed articulation of instruments meant to achieve them. The following discussion lists and classifies policies observed in the EU according to the simple taxonomy proposed. 1.1.1 Social Protection Expenditures in the EU Table 1.1 reports social protection expenditures as a proportion of GDP in 1996 and their decomposition by functions.4 The amount of resources devoted to social protection varies considerably across countries. Thus, the Nordic countries (Sweden, Finland, Denmark) devote about onethird of GDP to social protection expenditures; slightly more than the continental “core” countries (Belgium, Germany, France, the Netherlands, and Austria) which devote around 29 percent of GDP to social protection expenditures, and significantly more than the southern countries and Ireland, which devote less than one-fourth of GDP to social protection expenditures. In resources devoted to social protection, the United Kingdom is between the continental core and the southern countries. EU countries also differ, however, in per capita income. As shown in figures 1.1a and 1.1b, there is a close relationship between social protection expenditures per capita and GDP per capita: richer countries have higher levels of social expenditure per capita than the relatively underdeveloped southern countries. The figures also include the United States which, compared to the EU countries, displays a much lower level of social protection expenditure (SPE) per capita for its level of development. Social protection expenditures, however, vary across countries at any given level of development. In part, this may reflect measurement problems. Gross SPE are an imperfect measure of the scope of social policies because taxation of social transfers is not uniform across countries; typically, countries with higher transfers and benefits also tax these transfers and benefits more heavily. Hence, net SPE per capita are more closely related per capita GDP than indicated by table 1.1 and figure 1.1. Adema et al. (1996) propose a methodology to compute “net social expenditures” taking into account the three main differences in

EU Welfare Systems and Labor Markets

31

SPE per capita (PPS, in logs)

8.6 8.4

Sweden Netherlands Denmark France Germany Austria Belgium Italy Finland UK

8.2 8

USA

7.8 7.6

Spain Ireland

Greece

7.4 7.2 7

Portugal

9

9.1

9.2

9.3

9.4

9.5

9.6

9.7

9.8

9.9

10

GDP per capital (PPS, in logs)

SPE per capita (PPS, in logs)

Figure 1.1a Social protection expenditures per capita and GDP per capita, 1990

9 Denmark Germany Sweden Belgium Netherlands Austria France Finland UK Italy

8.8 8.6 8.4

USA

8.2 Spain

8 7.8 7.6 9.3

Ireland

Greece Portugal

9.4

9.5

9.6

9.7

9.8

9.9

10

10.1

10.2

10.3

GDP per capita (PPS, in logs) Figure 1.1b Social protection expenditures per capita and GDP per capita, 1996

institutional arrangements across countries: (1) the method of benefit payments, which may be net or gross of taxes; (2) the use of tax instruments rather than cash or in-kind transfers for providing social insurance; and (3) the degree to which governments require private agents to provide social protection. Tax expenditures on cash transfers (reduced taxation on particular sources of income or types of households) are ignored, and social fiscal measures (tax reductions that replace cash benefits or stimulate the provision of private expenditures) are accounted for.

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Bertola, Jimeno, Marimon, and Pissarides

Table 1.1 Composition of social protection expenditures in the EU15, 1996 Belgium

Denmark

Germany

Greece

Spain

France

Ireland

17.7

29.7

26.3

29.14

28.9

34.3

10.7 38.8 0.1 12.4

7.3 39.2 1.9 9.4

8.6 41.2 7.8 8.3

7.8 41 4.3 2

6.1 36.9 6.6 8.7

4.8 20 6.1 12.8

13.8 2.4 4.1

9.6 0.6 2.3

4.3 2.4 1.1

14.5 0.5 0.8

8.1 3 1.7

16.7 3.3 2

7.3

5.8

8.7

5.9

6.4

8.5

6.2

1.8 9.1 3.1 2.2

3.5 12.7 0 4.1

2.2 11.5 0.6 2.8

1.9 9.2 1.8 1.9

1.7 9 0.9 0.4

1.8 10.8 1.9 2.5

0.9 3.6 1.1 2.3

4.1

4.5 0.8 1.3 32.7

2.8 0.2 0.7 29.5

1 0.5 0.2 22.4

3.2 0.1 0.2 21.9

2.4 0.9 0.5 29.3

3 0.6 0.4 18.1

Percent total expenditure Sickness/Health 25.8 care Disability 6.2 Old-age 32.2 Survivors 11 Family and 8 children Unemployment 14.5 Housing Social exclusion 2.3 Percent GDP Sickness/Health care Disability Old-age Survivors Family and children Unemployment Housing Social exclusion Total

0.7 28.3

Source: Eurostat (1999). For the United States, data refer to 1995 and are taken from the OECD Social Expenditure Database (SOCX).

Applying this methodology to six countries (Denmark, the Netherlands, Germany, Sweden, the United Kingdom, and the United States) in 1995, they find that gross social protection expenditures ranged from 17.1 percent in the United States to 37.6 percent of GDP in Denmark, and net social protection expenditures ranged from 18 percent in the United States to 27.9 percent in Germany.5 Thus, the dispersion of net social expenditures across countries is much lower than that of gross social expenditures. More interestingly, different propensities to devote resources to social policy at a given level of development reflect differences in the preferences for social policies, in demographic and labor-market participation features, and in the role of the private sector in fulfilling some of the aims of social policy (as, for instance, in the

EU Welfare Systems and Labor Markets

33

Italy

Netherlands

Austria

Portugal

Finland

Sweden

U.K.

Eu15

U.S.

21.5

28.3

25.2

33

21.4

22

25.4

27

20.0

7 54.2 11.7 3.6

15.3 32.9 5.5 4.4

8.1 38 10.5 11

11.6 36 7.3 5.6

14.6 30 3.9 12.5

12 36.4 2.5 10.5

12.2 34.8 5.3 8.7

8.5 39.2 5.4 8

2.8 16.1 2.9 1.9

1.9 0 0

12 1.2 0.4

5.7 0.3 1.2

5.8 0 0.6

13.9 1.3 2.3

10.3 3.2 3.1

5.8 7.2 0.7

8.4 2 0.5

1.7

5.1

8.3

7.2

6.4

6.7

7.5

6.8

7.4

6.7

1.7 12.9 2.8 0.9

4.5 9.7 1.6 1.3

2.3 10.9 3 3.1

2.2 6.9 1.4 1.1

4.6 9.4 1.2 3.9

4.1 12.5 0.9 3.6

3.2 9.3 1.4 2.3

2.3 10.8 1.5 2.2

0.9 5.4 1.0 0.6

0.5 0 0 23.9

3.5 0.3 0.1 29.3

1.6 0.1 0.3 28.5

1.1 0 0.1 19.2

4.3 0.4 0.7 31.2

3.5 1.1 1.1 34.3

1.6 1.9 0.2 26.7

2.3 0.6 0.4 27.5

0.6

1.9

0.6 15.8

case of private pension schemes). These factors determine not only the overall size but also the composition of social expenditure. Table 1.1 also reports social expenditures disaggregated according to their main functions.6 The relative importance of the various budget lines may be interpreted in light of differences in the design and implementation of social transfers, in the age structure of the population, and the incidence of nonemployment across different population groups. The table displays the following information: All countries (with the sole exception of Ireland) devote the largest share of social expenditures to old-age and survivor benefits. The burden of old-age and survivor pensions is lowest in Ireland and •

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Bertola, Jimeno, Marimon, and Pissarides

Portugal (5 and 8 percent of GDP, respectively) and highest in Italy and Austria (15 and 13.9 percent, respectively); in most countries, it absorbs around 12 percent of GDP. Sickness and health care have the next-highest share of social protection spending, at about 7 percent of GDP with Germany and France (8.5 percent of GDP) on the high side, and Denmark and Italy (5.1 and 5.8 percent of GDP) on the low side. •

Unemployment benefits are often regarded as an important component of social expenditures, but account for only 8 percent of total SPE and 2.3 percent of GDP in the EU average, although a significant group of countries (Belgium, Denmark, Spain, Ireland, the Netherlands, Finland, and Sweden) spend over 3 percent of GDP in this function. Sickness and disability transfers perform a similar function as protection against nonemployment. Hence, they represent a relatively high fraction of social protection expenditures in countries with a high level of benefits (the Netherlands and the Nordic countries) but also in the United Kingdom. •

Resources devoted to transfers to families and children are highly dispersed. They range from a minimum of 0.4 percent of GDP in Spain to a maximum of 4.1 percent of GDP in Denmark, with other southern countries on the low side, and other continental EU countries with proportions around 2 percent of GDP. Expenditure on social exclusion is around 0.5 percent of GDP, with insignificant figures in Italy, Portugal, the Netherlands, and Spain, and the highest values in Denmark with 1.3 percent of GDP, and Sweden with 1.1 percent of GDP. Finally, housing is the lowest spending function in most countries, with the exception of Denmark, France, and Sweden, where it represents around 1 percent of GDP, and the United Kingdom where almost 2 percent of GDP is devoted to housing transfers. •

Another important dimension in the composition of social protection expenditures is the breakdown between in-kind service and cash provisions. Here the Scandinavian countries stand out as those relying most on the provision of in-kind services: in 1992, the ratio of expenditures on in-kind services to expenditures on cash provisions was about 0.45 in Sweden, 0.33 in Denmark, and 0.21 in Finland. In the remaining EU countries this proportion was lower than 0.15, except for Ireland where it was 0.16 (see Esping-Andersen 1999, table 8A). •

EU Welfare Systems and Labor Markets

35

1.1.2 Combating Social Exclusion A primary intermediate goal of social policy is guaranteeing subsistence to people in need, regardless of their current and past employment. To achieve this goal, social assistance schemes either provide benefits to all people below a specified level of income (general assistance), or target specific groups, like the elderly, large families, disabled individuals, immigrants, and others (categorical assistance). Under these schemes, benefits may be in cash or may be “tied,” that is, free or subsidized access to specific goods or services (notably, housing). Finally, benefits may be provided either at the local level (with local and regional governments running their own schemes) or at the national level.7 In most EU countries, except the United Kingdom and Ireland, social assistance plays a residual role in providing a safety net, as most people are covered by either universal benefits or employment-related benefits. In this respect, as in many others, the various “goals” of our descriptive taxonomy are of course intimately related. In any case, social assistance schemes in EU countries are quite heterogeneous. On the basis of the information in Eardley et al. (1996a), several groups of countries can be identified on expenditure composition in 1990–91. Social assistance has the highest weight in the United Kingdom and Ireland. In these countries, schemes are exclusively organized at the national level; the number of beneficiaries amounts to more than 10 percent of total population and expenditures on social assistance amount to around 3 and 4.3 percent of GDP, respectively. At the other extreme, expenditures on social assistance schemes are lowest in Greece, Finland, Portugal, and Belgium. Among the rest of the EU countries, the Netherlands, France, and Germany devote around 2 percent of GDP to social assistance expenditures, while in Austria, Denmark, Italy, Spain, and Sweden social assistance expenditures amount to around 1 percent of GDP (almost 1.5 percent of GDP in Austria and Italy). In Portugal social assistance is run exclusively on a national basis, and in Austria it is completely decentralized at the local level; the rest of the continental European countries implement social assistance schemes both at the national-federal and the local-state levels, and the local component has a relatively large weight in Spain and Sweden.

36

Bertola, Jimeno, Marimon, and Pissarides

1.1.3 Reducing Overall Inequality Although specific social assistance policies may be addressed to particularly needy individuals and households, it is hard for designers of social intervention to target benefits precisely. Either to achieve the more general aim of improving social cohesion or as a side effect, social policy does reduce inequalities through the whole spectrum of income distribution. To assess the performance of European welfare states, we review some evidence on the incidence of social benefits on the distribution of household income. Measures of inequality and of poverty must address complex conceptual issues, but they are also importantly constrained by data availability (see Atkinson 1998 and references therein). Since our purpose here is to document and characterize the wide heterogeneity of social policy intervention in EU member countries, we summarize evidence from the first wave of the new European Community Household Panel (ECHP). The data were collected in 1994, and only preliminary statistics have been made available (European Commission 1998b; Vogel 1997).8 Comparable statistics are not provided for the United States, but among OECD countries, the United States displays by far the greatest degree of inequality (see Atkinson 1995, Gottschalk and Smeeding 1997, and the evidence in section 2). We proceed in three steps. First, we focus on the EU countries’ household structure which are considered the ultimate focus of the social protection system. Means-tested benefits and social-assistance schemes are often defined by household not individual income. Thus, any analysis of the incidence of social benefits should start with the description of the household structure. Moreover, in some EU countries the “extended household” constitutes an important source of insurance to individuals and, hence, a partial substitute for the social protection system. Second, we document the incidence of poverty and the magnitude of income inequality across EU countries. Differences in the design and implementation of social policies are likely to translate into different degrees of poverty and inequality. Finally, we report on the effectiveness of social policies at reducing inequalities by focusing on the changes in the distribution of household income due to social benefits and on the distribution of transfers across households. Vogel (1997) collects some descriptive statistics on the size and composition of households in EU countries, namely the average household size, the proportions represented by several types of households, and the incidence of extended households (those with three-generation families and those with other relatives or persons). Household forma-

EU Welfare Systems and Labor Markets

37

tion patterns vary across EU countries. The average household size in the Nordic countries is 2.1 in Sweden, 2.2 in Denmark, 2.4 in Finland; in central Europe it is 2.5 in Belgium and Germany, 2.6 in Luxembourg and France; and in the United Kingdom 2.5, while in southern Europe it is 2.8 in Italy, 3 in Greece, 3.1 in Portugal, and 3.3 in Spain, and in Ireland 3.3. These differences mostly arise from a higher proportion of single-person households in the former countries (where single-person households are roughly twice as frequent as in the latter; in Sweden, the proportion of single-person households is more than three times higher than that in Greece, Spain, and Portugal). Thus, both the proportion of people below 30 years of age and that of those above 65 years of age are higher in central and northern Europe than in southern Europe. Single parent households are also much less frequent in southern Europe. Finally, the proportion of 16–30 years old living with parents is higher in southern European countries than in the rest of EU countries. As a result the proportion of the population in extended households is around 20 percent in Greece, Portugal, and Spain, while it is almost negligible in Denmark, the Netherlands, Finland, and Sweden. Vogel (1997) also presents some indicators on the degree of poverty and inequality in EU countries (see table 1.2). The indicators refer to adjusted disposable income, computed as the sum of all income sources for all household members divided by the number of consumer units, which are defined as 1 for the first adult, 0.5 for each other member over age 14, and 0.3 for each younger child.9 Before turning to the analysis of the distribution of household income, it is useful to describe the distribution of net earnings. The Gini coefficient of this latter distribution is presented in the first two rows of the table (the first row, for those between 20–84 years of age; the second, for those between 20–64 years of age). EU countries may be classified into three groupings: the Nordic countries, which present the lowest levels of inequality, the southern countries and Ireland, which present the highest levels of inequality, and the rest of the countries in the middle (although the United Kingdom is closer to southern European countries than to central European countries). The remaining rows of table 1.2 report descriptive statistics of the distribution of adjusted disposable income as defined above. The Gini coefficient for adjusted disposable income is much lower than for earnings, reflecting not only the obvious progressive nature of welfare state subsidies and of taxation but also the equalizing role of family arrangements in the distribution of income. Figure 1.2 shows that several

38

Bertola, Jimeno, Marimon, and Pissarides

Table 1.2 Poverty and inequality in the EU14, 1994 B (1) Inequality of net earnings (Gini coefficient) 20–84 years of age (2) Inequality of net earnings (Gini coefficient) 20–64 years of age (3) Inequality of adjusted disposable income (Gini coefficient) 20–84 years of age (4) Adjusted disposable income below 50% of national average (% households) (5) Adjusted disposable income below 50% of EU average (% households) (6) Adjusted disposable income above 200% of national average (% households) (7) Adjusted disposable income above 200% of EU average (% households) (8) Trends in income inequality in the 1990s

DK

D

GR

E

F

0.621

0.511

0.610

0.694

0.730

0.657

0.544

0.413

0.541

0.629

0.673

0.590

0.251

0.243

0.280

0.354

0.354

0.303

12.6

6.5

10.9

8.7

4.4

7.6

4.6

3

5

7.4

4

Incr.

n.a.

21.8

19.1

13.1

42

31.7

10.5

6.9

7.7

6.4

8.9

2.1

3.2

6.9

Incr.

n.a.

n.a.

Incr.

Source: Vogel (1997).

clusters of countries may be identified from this perspective. First, in the Scandinavian countries both the inequality of net earnings and the inequality of adjusted disposable income are quite low. Secondly, the Benelux countries and Germany show an intermediate degree of both net earnings inequality and adjusted disposable income inequality. Southern European countries together with the United Kingdom and Ireland show a higher degree of net earnings inequality. In adjusted disposable income inequality, however, only Portugal stands far above the EU average. Heterogeneity among these clusters reflects a variety of countryspecific phenomena. On the horizontal axis, the degree of earnings inequality is affected by labor market regulations (see section 1.1.4) as

EU Welfare Systems and Labor Markets

I

IRL

L

NL

P

39

FIN

S

UK

0.693

0.676

0.617

0.623

0.717

0.508

0.521

0.650

0.643

0.636

0.565

0.553

0.651

0.442

0.416

0.573

0.348

0.255

0.298

0.295

0.473

0.176

0.242

0.357

17.9

20

23.8

EU14

12.9

11.4

26.8

4.6

5.5

20.6

15.3

28.3

1.3

9.2

47.5

5.8

5.9

14.8

16.2

5.9

6.3

6.1

5.3

8.1

3

3.1

6.6

5.9

3.4

3.4

38.4

6.9

3

2.2

2.8

10.3

6.6

Incr.

Decr.

Incr.

Incr.

n.a.

Decr.

Incr.

Incr.

well as by early retirement, patterns of work by age, and the incidence of self-employment and agricultural employment. On the degree of inequality of disposable income, the equivalence scale used for the computation of per capita disposable income is relevant in light of the differences in family size across countries. The message of figure 1.2, however, is simple: EU countries are rather heterogeneous in the degree of disposable income inequality, which is positively related to earnings inequality, indicating that neither the family nor the government can completely offset labor market outcomes. As to the incidence of poverty, we consider evidence on the proportion of households with adjusted disposable income below 50 percent of the national average. The southern countries have a much higher

40

Bertola, Jimeno, Marimon, and Pissarides

Inequality of adjusted disposable income (Gini coefficient, ages 20-84)

0.5

y =0.6167¥ - 0.0441 R2 =0.5386

Portugal

0.45 0.4 Greece 0.35

UK

0.3

France Netherlands Germany

0.25 Denmark Sweden

Italy

Spain

Ireland

Belgium

0.2 Finland 0.15 0.4

0.45

0.5

0.55

0.6

0.65

0.7

Inequality of net earnings (Gini coefficient, ages 20–64) Figure 1.2 Income inequality in EU countries, 1994

proportion of poor households (26.8 percent in Portugal, around 20 percent in Greece, Portugal, and Spain, and 18 percent in Italy). At the other extreme, in the Nordic countries poverty afflicts only around 5 percent of the households. Symmetrical patterns can be observed in the upper tail of the distribution: rich households, defined as those with adjusted disposable income above 200 percent of the national average, are most frequent in Portugal, Spain, and Greece, and least frequent in Denmark, Finland, and Sweden. The remaining EU countries lie between the two extreme groups. From an EU-wide perspective, comparisons of household adjusted disposable income across countries (with purchasing power standard (PPS) adjustment) yield about 16 percent of households below 50 percent of the EU average and 6.6 percent of households above 200 percent of the EU average. Obviously, households with income below 50 percent of the EU average represent a much higher proportion in the relatively poor southern countries. Finally, as for recent trends, inequality and poverty were roughly stable over the 1980s (see Van Den Bosch 1998) but appear to have risen somewhat over the 1990s in most countries for which suitably comparable time series data are available. Given the high levels of social protection expenditures in EU countries, it is not surprising to find that social transfers represent an impor-

EU Welfare Systems and Labor Markets

41

tant source of income for many EU households. This is confirmed by the ECHP data, reported in the first row of table 1.3. According to this source, social transfers amount to around 30 percent of net household income: the percentage is lowest in Portugal (22.1 percent) and highest in France (37.4 percent), Belgium (36.5 percent), and Italy (32.7 percent). We have also seen, however, that EU countries are heterogeneous not only in the size and composition of social transfers, but also in patterns of household formation. Thus, a given amount of resources devoted to social transfers may have a very different impact on household income inequality in the various EU countries. A rough measure of such differential effects is given by the impact of social transfers on indicators of inequality and poverty. The second row of table 1.3 reports the difference between the Gini coefficients before and after transfers. For the EU12 the change in the Gini coefficient is 0.21, which represents roughly 40 percent of the Gini coefficient of income distribution before transfers. The seventh row of table 1.3 similarly reports the difference between the proportion of households with income below 50 percent of the national average before and after transfers. The impact of social transfers on the poverty rate amounts to 22.3 percentage points for the EU12 (about 56 percent of the proportion before transfers). Not surprisingly, both indicators display some variation across countries; social transfers produce the largest reductions of the Gini coefficient and of poverty rates in Belgium, Denmark, and France, and the smallest in Greece and Portugal. These findings largely reflect the relative size of transfers in these groups of countries; in relatively rich countries, transfers are more generous overall, and it would be very surprising if they did not reduce inequality and poverty more than they do in poor countries. To assess the efficiency rather than the efficacy of social policies, figure 1.3 plots the changes in Gini coefficients and poverty rates against the percentage of transfers in household income. The slope of the regression line displayed indicates the typical improvement of the two measures of inequality bought by a percentage point of transfers in household budgets. The countries whose observations lie above the regression line appear to configure their transfers more efficiently than the EU12 average for the purpose of reducing inequality. By this admittedly rough measure, the French system of social transfers appears much less oriented toward reducing inequality than, for example, the Danish.10 The social transfer systems of Greece, Portugal, Spain, the Netherlands, and Italy (which feature very different levels of overall

0.26

(2) Change in the Gini coefficient before/after transfers 0.24

30.5

DK

0.20

27.9

D

0.14

24.8

GR

0.20

29.7

E

0.24

37.4

F

0.22

27.8

IRL

0.22

32.7

I

0.19

27.0

L

13.0

29.5

(6) Households with income below 50% of average income after transfers

(7) Change (5)–(6)

Source: European Commission (1998b).

42.5

(5) Households with income below 50% of average income before transfers

28.6

8.5

37.1

23.2

12.8

36.0

13.7

23.7

37.4

20.5

19.1

39.6

24.9

15.7

40.6

20.8

21.2

42.0

22.7

17.7

40.5

21.5

14.5

35.9

(4) percent Transfers going to households with income after transfers relative to national average >150% Pensions 11 6 20 14 15 26 21 25 14 Unemployment benefits 5 5 29 7 5 24 11 12 3 Other social transfers 14 3 19 11 13 23 13 7 6 Household members 13 9 17 14 14 16 17 13 18 Total income 27 20 35 29 15 37 37 30 38

(3) percent Transfers going to households with income after transfers relative to national average <50% Pensions 17 9 8 6 8 12 10 7 18 Unemployment benefits 18 3 15 16 21 12 21 14 42 Other social transfers 12 4 11 15 21 18 19 16 34 Household members 13 9 18 13 14 24 19 16 21 Total income 4 3 5 4 6 7 7 5 9

36.5

(1) Transfers as percent net household income

B

Table 1.3 Transfers and their impact on household income, 1994

14 17 42

14 15 32

24.1

13.6

10.3

28.8

39.0

20

37.7

28

9

4

16

29 29

9 14

26

25 10

0.14

22.1

P

4 12

0.20

30.2

NL

19.8

22.8

42.6

37

6 16

7

18

8

29 23

19 32

0.20

27.3

UK

22.3

17.1

39.4

32

9 15

10

19

6

19 17

9 17

0.21

30.4

EU12

42 Bertola, Jimeno, Marimon, and Pissarides

Percentage change in the Gini coefficient

EU Welfare Systems and Labor Markets

43

1.2

UK DK

1 0.8 0.6

15

E

GR

P

0.2

F

NL IRL

0.4 0

D

L

B I

20

y =0.0349¥ - 0.3013 R2 =0.3794

25

30

35

40

Transfers as percentage of net household income

Percentage change in poverty rate

Figure 1.3a Transfers and changes in inequality, 1994

0.9 0.8

DK

0.7

D

0.6

L IRL UK

0.5 0.4

E

F

I

GR

0.3

P

0.2

y =0.0222¥ - 0.102 R2 =0.4855

0.1 0 15

B

NL

20

25

30

35

40

Transfers as percentage of net household income Figure 1.3b Transfers and changes in poverty, 1994

generosity, largely reflecting different average income levels) also appear to achieve smaller-than-average reductions in inequality and/ or poverty. 1.1.4 Increasing the Rewards from Labor-Market Participation A third distinct but intimately related aim of European social policies is that of improving the lot of workers, chiefly by protecting them from adverse labor-market or life-cycle developments. Many of the transfers provided by social policies are employment-related, in that eligibility and/or benefits are determined by previous employment spells. Unemployment benefits and pensions are, the canonical examples in this context. Since contributions and benefits in these and similar

44

Bertola, Jimeno, Marimon, and Pissarides

schemes typically redistribute across income levels as well as over an individual’s life cycle, an intimate relationship between work-related and resource-related social policies is readily apparent. A further set of interactions are particularly important in Europe, where the goal of increasing rewards from labor-market participation is also pursued by an array of pervasive regulations.11 Besides offering generous pensions and nonemployment benefits to former workers, the “Bismarckian” welfare state model seeks to protect breadwinners, prime-age males who are typically employed and, in the view of continental European lawmakers, should earn a stable flow of labor income. Hence, labor law covers all aspects of industrial relations. Most employment conditions are regulated by collective bargaining agreements that may raise or supplement the minimum conditions established by the law, and governments may act as “employers of last resource.” This panoply of transfers, regulations, and other government interventions is intended to improve the lot of workers by affecting wage determination and other employment conditions (working hours, health and safety at work, job security, etc.), and by providing insurance against the risks of becoming unemployed. EU member countries differ quite significantly on such policies and institutions. Some countries rely more on statutory legislation, while others allow employers and trade unions wider autonomy in regulating industrial relations. Thorough comparative information on all the relevant aspects may be found, in OECD (1994b, 1997b): here, we briefly offer a broad picture of the most relevant differences across current EU members. As to wage setting, a variety of institutional features are relevant and quite heterogeneous in the EU. In the mid-1990s, trade union density ranged from low values of 9 percent in France to 91 percent in Sweden. The coverage rates of collective bargaining agreements, however, are high in all countries: the lowest rates are observed in the United Kingdom (47 percent), Portugal (71 percent), Spain (78 percent), Italy (81 percent), while the remaining EU members display coverage rates of up to 98 percent. Despite recent trends toward decentralization in most countries, there are still “corporatist” countries, like Austria, with high levels of centralization and generalized extension rules. There are countries where a web of collective bargaining agreements at all levels interacts with medium levels of centralization and coordination, and countries like the United Kingdom with low levels of centralization

EU Welfare Systems and Labor Markets

45

and coordination. Thus, collective bargaining is the prevalent wagesetting mechanism across EU countries. Its wage-compression effects, however, are complemented by those of statutory minimum wages, which apply to workers not covered by collective bargaining. Some EU countries—like Belgium, France, Greece, Luxembourg, the Netherlands, Portugal, and Spain—have a statutory or national minimum wage that applies to all workers, sectors, and regions. Other countries set minimum wages at the sectoral level, extending to most of the work force the wage rates agreed to at the collective bargaining stage (this is the case in Germany, Italy, Austria, Greece, Denmark, Finland, and Sweden). Minimum wages in some countries are conditional on age or apprenticeship status, and employers and trade unions may or may not be involved in the revision of their levels, which may also be influenced by a variety of indexation mechanisms (see OECD 1998a, chapter 2). In practice, minimum wages range from 33 percent of average wages in Spain to 72 percent in Italy, but their incidence is very different across other EU countries: around 5 percent in Austria, Belgium, the Netherlands, and Spain, 8 percent in Portugal, 11 percent in France, and 20 percent in Greece (see Dolado et al. 1996). On top of statutory minimum wages, governments attempt to affect wage evolutions in other ways. In countries such as France, Germany, Italy, and Spain, where civil servants’ pay is determined directly by the governments, the wage evolution in the public sector may serve as a “signal device” for the private sector.12 Furthermore, in countries that are “corporatist”— where central organizations represent employers and workers—governments can devise income policies meant to reduce wage pressures. The effectiveness of these income policies is debatable, as wage moderation is often obtained by governments’ concessions on tax reductions and public expenditure increases. In countries like Austria and the Netherlands, however, income policy institutions are credited with having contributed to improve labor-market performance. Another institutional feature of most European labor markets is the prominence of employment protection legislation, which restricts employers’ ability to adjust their labor force after changing economic conditions and provide some insurance to workers. This protection is accomplished by regulation of dismissal procedures (which may include requirements for prior warnings to workers, written justification, notification to third parties, authorization of dismissals for third parties, a period of notice to workers before dismissal, and provisions for appeal against unfair

46

Bertola, Jimeno, Marimon, and Pissarides

dismissal) and by specifying severance payments (whose amount may depend on the reasons for dismissal, and may be established by labor legislation, by the labor courts or by collective agreements). Besides provisions against dismissal of workers under the “typical” employment contract, institutional arrangements vary across EU countries on the admissibility of “atypical” employment patterns (see OECD 1999a, chapter 2, for detailed information). In southern European countries and Ireland, a sizeable proportion of the labor force is selfemployed, which is, in general, subject to different regulation and benefits than the typical full-time employee. Not surprisingly, atypical employment is more prominent where regular employment is more stringently regulated. Thus, temporary/fixed-term/determined duration employment contracts are now widespread in countries where the degree of strictness of employment protection legislation is high, while they remain limited in countries with less strict employment protection legislation.13 Finally, the incidence of part-time employment, whose regulation differs across countries, is lowest in southern European countries, which have less than 10 percent of total employment under part-time contracts, and highest in the Nordic countries and especially in the Netherlands, where almost 40 percent of workers have part-time jobs. Unemployment benefits aim at compensating job losers (rather than at preventing job loss, like employment protection legislation; among EU countries, some rely more heavily on one or the other of the two policies: see Buti et al. 1998). Unemployment benefits are available under two different schemes, one based on an insurance principle, under which both eligibility and benefits are employment-related, and another based on an assistance principle, where eligibility is universal and benefits are means-tested. Replacement rates, eligibility requirements, generosity indexes, and benefit coverage rates differ considerably across EU countries (see Nickell and Layard 1997, and OECD 1997a). The Netherlands, Belgium, Finland, and especially Denmark offer the highest replacement rates and duration; at the other extreme, benefits are least generous in the United Kingdom and Italy. The coverage rates of unemployment benefits vary from 40 to 45 percent in Spain and Portugal to values above 100 percent in the Netherlands, Belgium, and Finland. Throughout the 1990s, there appears to be no significant trend in the generosity indexes of unemployment benefits in most EU countries. Generosity appears to have increased in Italy and Greece (countries where benefits were relatively

EU Welfare Systems and Labor Markets

47

low in 1990) and Denmark and Finland (countries with very generous benefits in 1990), while generosity has decreased in Austria and Ireland (countries close to the average in 1990) and the Netherlands (a country with generous benefits in 1990). Active labor-market policies (employment services, training, employment subsidies, job creation) also vary widely in size and structure across EU countries (OECD 1997a). Roughly half of the EU countries spend over 1 percent of GDP on active labor market policies (ALMPs), and Sweden and Denmark spend well above that. The UK, Austria, Greece, Portugal and Spain spend around 0.5 percent of GDP on active labor-market policies. In most of the countries, the expenditure on active labor-market policies is below 45 percent of total expenditure on labor-market policies. The early 1990s feature an increasing trend in spending on active labor-market policies, either in GDP (with the exceptions of the United Kingdom, Greece, Portugal, and Spain) or in its weight in total expenditure on labor market policies, as is the case in Germany, France, and Denmark. The composition of active labormarket policies is also quite varied. For instance, expenditure on training programs is relatively high (close to or above 40 percent of total spending on active labor market policies) in France, Denmark, and, overall, in Spain (where its weight has more than doubled in five years). It represents less than a quarter of expenditure on active labormarket policies in Holland, Belgium, Greece, and the United Kingdom. Furthermore, expenditure on job creation is relatively high in Germany, Belgium, Denmark, Finland, and Sweden, while it plays a minor role in France, the United Kingdom, Austria, Greece, Portugal, and Spain. Thus, there is also a high degree of heterogeneity here among EU member countries. As expenditure on active labor-market policies is somewhat conditioned by the incidence of unemployment among different groups, which is quite heterogeneous across EU countries, such degree of heterogeneity should not come as a surprise. In Denmark, labor-market policy has been reformed and refocused during the 1990s. The most relevant change was the abolition of the right to requalify for entitlement to unemployment benefits by participation in active labormarket programs. Until 1994, activation offers were made immediately before unemployment benefits expired and, if accepted, qualified participants for a further benefit period. After the reform, activation offers are mostly based on the qualification of the unemployed and the opportunities offered by local labor markets. Additionally, active labormarket programs are now based on the principle of “right and duty,”

48

Bertola, Jimeno, Marimon, and Pissarides

so that every unemployed person receives activation offers at regular intervals and is punished by a reduction of benefits if the offer is rejected. 1.1.5 Funding Social Policies Social policies are financed from two sources: general taxation and social contributions, which are levied on income from employment (in some countries, also on social benefits recipients) and paid by employers as well as by employees.14 For the EU as a whole, around 40 percent of social protection expenditures come from contributions levied on employers, 24 percent from contributions levied on workers (employees, self-employed, and benefit recipients), around one-third from general taxation, and about 2 percent from earmarked taxes (see European Commission 1998b). There are, however, noticeable differences in the funding of social policies across EU countries, with continental and southern countries (with the exception of Portugal) obtaining about two-thirds of revenues from social contributions, as opposed to Nordic countries, the United Kingdom, and Ireland, where social contributions account only for 40 percent of total finance or less. Nevertheless, the combined effect of general taxation and social contributions on wages is relatively similar across EU countries. Table 1.4 gives the OECD’s estimates of the total tax wedge and employers’ social security contributions for the average production worker. (see OECD 1998b). As seen in the table, the total wedge ranges from low values of around 25 to 35 percent, depending on the family status of the employee, in the United Kingdom, Portugal, Ireland, and Greece; to 40 to 55 percent in Sweden, Italy, Belgium, France, and Finland. The weight of employer’s social security contributions in the wedge varies significantly across countries; it is largest in the southern countries and France, where it amounts to close or above 50 percent of the total tax wedge. Although EU countries are more similar now about the tax wedge than they were fifteen years ago, the differences in the weight of employers’ social security contributions within the wedge have not significantly diminished in the last decade. An aspect of employers’ social security contributions that will be important in this analysis is their degree of progressivity. Most EU countries’ social security contributions are configured on a flat rate basis with ceilings: hence, in contrast to income taxation, contributory schemes are typically regressive. In Belgium and Italy, the contribution rate is almost 4 percentage points lower for employees earning five-

EU Welfare Systems and Labor Markets

49

Table 1.4 Tax wedge in EU countries (percent) Single earner

Austria Belgium Denmark Finalnd France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden U.K.

One-earner married couple

Total

Employers’ social security contributions

Total

Employers’ social security contributions

41.5 56.4 44.8 50.3 49.7 51.2 35.8 36.1 50.8 43.8 33.8 38.8 50.2 32.6

14.2 15.1 0 12.7 21.9 9.9 18 7.6 22.8 4.6 15.7 18.9 16.5 6.8

28 40.4 31.1 42 40.7 35 35.9 25.6 43.8 33.5 26.9 33.5 44.6 25.3

17.6 20.6 0 14.9 25.6 13.1 19.6 8.9 26.1 5.5 17.4 20.5 18.4 7.6

Source: OECD (1998b). Note: The total tax wedge is defined as the employees’ and employers’ social security contributions and personal income tax less transfer payments as a percentage of gross labor costs for employees at the average wage level.

thirds of the average wage than for those earning two-thirds of the average wage. Similar measures of contribution-rate regressivity are about 2 percentage points in the remaining EU countries, with the important exception of the United Kingdom, France, and Ireland where contributions are progressive over the same range, in that the higherwage employees pay higher contribution rates (by 1.5, 1.0 and 0.3 percentage points, respectively; see OECD 1998b). 1.2 Taking Stock: Status Quo and Trends As seen here, social benefits and regulations come in a wide variety of forms and countries articulate them differently. In part, this reflects the facts that the welfare state policies had different roots and evolved in different ways across EU countries. In this section we first classify EU countries in different clusters according to the main features of their social policies, building on the information provided in section 1.1.

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Bertola, Jimeno, Marimon, and Pissarides

Second, we also document recent reforms and developments in the social policy field. Social policies in the EU countries are in a state of flux as governments try to cope with the consequences of new economic and political events. We assess to which degree governments are following similar strategies when reforming social policies. 1.2.1 One Europe, How Many Welfare States? Political scientists have proposed a variety of welfare state regime classifications. Some authors distinguish among the liberal welfare state regime (United States, Canada, Australia, and the United Kingdom), the conservative welfare state regime (Germany, France, Italy, Belgium, and Austria) and the social-democratic welfare state regime (the Nordic countries, Denmark, and the Netherlands).15 Such classifications are closely related to the prevalence of different types of social transfer programs. Four types of social transfers can be identified on the basis of eligibility and benefit criteria: 1. Targeted benefits are aimed at those in proven need and provide assistance (minimum) benefits. 2. Basic security benefits, to which all citizens are entitled, are usually established on a flat-rate basis. 3. Corporatist benefits, which require some previous employment to be eligible, are related to income. 4. Encompassing benefits, under which eligibility is determined by citizenship and employment, are designed under a two tier (flat-rate and income-related) system. Broadly speaking, targeted and basic security benefits are more prevalent in Anglo-Saxon countries, corporatist benefits are more prevalent in continental Europe, and encompassing benefits are more widespread in the Nordic countries. Here we study how these broad characterizations are supported by quantitative and qualitative indicators. We also aim at characterizing recent trends in EU social policies, attempting in particular to ascertain whether different approaches to social-policy interventions are converging or diverging in the recent past. In reviewing current social policies in the EU, we have highlighted many aspects in which social transfers and regulations differ across countries. A convenient way of summarizing them, as shown in table 1.5 is by presenting measures on some selected indicators of social transfers and regulations in these countries. The following descriptions are one such orthodox classification of EU countries (see also Ferrera 1998).

IRL UK NL D F I E A DK S P B FIN GR Lowest

IRL UK NL D

F A I DK E S B P FIN GR Lowest

S DK FIN D

NL F A B UK I GR E P IRL Lowest

Highest

D NL F I E GR UK P

FIN S DK B IRL

Lowest

Inequality of adjusted disposable income

IRL D UK F B DK NL FIN S S Lowest

GR P E I

Highest

Extended households

Less “generous”

F P E S D IRL A GR I UK

Most “generous” DK NL FIN B

Unemployment insurance

Less restrictive

D F NL P E I UK GR A Lowest

B IRL

E F G S B A NL FIÑ DK IRL UK

S DK FIN

Highest

Most restrictive P GR I

Employment protection legislation

Active labor market policies (% GDP)

DK NL IRL D FIN S F P UK E Lowest

I GR A B

Highest

Minimum wage (% of average earnings)

Less centralized

B S I IRL NL E P DK UK

Most centralized A FIN F D

Collective bargaining

Increasing rewards from labor market participation

Highest

NL A UK F IRL I GR P E

D B

DK S

FIN

Lowest

Inequality of net earnings

Source: The ranking of minimum wages is taken from Dolado et al. (1996). The ranking of collective bargaining is with regard to the coverage rate of collective bargaining according to OECD (1994b). The rest of the columns are based on the evidence discussed in section 1.1.

Highest

Highest

Highest

Social assistance (% SPE)

Social assistance (% GDP)

Helping the poor

Social policy expendiure (% GDP)

Reducing inequality

Table 1.5 Selected indicators of social policies across EU countries (circa 1995)

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The Nordic countries. Sweden, Finland, and Denmark, and the Netherlands are countries that come from a tradition of full employment and universal welfare provision. They have the highest levels of social protection expenditures (about one-third of GDP), a high share of in-kind service provision, and a very low degree of income inequality (both in earnings and adjusted disposable income). In labor-market institutions, they have relatively generous unemployment insurance benefits, and their active labor-market policies (including job creation in the public sector) play an important role. Here social assistance plays a residual role, with some heterogeneity; and the relevance of social assistance schemes changes form country to country, being highest in the Netherlands and lowest in Finland. The Continental countries. Austria, Belgium, France, and Germany have policies derived from the Bismarckian tradition. These countries devote around 27 to 30 percent of GDP to social protection expenditures and have moderate degrees of income inequality. In these countries, wage determination is mostly centralized, legal minimum wages (or binding contractual minima) are relatively high, the generosity of unemployment insurance benefits is also high, the strictness of employment protection legislation and the weight of active labor market policies is close to the EU average, and social assistance schemes provides a general basic safety net. The Anglo-Saxon countries. The United Kingdom and Ireland are closer to the Beveredgian tradition, featuring relatively important social assistance schemes and high degrees of income inequality, especially in adjusted disposable income in the United Kingdom. They also have relatively low unemployment insurance benefits and less strict employment protection legislation, while wage determination is relatively decentralized and active labor market policies are not relevant. The southern European countries. Greece, Italy, Portugal, and Spain have welfare states that were developed more recently. These countries have the lowest levels of social protection expenditures (about onefourth of GDP) and relatively high levels of income inequality, which do not appear to be reduced by transfers as much as in other EU countries. The prevalence of extended household arrangements, conversely, noticeably decreases the degree of inequality of adjusted disposable income (particularly in Greece, Italy, and Spain), whether because adult

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household members assist their children, or because adult children assist their elderly parents. These countries are also singled out by the strictness of employment protection legislation, and relatively underdeveloped active labor market policies and social assistance schemes. This four-way classification is meaningful to the objectives of our analysis below, highlighting relevant aspects in the evaluation and prospects for reforms of social policies in Europe. Formal corroborating evidence can be obtained by statistical cluster analysis on a given set of variables measuring different dimensions of social policies. When the size and composition (rankings, in the case of employment protection legislation, minimum wages, and collective bargaining) of the social policies listed in table 1.5 are taken into account, the following clusterings emerge: For 1990, five different groups are obtained: (1) Denmark and the Netherlands; (2) Spain and Portugal; (3) Ireland and the United Kingdom; (4) Greece and Italy; and (5) Germany, Austria, France, Finland, and Belgium. •

For 1996, small differences with 1990 arise. The groups obtained are: (1) Denmark; (2) Spain and Portugal; (3) Ireland and the United Kingdom; (4) Germany, Austria, Greece, and Italy; and (5) France, Finland, the Netherlands, Sweden, and Belgium. •

Thus, statistical procedures confirm the traditional groupings outlined above. In particular, the Anglo-Saxon cluster stands out clearly in both years considered; similarly, Spain and Portugal are unambiguously clustered together. Interestingly, sharp distinctions do not appear between Nordic and continental countries in the dimensions considered: while the particularly Nordic configuration of Danish social policy stands out on its own, Sweden, Finland, and the Netherlands are intermingled with continental countries. 1.2.2 Recent Trends in EU Social Policies The next section discusses how a changing economic environment (especially, though by no means only, the extent of European economic integration) may, by increasing their economic efficiency costs, challenge the sustainability of welfare and labor-market institutions. Pressures for reforms can be noticed already, in that most countries have been revising their social programs and regulations in the last decade. Here, we offer a preliminary assessment of these reforms’ scope and patterns, focusing in particular on relationships across the clusters of

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EU countries identified above between status quo heterogeneity and reform trends. If measured by expenditure, the generosity of EU national welfare systems has hardly decreased during the first half of the 1990s. Social protection expenditures have increased as a fraction of GDP; in gross terms, total spending on social protection increased from 26 percent of GDP in 1990 to 28.5 percent of GDP in 1995 in the whole EU (European Commission 1998b). According to the most recent Eurostat estimates, between 1990 and 1996 social expenditure increased as a fraction of GDP in each of the member countries except Ireland, where it remained more or less constant, and the Netherlands, where it fell by about 1.5 points.16 Some reforms (such as those of pension schemes) only affect expenditure after a prolonged transitional period. Furthermore aggregate data are an imperfect indicator of a welfare system’s generosity over such short periods, where cyclical dynamics are quite important. The dynamics of the denominator during the recession of the early 1990s determine most of the increase in the ratio of social protection expenditures to GDP observed during the 1990–95 period. Figure 1.4 shows that increases of the ratio have been mild after 1993 and negative in all countries except Germany, Greece, France, Austria, and Portugal. Nevertheless, the overall rise in expenditures over the 1990–95 period appears contradictory to the fiscal pressure exerted by the Maastricht Treaty’s convergence criteria. The fall in public deficits despite nondecreasing social expenditures reflects four features of recent experience: 1. Fiscal consolidation proceeded with higher intensity after 1996 (a period for which there are no data available yet). 2. Faster economic growth occurred in the second half of the 1990s compared to the 1990–95 period. 3. Other budget lines, mainly public investment, have borne the brunt of expenditure cuts. 4. Tax increases (and nonfiscal revenues, like privatization revenues) have played a more important role than expenditure cuts in the sharp reduction of EU public deficits during the 1992–97 period. Although the evolution of total social protection expenditures (even after considering cyclical effects) gives no indication of a significant trend toward a retrenchment of social policies in EU countries, except in the Netherlands and Sweden, there is some evidence that countries

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12 (Percentage)

10 8 6 4 2 0 -2 -4 B

DK

D

GR

E

F

IRL

I

L

NL

A

P

FIN

S

UK USA

Figure 1.4 Average annual rate of growth of the ratio of social protection expenditures to GDP Source: EUROSTAT, ESSPROS. Data for Sweden not available. Data for the USA are taken form the OECD Social Expenditure Database.

have been changing their implementation of social policies during this period. Kalisch et al. (1998), in their analysis of member countries’ responses to the OECD Caring World questionnaire, highlight the following developments during the 1990s: A reduction of eligibility requirements for social protection programs has occurred, reducing payments and improving administrative practices to lower expenditures and enhance individuals’ economic independence. •

Better coordination of services has happened as well as some decentralization of social policy programs to local and regional governments. •

Social security payment structures have been modified to increase financial incentives to work. •

A trend exists away from public systems toward greater reliance on private social-policy agreements. •

Some of these qualitative trends, however, are not detectable in the data on the composition of social protection expenditures. Figure 1.5 plots the variation of the ratio of social protection expenditures by function to GDP during the 1990–96 period. Old-age and survivors transfers account for most of the increase in the ratio of social protection expenditures to GDP: it has decreased only in the Netherlands, and only in Germany, Greece, Finland, and the United Kingdom is this not the item that increased most. We will not analyze the demographic trends behind these developments and the overall sustainability of

(Percentage)

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Bertola, Jimeno, Marimon, and Pissarides

8 7 6 5 4 3 2 1 0 -1 -2 -3

Belgium Denmark Germany Greece Spain

Sickness/health care

Disability

France

Old-age and survivors

Ireland

Italy Netherlands Austria Portugal Finland

Family and children

Unemployment

Housing

UK

USA

Social exclusion

Total

Figure 1.5 Changes in social protection expenditures, 1990–1996 Source: EUROSTAT, ESSPROS. Data for Sweden not available. Data for the USA are taken form the OECD Social Expenditure Database.

European pension schemes. The ominous burden of pension payments, however, will loom large in our discussion of funding requirements and participation incentives within the integrated European economy. Housing and social exclusion are the items that have displayed the largest rates of growth in relative terms (although, given their small weight, their increase relative to GDP is smaller than for old-age and survivors). The ratio of expenditures on unemployment and disability (a function often regarded as an important source of pressure on the social policy budget) to GDP have increased on average by 0.75 points. The largest increases occurred in Finland, Germany, the Netherlands, and Portugal (where unemployment benefits were almost zero before 1989). Finally, for expenditures on family assistance, some countries have increased payments, especially for low-income families, which has resulted in some increase of expenditures relative to GDP (mostly noticeable in Denmark, Germany, Austria, Finland, and the United Kingdom). Considering next the tightness of eligibility criteria in social protection, figure 1.6 plots expenditures on means-tested benefits as a proportion of GDP and its change during the 1990–96 period. With the exception of Belgium and Italy, all EU countries have increased the amount of resources devoted to means-tested benefits. Clearly, higher

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3%

Change 1990–96

2%

Finland

UK

2% 1% Germany 1%

Portugal Spain Denmark Austria France Greece 0% 2% 3% 4% Belgium 1% 0% Italy - 1% Netherlands -

1%

Ireland 5%

6%

7%

y = 0.1297¥ + 0.0012 R2 = 0.0754

1990

Figure 1.6 Means-tested social benefits (as percent of GDP)

means-tested expenditures could reflect more intense take-up of existing means-tested programs rather than legislative strengthening of means-testing rules. This increase, however, has been largest in Finland, the United Kingdom, and Ireland where means-tested social protection arrangements were more important to begin with (excluding Ireland). If anything, this indicates that social-policy intervention schemes are becoming more dissimilar. Work tests, a prominent feature of Scandinavian welfare states, are becoming more prevalent in all EU social protection schemes. There are increasing requirements for active job search and acceptance of job offers for individuals of working age who claim social benefits. This trend is more apparent in the United Kingdom, where social-policy reforms embraced “welfare to work” and conditions for receiving benefits were established for participation in active labor-market programs or labor-market participation. The idea that social policies should ensure the “employability” of benefit recipients, however, is shared by all countries. The Luxembourg employment guidelines will be discussed below in some detail. In the data, concern about the labormarket implications of social-policy intervention is apparent by expenditures on active labor-market policies which have increased in almost all EU countries. Finally, in the countries relying heavily on unemployment benefits based on the insurance principle, active job

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search requirements are becoming more prevalent as a requisite to receiving unemployment benefits. To provide another indicator of convergence (or lack thereof) we have computed sums of squared deviations of social expenditure shares (to total social expenditure rather than GDP, to eliminate variation due to income levels). We decompose the observed sums of squares (SS) in a component deriving from within-model variation and one deriving from across-model mean variation. In the two charts in figure 1.7, the portion of the SS accounted for by variation across models is represented by the dark bars on the right. The explanatory power of models is limited from this empirical perspective. Many of the differences, for example, are in regulation and wage institutions which are difficult if not impossible to interpret quantitatively. Nevertheless, it is interesting to find that the differences across models explain, with few exceptions, the largest proportion of the total SS, both in 1990 and 1996. In the comparison between 1990 and 1996, this proportion has increased half of the functions (unemployment, old-age, disability, and health), and decreased in the other half (social exclusion, housing, family, and survivors). These two findings suggest that Social exclusion not elsewhere classified Housing Unemployment Family Survivors Old age Disability Health 0%

10% 20% 30% 40% 50% 60% 70%

80% 90% 100%

Figure 1.7a Decomposition of the differences in the composition of social expenditures, 1990

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Social exclusion not elsewhere classified Housing Unemployment Family Survivors Old age Disability Health 0%

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Figure 1.7b Decomposition of the differences in the composition of social expenditures, 1996

the clustering of countries around models proposed above is not at odds with the differences in the composition of social protection expenditures, and that •

between 1990 and 1996, there is no clear trend at the convergence in composition of social protection expenditures. On the basis of this admittedly rough measure, there are no signs of decreasing heterogeneity across models. •

On regulations, quantitative indicators are not available, since rankings are not comparable over time. All EU countries have, to some extent, introduced legislative and institutional changes meant to improve the functioning of the labor market. In some countries, not only the number of reforms have been large but also some reforms were, to some extent, contradictory with each other when considering their effects on the flexibility of labor-market institutions: we discuss the evidence briefly in section 2.4.3, in light of theoretical considerations. With the sole exception of the United Kingdom and the Netherlands (on nonemployment benefits), reforms aimed at increasing flexibility have been mostly marginal, not fundamental, so that the institutional framework of EU labor markets has not drastically changed.

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2 Social Policy and Economic Performance The above analysis of EU national welfare systems’ panoply of variously motivated instruments paints a rather complex picture. We now step back from it to discuss theoretical issues in the motivation and implementation of social policies and to consider broader patterns of evidence emerging from historical patterns and from the experience of non-EU countries. Section 2.1 offers some broad considerations on the desirable economic role of social policy, discussing its possible undesirable side effects. Redistribution is also motivated by social and political considerations. Section 2.2 briefly reviews evidence on its economic effects in a sample of countries wider than the EU, and section 2.3 discusses channels through which social policy may interfere with the functioning of labor markets. The effects of social-policy instruments (in the labor market and elsewhere) depend on the characteristics of the economic environment in which they are implemented. Section 2.4 outlines how productivity, demographic, and economic integration trends may explain a deterioration of social-policy performance over the last two decades. 2.1 The Economics of Social Policy Economists often find it useful to think of a hypothetical situation where all markets are perfect and complete. In such a world, social policy should be limited to simple redistribution, taxes and subsidies should be designed so as to be as nondistortionary as possible, and deregulation should be pursued as an end in itself. Reality, however, is different from the economist’s reference point. Social policy can play a meaningful role if is substitutes missing or highly imperfect market interactions. For example, appropriate health and safety regulation can improve on market outcomes when the latter could not ensure that workers are suitably informed about the characteristics of their workplace, because it is too easy (and profitable) for employers to misinform them and too costly for individual workers to obtain the relevant information. For similar reasons of asymmetric information, it may be impossible for laissez-faire economies to supply insurance against the risk of becoming or remaining unemployed. Workers would not try as hard to avoid unemployment and find new jobs if they were covered against the negative consequences of the event. And by purchasing insurance at a given market price, workers who know they have par-

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ticularly high unemployment risk would make the scheme unprofitable for insurance providers or unattractive to workers with average risk. One can then see why social policy would try and remedy the inequitable or “unfair” labor-market treatment of workers who, lacking insurance, become or remain unemployed despite their best efforts. If socially agreed upon forms of income redistribution and regulation can perform the same function as the market interactions they mean to replace, then the welfare state can improve economic efficiency as well as equity. As in the case of public goods, economic interactions often need to be mediated on the basis of collective agreements rather than of individual choices. An economic case can be made for arrangements that mimic the features of desirable contracts not supported by laissez-faire economic interactions. Social-policy intervention, however desirable, unfortunately does face much the same information constraints that prevent markets from achieving first-best equilibrium configurations. Information problems plague public intervention in both its efficiency-seeking and equityseeking dimensions. Clearly, workers have no less incentive to decrease their effort when covered by social instead of private insurance. Collective information-gathering facilities may be superior to those of private agents (and both may improve over time as information technology progresses), and governments should be better able to enforce transfer and regulation schemes (at least in the absence of corruption). Even the fictional “big brother” governments of Orwell’s 1984 and Bradbury’s Fahrenheit 451, however, enjoy much less than perfect information and enforcement facilities. Imperfect information about effort and about personal characteristics plagues social policy with the same problems that make it so hard for private markets to address the adverse effects of otherwise desirable contractual arrangements. On the other hand, efficient provision of social protection cannot eradicate all unfair inequality. If individual characteristics and behavior are not verifiable, then richer individuals may take advantage of subsidies or tax exemptions meant to benefit a society’s more unfortunate members. Accordingly, standard optimal-taxation theory stipulates that some admittedly unfair inequality must survive redistribution efforts. If individuals with higher pretax welfare cannot be singled out ex-ante but only on the basis of information revealed by their behavior, they must remain better off after the introduction of taxand-subsidy packages, for otherwise they would have no incentive to reveal their true pretax standing.17

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Because of these incentive or “loophole” problems, redistribution schemes generally increase pretax inequality as they attempt to decrease posttax welfare inequality. Most straightforwardly, theory predicts that progressive income taxation should decrease labor-supply incentives for high-ability workers—surgeons, for example. Lower supply of such high-skill services must increase their price in equilibrium (to an extent that depends on the elasticities of demand and supply). Qualitatively similar dynamic mechanisms may be at work in the presence of uninsurable uncertainty, that is in a situation where social policy can be expected to substitute missing markets. To the extent that unemployment insurance decreases job-search incentives, more individuals can be expected to be unemployed (and, at zero income, increase pretax inequality). Also, ex-post redistribution increases risk-taking, like a well-functioning financial market would. This improves the economy’s productive efficiency but, as individuals engage in more risky activities, pretax inequality can increase so much that posttax inequality is also higher than in the absence of social redistribution (Sinn 1995). The direction of these effects is unambiguous: to some extent, social policy must be less than fully successful. Their intensity, however, depends on many details of the economy’s productive and informational structure, and on the administrative structure of social policies themselves. In principle, social policies’ side effects may be so strong that they defeat the purpose of policy interventions. For example, social insurance may so strongly encourage risk taking that not only pretax but also posttax inequality is larger than in the absence of social policies. Publicly provided pensions and taxation of private capital income may reduce private wealth accumulation so much as to leave the old as poor as they would be if they were left to their own devices. Nonemployment benefits and labor taxes may so discourage (through “poverty traps”) labor-force participation and human capital accumulation as to leave disadvantaged individuals as poor as, or poorer than, they would be in the absence of policy interventions. Finally, social policy might defeat its own purpose through general equilibrium interactions. Lower efficiency and slower capital accumulation may so adversely affect aggregate income that poor individuals, even as they obtain a larger share of it, are worse off than they would be if they could obtain a smaller slice of a larger laissez-faire social pie.

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2.2 History, Politics, and the Effects of the Welfare State If the unavoidable side effects of social-policy interventions were so strong as to defeat its intended economic purposes, one would wonder why such misguided interventions would ever take place. Before discussing some of the relevant empirical evidence, however, we need to acknowledge that social policy cannot be studied from the purely economic viewpoint. The welfare state not only supplies insurance to individuals, like a hypothetical financial market, it also offers a minimum standard of living to individuals who could never purchase insurance in the market, and—aiming at reducing social tensions and preventing exploitation—redistributes income on the basis of social, rather than individualistic, solidarity criteria. Hence, social policies have political and often nationalistic motives beyond the more directly economic mechanisms illustrated here. Although from an economic point of view social policies should be simple and transparent, the complex welfare state schemes discussed in section 1 can only be rationalized considering their history. Social policy has firm nationalistic and often paternalistic roots, and many features of the welfare state were introduced and developed in the context of the European militaristic nation state, a fact that has particularly interesting implications as formation and continued integration of the EU makes that concept obsolete. The employment-related old-age and sickness benefits introduced in Bismarck’s nineteenth-century Germany were meant to keep revolutionary pressure under control. Similarly, the Beveridgian welfare state of the United Kingdom and other Anglo-Saxon countries was formulated and implemented in the nationalistic climate surrounding World War II.18 The current configuration of these two models in Europe, alongside the egalitarian Scandinavian welfare state and the mixed and underdeveloped schemes prevalent in Mediterranean countries, remains difficult to understand without reference to their origins. A second important aspect of real-world social-policy provision is that welfare state features are not designed and implemented once and for all at a constitutional stage where their economic and social purposes can be best taken into account behind a veil of ignorance. In reality, “winners” and “losers” are quite easy to identify for many, if not all, policy instruments. Hence, the original designs of social-welfare policy systems are the result of complex political interactions, where special interests play an

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important role, and the same is true of their reforms (or lack thereof). The politics of welfare are the politics of the status quo: each member of the welfare state “families” identified in the literature has its own history-dependent, layered structure, shaped by bureaucratic and political resistance to change at least as much as by its intended purposes.19 The remarkable heterogeneity of social-welfare policies and its rather exogenous (to economics) sources are a blessing for research on their economic implications. As noted in section 2.1, theory indicates that welfare state policies may hamper economic performance and increase pretax income inequality at the same time as they try to redress market failures and/or equalize incomes. The quantitative importance of these effects, however, needs to be gauged empirically. To the extent that each national experience may be treated as a separate experimental outcome, researchers can rely on ample comparative evidence from different countries. Such exercises are more informative when conducted on sets of countries that implement different sets of social policies but are otherwise comparable. Hence, it is advisable to broaden the scope of this discussion beyond the confines of the EU and consider comparative evidence from other industrialized countries. The extensive Luxembourg Income Study (LIS) data sets cover five non-EU countries (Australia, Canada, Norway, Switzerland, and the United States); among EU countries, however, Austria, Greece, Portugal, Spain, and Luxembourg are not covered. The LIS evidence does not support the notion that social policy’s “side effects” may be so strong as to defeat its intended purpose: more generous welfare states are unambiguously associated with lower poverty rates (see Kenworthy 1998, or Förster 1994). Table 2.1 reports some relevant statistics. The incidence of pretax absolute poverty is high in rich, nonredistributive economies such as the United States rather than in countries with pervasive and generous redistribution schemes. This simple fact, and more sophisticated statistics, indicate that social policy does accomplish its stated purpose of reducing poverty. Redistribution does not decrease private incentives to work and save so strongly as to impoverish the poorest citizens (and the whole economy) at the same time it grants them a larger share of aggregate income. The data also indicate that posttax poverty is highest in the United States and other Anglo-Saxon countries; despite the fact that these countries are relatively rich on an absolute scale, their reliance on targeted benefits (rather than on universal or employment-related welfare provision and labor market regulation) apparently leaves many of their citizens poor

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Table 2.1 Post-tax/transfer absolute poverty rates (percent), circa 1991 Percent of the U.S. post-tax/transfer median at which the poverty line is set

Australia Belgium Canada Denmark Finland France Germany Ireland Italy Netherlands Norway Sweden Switzerland United Kingdom United States

Year

50%

40%

30%

1989 1992 1991 1992 1991 1989 1989 1987 1991 1991 1991 1992 1982 1991 1991

20.1 14.2 11.3 13.5 8.1 19.7 11.5 43.7 26.1 16.0 4.0 11.0 6.2 27.0 17.7

11.9 6.0 6.5 5.9 3.7 9.8 4.3 29.4 14.3 7.3 1.7 5.8 3.8 16.8 11.7

5.6 2.2 3.1 3.4 1.4 4.8 2.1 15.6 5.6 4.2 0.7 3.1 2.7 6.1 6.6

Source: Kenworthy (1998), calculations from the LIS database. The numbers in the table refer to the percentage of each country’s citizens living in households whose per-capita income (adjusted for purchasing power on the basis of OECD estimates, and for size using the standard square-root equivalence scale) falls below a given amount, defined as a percentile of the U.S. income distribution. “Post-tax and -transfer income” of the households surveyed in the LIS microeconomic data sets account for income from all sources, government benefits (including “near cash” benefits, such as food stamps), and tax payments. Note: Percentage of individuals in households with post-tax/transfer incomes (adjusted for household size) below poverty line in 1991 U.S. dollars.

on an absolute basis. It is also interesting that Italy, the only member of the Mediterranean EU cluster in this table, displays a very high rate of absolute poverty. This may reflect its particularly heterogeneous regional income distribution but also the relatively inefficient and misdirected configuration of its social policies. Italy, like most Mediterranean countries, has no minimum standards for social assistance provision, and many of its transfer programs fail to target the poorest citizens. The data also give no evidence that the generosity of welfare policy has long-run adverse effects on broad measures of economic performance (see, for example, Atkinson 1999, chapter 2; Perotti 1996,

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and other references in Bertola 1999b). This is of course not surprising from the economist’s viewpoint; if social policy is mostly aimed at mending the shortcomings of laissez-faire markets, then it might be expected to foster rather than hinder production. We illustrate this evidence simply in figures 2.1 and 2.2 by plotting long-run income level and growth indicators against an index of welfare state generosity, namely the extent of within-country redistribution measured by the difference between pre- and posttax and transfer relative poverty rates.20 This index is of course a rough measure of welfare state intervention. On the one hand, if individuals do work and save less because of taxes and transfers, then the change in poverty rates overstates the effect of social policy (which increases pretax inequality at the same time as it decreases posttax inequality). On the other hand, welfare state institutions achieve their more or less obvious goals with different instruments, such as public employment and wage-setting institutions, that have broad effects on pretax inequality. The evidence should be further qualified by the observation that, to the extent that social policy does reduce economic efficiency, exogenously richer societies would generally find it easier to afford production losses, implying that redistribution and economic performance could be jointly, rather than causally, determined in the data. In practice, however, there is essen-

1983–96 Linear (1983–96)

24 U.S.A. 22 GDP per capita

Switzerland 20 18

Norway

Canada

Germany

U.K. Australia

16 14 12

Finland

Sweden Italy Netherlands

France Belgium

Denmark 2

R = 0.2717, slope t = 2.20 Ireland

10 Difference between pre- and post-tax /transfer poverty rates, circa 1991 Figure 2.1 Social policy and GDP per capita (PPP) Source: Poverty rates, Kenworthy (1998); time-averaged income levels, computations on PPF basis data drawn from the OECD economic outlook database.

EU Welfare Systems and Labor Markets

GDP per capita, growth rate p.a.

5

67

1983–96 Linear (1983–96)

4.5

Ireland

4 3.5 3

Norway

2

2.5

Australia

2

U.S.A.

1.5

Germany

Finland

R = 0.062, slope t = 0.93 Netherlands Denmark Italy U.K. Belgium France Canada Sweden

1

Switzerland

0.5 0

5

7

9

11

13

15

17

19

21

23

25

Difference between pre- and post-tax/transfer poverty rates, circa 1991 Figure 2.2 Social policy and growth Source: Poverty rates, Kenworthy (1998); income growth rates, computations on PPPbasis data drawn from the OECD economic outlook database.

tially no relationship between the extent of redistribution and GDP growth rates, and a very mild negative statistical association between redistribution and income levels.21 Although the welfare state appears to achieve its intended povertyreduction purpose with no obvious adverse effects on income levels or growth rates, it would be naive to conclude on the basis of this simple evidence or of the more sophisticated statistics in Kenworthy (1998) or Perotti (1996) that redistribution has no negative effects on economic performance. And it would be especially naive to dismiss the economic challenges faced by the welfare state in the EU context, where labor-market issues loom particularly large. Figure 2.3 plots the poverty-rate-based summary measure of welfare state generosity against an equally rough summary measure of labormarket performance, namely standardized unemployment rates, again averaged for each country over the 1983–96 period to eliminate cyclical effects and possible reverse-causation mechanisms. When indicators of social-policy redistribution are considered jointly with unemployment, a positive relationship between poverty-reduction success and unemployment is readily apparent. This relationship is only suggestive: see Atkinson (1999) for a critical discussion of similar, more

Average unemployment, 1983–98

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16.00 Ireland

14.00 12.00

Belgium France

R2 = 0.4351, slope t = 3.16

10.00

Italy Canada Australia Germany Netherlands

Finland

8.00 U.S.A.

U.K. Denmark

6.00 Sweden

Norway

4.00

U 83–98 Lineare (U 83–98)

Switzerland

2.00 0.00 5

7

9

11

13

15

17

19

21

23

25

Difference between pre- and post-tax/transfer poverty rates, circa 1991 Figure 2.3 Social policy and the labor market Source: Poverty rates, Kenworthy (1998); average unemployment, computations on standardized data drawn from the OECD unemployment outlook database.

formal evidence. Interestingly, the relationship between welfare state generosity and employment rates is much weaker, perhaps a reflection of the fact that many countries with a high level of social protection also feature high public employment, especially among women (and often in the administration of social protection programs). A similar picture emerges in the two panels of figure 2.4, where we investigate the interaction between family-based transfers and the labor market impact of social policies by plotting the poverty-based measure of the latter against household employment rates. Unfortunately, limited data prevent this exercise from providing much information, particularly as the relevant statistics are available only for Italy among the Mediterranean countries where our discussion of section 1 found family structure to be most relevant. The 1996 data indicate that social policy has a smaller and less statistically significant impact on family nonemployment rates than on the individual unemployment rates considered in figure 2.3. This might indicate that incentives to obtain market employment particularly affect young and female household members but are not so strong as to induce nonemployment of primary breadwinners. When we consider average 1996 and 1985 data for the (fewer) countries where both are available, however, family nonemployment rates are just as significantly and positively related to welfare state generosity as the individual unemployment rates in figure 2.3.

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24.00 Nonemployment rate of working-age households

23.00

Belgium

22.00 Denmark

21.00

Germany

Netherlands

20.00 19.00

Italy Canada

y =0.3513¥ + 13.495 R2 =0.4582

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avg 96, 85 Linear (avg 96, 85)

17.00 16.00 15.00

Australia

U.S.A. 5

7

9

Ireland France

11

13

15

17

19

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Difference between pre- and post-tax/transfer poverty rates, circa 1991 Figure 2.4a Social policy and families in the labor market

Nonemployment rate of working-age households

30 Finland 25

Belgium y = 0.3715x + 13.842 R2 = 0.1532

20

Germany

Denmark Canada

Netherlands Australia

U.S.A.

15

France Ireland

Italy

10

1996 Linear (1996)

Switzerland 5 5

7

9

11

13

15

17

19

21

23

25

Difference between pre- and post-tax/transfer poverty rates, circa 1991 Figure 2.4b Social policy and families in the labor market Source: Poverty rates, Kenworthy (1998); household nonemployment rates, OECD Employment Outlook 1998, table 1.7, all working-age households.

As in the other diagrams, the direction of causation between socialpolicy generosity and employment performance is far from clear; the variation in the data may be generated by a variety of countryspecific factors affecting both variables. One can hardly deny, however, that social policy is associated with high unemployment rates. In sharp contrast to the picture offered by GDP levels and growth rates, individual and family employment rates are negatively and rather

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significantly related to the generosity of welfare. The relevant theoretical mechanisms and practical experiences are discussed next. 2.3 Labor-Market Issues: Efficiency Costs We have argued that many welfare state policies aim at mending the free markets’ failure to insure workers adequately against a variety of risks that cause income loss. Free markets fail to provide adequate insurance because of the efficiency costs associated with moral hazard and adverse selection. Compulsory universal coverage as exercised by governments may reduce some of those costs or at least make the implementation of the policies feasible. This section discusses the main efficiency costs of social policies and their relevance in EU countries. From an economist’s point of view, it is far from surprising that social policy should interfere with the workings of labor markets. After all, an important component of social policy aims at freeing individuals from the need to toil and work to survive. Political scientists point out that such “decommodification” can have important beneficial effects inasmuch as a credible option to refuse employment altogether helps workers obtain better treatment from an otherwise harsh labor market.22 While families and rural communities made such options available in preindustrial societies, and may still do so in some regions of southern Europe, social policy fulfills a similar role in most modern market economies. Whether or not an economy may generate favorable employment opportunities that “decommodified” workers require is an open question. In equilibrium, high benefit levels may be taken up by workers, leading to lower employment rates at the same time as they avoid the formation of a “working poor” class. While policy cannot completely escape the trade-off between inequality reduction and high employment levels, the shape of the trade-off and an economy’s position in relation to the efficient frontier depend on policy configurations. For example, universal benefits, such as family allowances, have only income effects—they reduce the overall need to seek gainful employment, but do not distort the choice between working and not working. Conversely, means-tested benefits—and the tax instruments used to finance all social benefits—depend on market income. Hence, they decrease labor supply through both income and price effects, and may generate “poverty traps”—situations where an individual’s or a household’s income is lower when working than when not working. In the case of social assistance measures, the general

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trend toward in-work benefits noted in section 1 is meant to reduce or eliminate this effect. To achieve this desirable effect, however, lowwage employment opportunities must be available in the labor market, which may not be the case when working hours and wage rates are themselves regulated. Unemployment benefits would “trap” workers out of employment only if they were higher than any wage the worker concerned could possibly earn. Their effects on employment are rather obvious also in less extreme cases. Since their payment is contingent on not working, however, unemployment benefits can hardly be expected to increase incentives to work. For this reason, unemployment insurance schemes are widely studied in the labor market context. In most countries’ experiences, however, old-age and disability pensions have fulfilled much the same redistributive role and have had similar employment effects. In the United Kingdom reductions in the generosity of unemployment benefits were accompanied by a spectacular increase of disability benefits, especially in industrial crisis areas. Old-age pensions have also been used by many countries to fulfil a social insurance role that would be more properly assigned to unemployment benefits. Italy, where unemployment insurance is practically nonexistent, has one of the lowest labor market participation rates for men aged 55 to 65, who have been able to draw “exceptional” early-retirement benefits upon displacement from their jobs.23 Clearly, workers whose labor market position is weak have more incentives to claim disability or lobby for early retirement when unemployment benefits are not available, and obvious asymmetric information problems make it impossible to rely on objective medical criteria in awarding them. From this perspective, it is not surprising that the reduction not only of unemployment but also of disability benefits was associated in the Netherlands with increased job creation and lower unemployment (Nickell and van Ours 1999). The efficiency costs of unemployment insurance and similar policies are due to their wage effects and the disincentives that they create in the job search. The discipline on union wage demands is usually the unemployment cost of high wages. With generous unemployment insurance, unemployment is not as costly and unions push for higher wages. Unemployment insurance also reduces the urgency with which unemployed workers look for a job, thus increasing the duration of unemployment.24 Studies of the aggregate evidence typically find that unemployment insurance has exerted substantial influence on unemployment (see OECD 1994a, chapter 8, and Atkinson 1999, chapter 2,

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for a discussion; Scarpetta 1996 found that the rise in unemployment benefits can explain about 20 percent of the rise in the average OECD unemployment rate between 1973 and 1993). Unemployment insurance, however, also reduces wage inequality, partly because it acts as a wage floor and partly because low wages are likely to increase by more in proportional terms than high wages are when unemployment insurance benefits are introduced. In fact, as seen in section 1.1, the complex web of welfare state policies in EU countries aims at decreasing inequality as well as at reducing poverty. Bargaining institutions have an important role in the pursuit of this goal, as well as in determining the impact of social-policy interventions on labor costs and employment levels. For example, if there is a rise in labor costs because of a rise in the payroll tax, unions engaged in nationwide wage bargaining may internalize the fact that unemployment would increase unless take-home pay concessions are made. Small, decentralized unions may instead resist changes in their members’ take-home pay; if every union follows the same policy, the outcome would be higher wages at the macroeconomic level, thus implying a higher employment cost than with a nationwide union. This argument (see also Esping-Andersen 1990) applies to social-policy interventions the familiar argument applied by Calmfors and Driffill (1988) to the labor-market effects of macroeconomic shocks. As in this setting, a competitive market without unions would also yield favorable employment outcomes, as take-home pay would generally tend to adjust, ensuring that labor costs are consistent with full employment (of a smaller labor force if, as is likely, lower take-home pay decreases labor market participation incentives). Thus, socialpolicy intervention can be compatible with high employment and wage moderation in widely different circumstances. This is true if unions are weak—for example, in the United Kingdom since the 1980s—or in the presence of extensive consultation among unions, government, and employers—for example, in the Netherlands’ recent experience— where welfare reforms were facilitated by wage moderation on the part of “corporatist” unions (Nickell and van Ours 1999). Two aspects of the structure of the unemployment insurance system influence its efficiency cost: the duration of benefits and the relation of unemployment benefits to the wage rate (the replacement rate). The theory of job search suggests that declining benefits during unemployment increase the incentives to look for work (Shavell and Weiss 1979). Workers who expect their benefits to run out when they become

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unemployed try harder to find a job quickly to avoid an income drop. Incentives are maximized when the whole compensation is given before job search begins, but this approach would be less than fully satisfactory for insurance purposes, since the amount of compensation would be independent of how lucky or unlucky a worker may be while searching for a job. In practice, the duration of benefits varies across countries, and countries with longer-lasting benefits appear to have experienced a bigger rise in unemployment during the 1980s (Blanchard and Wolfers 1999). Active labor market policies are often implemented in Europe and, as seen in section 1.1, particularly in Nordic countries. From the perspective here, these policies appear quite attractive: if social policy and income support decrease work incentives, what could be more advisable than “active” measures specifically aimed at remedying the labormarket effects of social protection? The record of active policies, however, is mixed (see Martin 1998). Almost by definition, active labormarket policies reduce the duration of unemployment, but they do have an important drawback: they are expensive (and, as we shall see, particularly so when the welfare state is challenged by adverse exogenous developments). The most expensive kind of active policy, and consequently the most controversial, is the provision of public employment or subsidized training for targeted groups of unemployed workers. Training forms the backbone of Sweden’s active labor-market policies. Unemployed workers lose their entitlement to benefit after six months of unemployment and are transferred to a job with some training provision. Clearly, such a policy reduces unemployment both directly, because those on training programs become employed, and also indirectly by making those receiving training more employable after the end of subsidized employment. Britain’s current “new deal” for young unemployed also has features of this program. The scheme, however, has been criticized on a number of grounds. It can be expensive when a large number of unemployed workers reach the end of six months of job search without success. Also, it has been claimed by Swedish economists (e.g., Calmfors and Nymoen 1990) that the availability of a job guarantee reduces the discipline effect that unemployment has on union wage demands. Thus, even though active labor-market policies may speed up the transition to a job for those unemployed, they lead to less job creation because of their wage effects. Finally, some of those trained may return to unemployment, after the end of subsidized employment, with little change in

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their employment prospects (see Martin 1998 for a review of the relevant evidence). Employment protection legislation has been used extensively in Europe for the purpose of providing job security to the employed. But once again, there is an efficiency cost to the insurance, since job security tends to reduce labor mobility from low- to high-productivity jobs. The efficiency costs of this policy, however, are not necessarily loss of employment. Dynamic labor-market models imply that employment protection legislation reduces job destruction, but it also reduces job creation (Nickell 1982; Bertola 1990; Millard 1996). The reason for the reduction in job destruction is clear: employment protection legislation is a firing cost imposed on the employer, so job destruction, which necessitates firing the employee, becomes more expensive. The reason for the fall in job creation is that since dismissal is now costlier, the firm creates a job and recruits an employee to it only if the revenue generated by this decision is sufficient to cover expected turnover costs. Thus, jobs that are not expected to have a long life are not created when there are stringent job destruction rules, and the policy is effective in reducing the risk of job loss of those in employment. Since both job creation and job destruction are reduced, the relation between employment protection and levels of unemployment is ambiguous, both in theory and in empirical data (Bertola 1990; OECD 1999a, chapter 2). Not surprisingly, employment adjustments are lower in countries with stronger employment protection legislation, which are also countries where more people are out of the labor force (Scarpetta 1996) and wages display lower cross-sectional variance and faster trend growth (Bertola 1999a and references therein). The funding of social policies can also have efficiency implications. In competitive labor markets, where wages are determined by the aggregate supply and demand for labor and individual employers and workers do not have an influence on their rates of pay, the only tax variable that influences wages and unemployment is the size of the tax wedge (see Pissarides 1998). The wedge increases labor costs at given real wages and so shifts the demand for labor down. Whether the effect is on wages or employment depends on the slope of the labor supply curve. If labor supply is inelastic, employment does not change but wages fall to reflect the tax. In this case, workers pay for the tax in equilibrium—there is what some authors call no real wage resistance (see, e.g., Tyrvainen 1995). But if labor supply is elastic there is real wage resistance and more of the tax is passed on to employment. In general,

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the elasticity of take-home pay to tax and benefit levels depends on wage-setting institutions; the response of labor-market participation to take-home pay and of employment to employers’ labor costs depend, respectively, on the elasticity of labor supply and of labor demand. If wages are determined by a bargain between employers and unions, the degree of progression of taxes also influences the wage outcome. When the tax is progressive, every time the union demands one more net euro in wages, the employer has to pay a larger amount in pretax wages. That is, a given additional concession to the union with a progressive tax adds more to labor costs than the same concession with a proportional tax. For this reason, when taxation is progressive there is less real wage resistance; more of the tax should be absorbed by wages with a smaller effect on unemployment. Raising revenue with progressive taxes is likely to have a bigger impact on wages and less on employment than raising them with proportional or regressive taxes.25 2.4 Crisis Factors In light of the many theoretical channels through which social policies can hamper economic efficiency and, in particular, reduce employment, it is hardly surprising that welfare state features are often blamed for the “inflexibility” of European labor markets, with high unemployment and potential stagnation. Such criticism can only too easily forget that some negative effects on employment are unavoidable, and that the Welfare State addresses real problems of laissez-faire market outcomes. Further, much of the current configuration of European welfare states was already in place by the early 1970s, when the employment performance of European countries was quite satisfactory. The labor market and other effects of social policies, however, are not independent of the environment in which they are implemented. A variety of developments can explain the intensity of current debates on welfare state “crises” and point to directions of reform. The focus here is on how exogenous changes in the economic environment may explain labor-market developments. It should be mentioned, however, that elements of the welfare state “crisis” may be endogenous to its own phenomenal growth in the postwar period. Almost by definition, the welfare state had to become too extensive and too complex before it stopped growing (Pierson 1999). As individuals or organized groups learn to take advantage of the many loopholes

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present in real-life legislation (Lindbeck 1997b) or to manipulate decision processes on new legislation, social policy had to become less effective. 2.4.1 Macroeconomic and Demographic Trends If the only shocks that affect an economy are cyclical, with mild recessions and booms, even poorly designed insurance policies will not put too much strain on the economy. Employment may on average be lower and fluctuations may have more amplitude with generous welfare policies, but the fiscal strains from the extra financing needs in recession and the rise in unemployment are not likely to cause political problems. Such was the situation in the 1960s and early 1970s, when most of Europe’s welfare systems were put in place. In addition, the economies of Europe were growing fast at that time, giving rise to more job creation and to wage gains beyond those expected a few years earlier. What went wrong with the scenario that brought the welfare states into being and what were the main strains? Three developments in the macroeconomic environment may be singled out as particularly relevant to the impact of labor market policies since the mid-1970s. First, the oil shocks of 1973–1974 and 1979 increased production costs and necessitated wage reductions, especially in manufacturing. Second, productivity growth slowed down; in the United States this happened at about the same time as the oil shocks and then soon afterward in the major European economies, making continued fast wage growth unsustainable. Third, the globalization and computerization of the 1980s and 1990s shifted the economic balance in favor of skilled workers. Further stress factors behind the welfare state crisis are demographic in nature: lower birth rates, family-size changes, longer lifetimes, and increasing health-care costs tend to increase social expenditure within each country and for all developed countries as a whole. The oil shocks of the 1970s and the skilled-biased shocks of the 1980s both required more flexibility in employment, especially among unskilled labor. The oil shocks necessitated across-the-board wage reductions and job loss in manufacturing, and structural shifts of employment toward the service sector, where productivity growth is slower, also exerted downward wage pressure. The skill-biased shocks required an increase in wage inequality and again some shifting of employment from low to high skill. Demographic trends magnified the

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effects of macroeconomic and technological shocks in making social policies increasingly difficult to implement. Slow productivity growth and aging populations have an obvious negative impact on pension arrangements. Single-parent households are more sensitive than standard nuclear families to work-incentives effects of nonemployment benefits, and they are more difficult to protect from poverty; similar considerations apply to single elderly households which, especially in urban environments, are more likely to suffer old-age poverty than traditional extended families. The welfare systems and methods of wage determination that European countries put in place before the mid-1970s proved unable to cope with the strains introduced by these shocks. A welfare state designed to insure principally against individual and cyclical risks was not suitable to insure workers against unfavorable economic conditions that would last for a long time. When the oil shocks arrived, however, this distinction was not observed. Both governments and trade unions reacted to the unfavorable conditions created by the higher oil and material prices in the same way as they would have reacted to a normal recessionary shock. Wages were not allowed to fall, cushioned by union demands and the social insurance net, and there was pressure on governments to follow traditional Keynesian policies to expand the economy. The result was an increase in both unemployment and inflation. European welfare states and systems of industrial relations not only led to excessive real wage demands but also had to cope with increasing dispersion of labor-market outcomes across individuals. Whether due to globalization and the entry of low-cost producers in international markets or to computerization and other technological advances, structural changes in industrialized countries worsened the lot of unskilled workers relative to that of skilled workers during the 1980s and 1990s. Social policy has more to do when more individuals are more severely disadvantaged, and the costs of social-policy intervention become more apparent at the same time as it becomes more desirable. To the extent that labor-market inequality persists across individuals, the insurance aspects of social policies are less apparent, while its redistributive aspects make them difficult to sustain politically. Different welfare state regimes have reacted differently to the new situation. Increasing wage inequality in the deregulated labor markets of the United States and the United Kingdom is one manifestation of

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the new economic environment. In these countries, social-policy provision conforms to Esping-Andersen’s (1990) “liberal” welfare state paradigm, where in-work benefits and targeted welfare provision manage to make some degree of social protection consistent with increasing low-wage employment in the private sector. In other countries, better entrenched and differently designed systems of welfare provision have either created higher-wage employment in the public sector, or stifled service employment growth by extensive regulation of labor and product markets (Pierson 1999). The former strategy has been adopted by Nordic Social-Democratic welfare states; its sustainability over time, however, encounters fiscal constraints. Sweden in the 1990s is an example. Sweden outperformed other European countries up to the 1980s and its generous, active policy-based welfare state kept unemployment low when in other European countries it was rising fast. Fast economic growth, partly reflecting expansionary macroeconomic policies combined with devaluations, could support a generous welfare system that protected the individual from employment risks but also provided basic social services to all. When growth declined in the 1990s, however, the system reached near breaking point because of the high budgetary cost. The experience of Sweden and Finland in the 1990s has shown that active labor-market policies cannot be used as an anticyclical device because of their high costs in recession.26 The second strategy is that of continental European ChristianDemocratic welfare states, where high wages and stable employment for prime workers are ensured by binding wage floors and extensive regulation of employment relationships. In this case, sustainability is challenged by low employment rates (especially among female and older potential workers) and by high, persistent, long-term unemployment (especially among the youth). In continental Europe, the wage setting institutions and the welfare state did not allow for a rise in inequality. Unemployment increased instead. This gave rise to the much-discussed unemployment inequality trade-off and to several attempts to find out whether the trade-off is really as prominent a feature of the data as argued by OECD and others.27 Figure 2.5 displays a clear trade-off between percentage changes in the ratio of earnings of the most educated group to the least educated group, and percentage changes in unemployment across countries. Like many of the other simple pieces of evidence put forward here, this is too blunt to capture all the nuances of real-life experience; taken at face value, in fact, the simple story would imply that the incidence of

EU Welfare Systems and Labor Markets

Percentage rise in inequality

USA

79

25 Canada

20

U.K.

15 Sweden 10 5

-20

-10

0 -5

Japan Australia 0

10

20

30

40

Denmark 50

60

Italy Netherlands

-10

70 80 Germany Norway France

-15 Percentage increase in unemployment rate Figure 2.5 The increase of unemployment and wage inequality Definition and source: Horizontal axis: log difference between the average annual unemployment rate in 1980–1990 and in 1974–79, from Layard et al. (1991), table 1, p. 398. Vertical axis: log difference of the early 1990s and early 1980 ratios of earnings of men with the highest education qualification (E, usually university degree) and men with the lowe education qualification (A, usually compulsory schooling only), from OECD Jobs Study, part II, table 7.A.1 (data for Italy are extrapolated from the wage distribution in chart 5.1).

European unemployment should be mostly on low-skilled workers, which was not the case.28 Still, the United States and Canada avoided a rise in unemployment and experienced large rises in wage inequality, while European countries experienced rises in unemployment but not in inequality.29 The United Kingdom is an exception to this rule, having suffered a rise in both unemployment and inequality over the period considered; this, however, was a transitional phenomenon following the reforms of the 1980s, which weakened the power of unions and reduced the generosity of unemployment insurance, and moved the United Kingdom’s institutional configuration from a position in the European cluster in the early 1980s to one closer to the North American cluster in the 1990s. The increasingly dismal employment performance of mature welfare states has spurred a flurry of reforms (see the introduction to this volume for a review of these and other aspects of recent experience). Only in a handful of cases, however, were reforms consistent and fundamental with significant and long-lasting effect. In many countries,

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the cumulative effect of marginal reforms appear to be that of decreasing generosity of nonemployment benefits. As to employment protection legislation, a common element during the 1980s and 1990s was liberalization of atypical employment contracts (fixed-term contracts, part-time contracts, etc.), which typically differ not only in terms of job security but also in terms of social security coverage. 2.4.2 Economic Integration and the Provision of Welfare After the Great Depression and World War II, the boundaries of markets largely coincided with the boundaries of (national) socialpolicy constituencies. On the one hand, this made it legitimate to consider each welfare system’s motivation and performance in isolation when assessing its empirical implications, as was done briefly in section 2.3. On the other hand, national welfare systems could try and mend market failures in splendid isolation, and they could enforce tax, subsidy, and regulation schemes without fear that their citizens could opt out of them. Alongside the broad productivity and demographic trends outlined above, however, significant changes have occurred in the extent to which industrialized economies interact with each other (especially in the context of European unification) and with less developed countries. Here, we briefly review how international spillovers may affect the economic and social impact of national social policies. Section 3 illustrates by example their relevance to the current European situation and discusses how institutions and reform processes may best cope with the issue. Economic integration may reduce the need for social protection if local shocks are better buffered by more extensive market interactions. For example, workers face less income uncertainty if adverse labor demand shocks can be partly accommodated by migration rather than by lower wages and/or higher unemployment.30 More importantly, the development of financial markets can reduce the need to provide social insurance within each country’s borders at the same time as financial markets make it possible for domestic residents to diversify away local sources of risk. To the extent that markets remain incomplete and poverty is still possible within a larger integrated economic area, however, social policy meant to address insurance or solidarity issues is more difficult to implement effectively. The market failures that need to be mended by collective action and enforcement within a national economy cannot be addressed by uncoordinated policy actions by interacting economic

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systems. Each individual does not, by definition, participate voluntarily in the kind of transfer or regulation policies that are not supported by laissez-faire markets, but he or she would rather free ride on provision of social services and transfers. Similarly, local communities cannot be expected to voluntarily implement policies that reduce their competitiveness in economic interactions within a wider, possibly “global” economic system. To illustrate this general insight, it is again helpful to focus on the particularly clear interaction featured by potential or actual migration. Broadly speaking, labor mobility increases the effective elasticity of local labor supply. As mentioned above, when labor supply is elastic then labor taxes may not be shifted to take-home wages, and have important employment effects instead. The effect is stronger if, in an effort to reduce the employment impact of social policies, their financing relies on progressive instruments. Although the elasticity of labor supply may be higher at low-skill levels when nonemployment is the alternative to work, highly-skilled workers are also likely to be more mobile and take better advantage of tax-arbitrage opportunities. Thus, a local economy that imposes high taxes on its workers but leaves them free to migrate will find it difficult to generate employment, and raise revenues, if taxes are lower elsewhere. On the other hand, poor individuals are likely to be attracted by relatively generous welfare systems. There is some relevant evidence from the United States, where in 1969 the Supreme Court ruled that state-level welfare benefits could not be conditioned on previous residence, exposing states offering generous benefits to the danger of attracting welfare recipients.31 Immigrants need not draw benefits themselves to trigger important consequences; when they compete with low-skilled workers and the latter’s wages fall below the nonwork benefits, substitution of the indigenous poor by foreigners is effectively subsidized by the taxpayers of more generous constituencies. A classic example is given by the situation created in the German construction-worker market by economic integration with the rest of the EU in the early 1990s. The plentiful employment opportunities created by huge infrastructure investment in the former East Germany were taken up by British, Portuguese, and Italian construction workers temporarily posted to Germany, while indigenous workers remained unemployed. Quite simply, the generous and essentially open-ended unemployment benefits granted to German workers were higher than the reservation wage of other European workers (though, of course, not higher than the

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German workers’ own previous wages). Thus, the well-motivated Bismarckian institutions meant to protect construction workers from the highly cyclical character of their trade clashed with the essentially permanent character of their job loss in the newly integrated European economy. Like the oil shocks of the 1970s, such developments called for structural reform. In general, labor mobility cannot make it any easier to sustain high welfare safety nets; rather, it may well excite raceto-the-bottom tensions in provision of welfare benefits and resentment against new immigrants (see below how this tension was resolved in the case of German construction work; see also Bean et al. 1998 and their references). As a general principle, in an integrated economy a local constituency can easily end up providing welfare to strangers and, in equilibrium, will have to restrain welfare provision for its own citizens. While migration is subdued in EU countries, labor mobility is a keystone of economic and monetary unification in the EU. Hence, the discussion of current and potential EU policy configurations here takes personal mobility for granted. More generally, free trade of goods and services and free factor mobility (which have essentially the same implications in standard models where factor prices are equalized in equilibrium) make it impossible to design and implement social policies on a localconstituency basis. The tax and subsidy arrangements of each integrated economic unit compete with the others’ in maximizing their attractiveness for productive factors (and tax revenues), and minimizing their attractiveness for welfare recipients (and social transfers). To the extent that social policy is meant to redress market failures or to implement solidarity transfers, competition among systems will not lead to efficient outcomes when the elements of the relevant equations span the borders of policymaking constituencies. By definition, collective action is needed to eliminate inefficient or “unfair” economic interactions, and bringing back competition at the interconstituency level defeats both purposes (see Sinn 1998, for further discussion of the general “selection principle” that should allocate activities to collective decision rather than market interactions). Such issues in the context of the current EU institutional framework will be evaluated below. Globalization and trade with less-developed countries may not a major source of welfare state stress in advanced economies, where aging and family trends, sectoral shifts, and productivity developments play obvious and very important roles (Pierson 1999). International spillovers of social policy, however, are an obvious issue in the European

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context, because within the EU politico-economic resolution of reform pressures (whatever their source) unavoidably are influenced by international coordination of policy reactions across nations, or lack thereof. 3 Economic Integration and Political Dynamics in the EU Equipped with the section 1 review of EU welfare models and the section 2 broader discussion of theoretical and empirical issues, we now turn to analyze how national social policies may evolve in the future. Social policies are remarkably stable in each country, despite their more or less obvious shortcomings and remain very different across countries in spite of essentially complete economic integration. While current and future reform pressures certainly reflect important country-specific factors, we especially focus on how economic and political interactions within the integrated (but not federal) institutional structure of the EU may rationalize the current patchwork of European social policies. Section 3.1 reviews the official EU approach to social policy issues. Section 3.2 argues that, despite conspicuous lack of effective EU-level action in this field, EU institutions do affect the design and implementation of national policies in a variety of ways. Section 3.3 shows how lack of EU-level action may be rationalized by the wide heterogeneity of economic and social circumstances within the EU, and it illustrates the trade-offs entailed by different degrees of centralization in the current EU institutional setting. 3.1 EU-Level Social Policy: Great Principles and Little Practice The institutional framework of the European communities is keenly aware of social policy issues, and not surprisingly so, in light of the prominence of welfare state intervention in each of the constituent member states. Article 118 of the original Treaty of Rome tasked the European Commission (EC) with “promoting close cooperation between the Member States in the social field.” In practice, however, progress has been extremely slow in this respect despite many declarations of principle.32 The Commission did use its supranational power to dismantle trade, labor mobility, and industrial regulation barriers (Scharpf 1998a, b). The European Communities were formed by nations, however, and members had no intention of “committing institutional suicide” (Pierson and Leibfried 1995). Hence, introduction of coordinated market regulation was left to intergovernmental agreements at the

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European Council level, where decisions were to be made on a unanimity basis. (Article 148 of the Treaty of Rome stipulated that the Council of the European Union would act by a majority of its members, save as otherwise provided in the Treaty. The Luxembourg Agreement of 28–29 January 1966, however, made it official practice not to vote at all, but to continue deliberating until consensus is reached.) Only selected matters can be decided by a qualified majority.33 On social policy, the Single European Act of 1986 introduced qualified majority decisions in the field of “working environment, as regards the health and safety of workers” (Article 118A). Article 49, as amended, also allows directives to be issued by the Council by a qualified majority “to bring about, by progressive stages, freedom of movements of workers.” Article 49, paragraph 1 states that the Council now has to operate in cooperation with the European Parliament. The council adopts a common position by qualified majority on proposals from the commission, after obtaining the Opinion of the European Parliament (but unanimity is required to amend Commission proposals). The parliament can reject this common position within three months, and a second reading by the Council requires unanimity. The Parliament can also propose amendments which, after Commission review, result in a modified proposal to be reexamined by the Council. The Council can approve the commission’s proposal by qualified majority voting, or unanimously accept the parliament’s amendments in toto. The Single European Act of 1986 introduced qualified majority voting in the area of health and safety at work, which was singled out for ultimate harmonization through directives setting minimum requirements for gradual implementation. Together with gender equality in the labor market (a long-standing concern of European treaties), the health-andsafety regulation area is the only one where EU-level initiatives have had an impact on member countries’ social policies (see Bean et al. 1998, and Pierson 1998). In other social policy areas, the European Commission was invited to promote dialogue between management and labor at the European level as an additional lever for harmonization. The preexistent European Social Fund (articles 123–128) was the subject of some new provisions, like the Agriculture Guidance and Guarantee Fund, the European Investment Bank, and other existing financial instruments in the new Part III added to Title V with provisions on economic and social cohesion. The 1998 Amsterdam revision of the European Union Treaty (which is in force as of May 1999) incorporated in the full fifteen-country treaty

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the provisions of the Social Protocol signed in Maastricht by only eleven countries, and envisioned Community policies aimed at “a high level of employment and of social protection.” Article 117 states more precise objectives: the Community and the Member States will promote employment and “improved living and working conditions, so as to make possible their harmonisation [. . .], proper social protection, [. . .] and the combating of exclusion.” Importantly, Article 117 states that these objectives may not be fulfilled by the functioning of the Common Market alone, and it states the belief that appropriate developments will ensue from the treaty’s own provisions and “approximation of provisions laid down by law, regulation or administrative action.” Article 118 lays down areas where council directives are envisioned; at point three however, it specifies that such action requires unanimity when “social security and social protection of workers,” and most other social-policy dimensions, are concerned. Some further social-policy matters to be decided by qualified majority voting are identified in the treaty: working conditions, information and consultation of workers, equality between men and women in the labor market, and the integration of persons excluded from the labor market. Article 118b states the need for social dialogue: “The Commission shall endeavor to develop the dialogue between management and labor at the European level which could, if the two sides consider it desirable, lead to relations based on agreements.” And article 118c tasks the European Commission with encouraging cooperation and with monitoring of national social policies. As seen above, the side effects of social policy are particularly apparent in the labor market. Not surprisingly, the EU coordination process is focused on the need to spur employment creation. In November 1997 at an Extraordinary European Council on Employment in Luxembourg the member states agreed to coordinate and stimulate employmentoriented policies, even before ratification of the Amsterdam Treaty, around four Pillars: 1. Improving Employability (measures envisioned under this heading have an active labor market policy character, particularly targeted toward training of young and long-term unemployed persons). 2. Developing Entrepreneurship (chiefly through deregulation and simplification of market access and operations by small firms). 3. Encouraging adaptability of businesses and their employees (through union-negotiated work reorganization).

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4. Strengthening the policies for equal opportunities (mostly along gender lines—a long-standing concern of EU social policy intervention—but also as regards labor market participation of disabled individuals). The nature of these guidelines and the character of the “Luxembourg process” by which they are implemented are quite interesting. Taken at face value, the Luxembourg process’s employment guidelines are quite consistent with the perspective put forth here on the employment effects of social policy. The four Pillars spell out a fairly coherent approach to Europe’s employment problem, which is viewed as a structural problem—that is, one that should be tackled by reform efforts, as Europe’s old-fashioned welfare states encounter unavoidable difficulties in a new macroeconomic environment.34 The guidelines, however, communicate a clear unwillingness to sacrifice the social-protection features of the current EU welfare state. Not only does the first pillar largely conform to the “active” labor market policies of the Nordic and, to some extent, Anglo-Saxon tradition of social intervention—policies that try to reconcile the conflicting goals of generous social protection and high employment but encounter crippling fiscal constraints; the concept of “adaptability” is also quite different from the “flexibility” advocated, for example by the OECD Jobs Study to address the challenges posed to industrialized countries’ welfare states by a new environment of global economic interactions and fast, skill-biased technological developments. “Adaptability” is required of employers as well as employees and, rather than relying on market incentives, envisions intense consultation between workers’ and employers’ organizations. As to the actual implementation of theoretical guidelines, the Luxembourg process is essentially a forum for discussion and evaluation of country-level practices. Each Member State is required to submit annual Employment Action Plans, where its experience and policies are discussed within the framework proposed. In practice, the Plans make an effort to enlist the panoplies of nation-specific existing measures within the Luxembourg pillars, often without reference to their effectiveness (which, in most cases, has never been properly evaluated). Not surprisingly, and quite interestingly, the different national approaches to social and labor market problems are reflected in the various reports. In its introduction, for example, the 1998 United Kingdom Employment Action Plan mentions “labor market flexibility” and, defining and

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discussing the notion, stresses the need for wages to “adjust sensibly to economic realities.” This is certainly a guiding principle of U.K. labor market policy, as evidenced by the wide and increasing inequality of British wages. It is not, however, a principle that would be easy to trace in the Luxembourg guidelines, which would rather align reality (through training, for example) to workers’ wage aspirations. Country practices are then evaluated by the Commission’s Services, with an eye to identifying national practices that, by adhering more strictly to the specific goals identified by the four pillars, might provide examples for further reforms and adjustments (see European Commission 1999). Thus, the Luxembourg process essentially leaves employment-policy reforms in the hands of the member countries’ governments. Its modest aim of creating consensus on “best practice” marginal reforms gives at most limited incentives to increase the expenditure on active labor market policies, and it focuses attention on narrow performance criteria within the pillars’ framework rather than on broader evaluation of welfare-provision and labor market institutional systems within the EU. Lack of effective policy action at the EU level is common in all socialpolicy fields. The high consensus requirement of Council decisions has made it very difficult to introduce regulation on an EU-wide basis. The institutional asymmetry between “negative integration” (dismantling of national regulations, which proceeds at a supranational level) and “positive integration” (introduction of EU-wide regulations, which has to be negotiated at the international level) has shaped the development of EU social policy (see Scharpf 1998a, b; the negative versus positive integration terminology was first introduced by Tinbergen in 1965). In the European treaties, “general” social policies (such as tax rates or overall levels of social services) are largely left to nation-level, “subsidiary” decisions (indeed, only with the Amsterdam revision the possibility of some EU-level intervention in this field is of any practical relevance). “Specific” policies, that is, those that affect different productive sectors differently within each member state’s economy, are instead subject to scrutiny because their effects could in practice be the same as those of explicit trade barriers. The distinction between general and specific social policies is hard to make precise—after all, regulation and redistribution do in general have different implications across producers (see Bean et al. 1998, for a fuller discussion). In practice, however, the European Commission can challenge national welfare

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policies whenever they may be suspected of distorting competition. Recent examples are the EC ruling against the Italian policy of subsidizing new employment through “contratti di Formazione e Lavoro” (training employment contracts), which in the commission’s view benefit employers (rather than workers) when subsidies are granted in relatively strong regions or to relatively old workers. Similarly, the commission is reluctant to approve local tax incentives— even in less-developed regions within each country—when the actual or potential concentration of some sector’s production in privileged geographic units would effectively make it possible for the whole country, rather than only the region’s residents, to enjoy competitive advantages. Conversely, the complexity of international coordination and of the relevant decision processes paralyzes “positive” integration. In practice, the EU is reduced to envisioning social-policy convergence on the basis that all European countries share a common “social model faced by common challenges at each national level” rather than on the basis of explicit collective action. In light of the wide heterogeneity of economic circumstances and social-policy models documented in section 1 above, however, it is far from clear that the challenges are indeed “common,” or that solutions and reforms implemented at the national levels should lead to convergence. Article 117 recognizes that diversity of national practices must be taken into account. The process of convergence is complicated by the heterogeneity of welfare state models within the EU, which were documented in section 1. As mentioned in section 2.4, each of these models encounters different problems in the face of common national trends, and problems and possible solutions also differ in the face of increasing economic integration. In summary, social-policy problems (especially in their employment implications) feature quite prominently in the EU agenda. Yet, supranational policymaking is not well developed in this field. EU institutions offer, at most, a forum for discussion of social policy while leaving its implementation to national or regional governments, on a subsidiary principle basis, even as economic integration and supranational interference constrain its operation.35 Next, we examine in some detail the challenges posed by EU integration to various dimensions of the member countries’ welfare states, and we discuss how the structure of political decision processes may address the relevant issues.

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3.2 Challenges for Social Policy in an Integrated but Diverse EU Economy To flesh out our interpretation of the European situation, we bring themes from the previous sections to bear on specific examples drawn from EU experience. The national systems of welfare provision discussed in section 1 feature many interacting instruments, all of which rely essentially on legal restrictions; national legislation imposes taxes and contributions, identifies individual entitlements to transfers and social services, and regulates employment contracts and other market interactions. In section 2, we briefly discussed how economic integration, by increasing opportunities to opt out for individuals, generally makes it more difficult to specify and enforce binding legal restrictions. The first and most obvious challenge to national welfare systems in the EU is posed by such opting out opportunities. Free mobility of goods, capital, and labor in the single market undoubtedly makes it easier to circumvent some of the existing legal restrictions. Incentives to escape taxation are stronger at the high end of the income distribution, where the burden of social-policy funding is highest and benefits are lowest. Clearly, social policies could not be financed by a welldefined “national” tax base if firms and individuals were completely free to choose whether to pay taxes, or opt out of supposedly mandatory arrangements. As we mentioned in section 2, participation in social security schemes (unlike private insurance contracts) needs to be enforced. Tax competition among systems unavoidably tends to replicate the imperfect market interactions that at least some social policies are meant to correct, and this is an issue in the EU context as well as in the broader context of global economic interactions. In general, and in the EU, the same factors that are more heavily taxed by progressive schemes (capital and skilled labor) are also highly mobile, and their mobility can only decrease the tax base of social policies. Such tensions arise on the wider arena of global economic interactions as well as within Europe’s single market and may not yet be so strong as to put much pressure on national social policies. As seen in section 1, national social policies are remarkably stable in recent experience within each of the EU countries. The development of a new legal framework and new institutions at the European Community level, however, dilutes national law-making and enforcement powers, and this poses a second and EU-specific challenge to the existing system of

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welfare provision. While essentially all fiscal legislation is allocated to national authorities on a subsidiarity basis, the European Court of Justice is empowered to strike down national legal restrictions that discriminate among European citizens. Thus, not only the tax base but also the beneficiaries of social policies are not under complete control of national policymakers. Such interference, however motivated, can only reduce the national character of welfare systems. In particular, even if national tax rates were harmonized (through competition or coordination), potential access to each nation’s social services by any European citizen dilutes the identification of taxpayers and recipients. Contributions and benefits need not balance for all individuals ex ante and certainly do not balance ex post if social policy provides insurance within each national welfare system. The extent of ex ante and ex post redistribution, however, is part of the system’s design: the identity of taxpayers and recipients is a necessary element of any (national) social contract. By denying national policymakers the power to decide the extent of the redistribution’s scope, legal restrictions within the EU endanger all redistributive schemes. Furthermore, the introduction of EU-wide legal restrictions redefines the scope of existing national welfare systems. In spite of strongly voiced statements such as the one by Jacques Delors that opens this chapter, EU legal restrictions in the social-policy field have been minor, but other EU policies do have an impact on national welfare systems. For example, the EU-level “legal restrictions” underlying the Stability and Growth Pact and the monetary union itself are not directly concerned with social policies. As seen in section 1, fiscal consolidations needed to achieve the Maastricht convergence criteria were not achieved at the expense of social policies. To the extent that public deficits and inflation have distribution as well as macroeconomic implications, however, supranational constraints have undeniable indirect effects on national welfare systems and on their reforms. For example, a transition from a pay-as-you go to a fully funded system cannot avoid harming either current contributors or current recipients if governments cannot borrow.36 The Stability Pact’s parameters may be too stringent to make a smoother transition possible, and it may be advisable to relax them when deficits are explicitly linked to welfare state reforms. Similarly, fiscal discipline translates the tax-competition pressure noted above into immediate expenditure constraints and makes it impossible to dilute redistributive tensions to future generations. Fiscal discipline is welcome, if it can prevent the excessive “social” spending

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that is only too familiar from the past experience of many EU countries. Still, it does present a challenge to policymaking institutions. The other challenges are also familiar to European citizens and lawmakers. As the following examples make clear, similar tensions arise within each of their countries whenever social policies are shared among multitiered jurisdictions: Shopping for services. When local social services are subsidized with local taxes and citizens from outside cannot be discriminated against, there is an obvious tendency to shop for services. Consider, for example, the case of hospitals price policies in Germany (Pierson and Leibfried 1995). Investment costs, covered by the Länder and by the federal government of Germany, are not reflected in the price of services. Clearly, nearby Länder should be tempted to free ride on provision of health services for their citizens. Similar issues arise in higher education, which is funded at the Länder level within the Federal Republic of Germany, and is open to students from other Länder. In practice, only the poorest Länder underprovide such free-access services; presumably, richer local governments are relatively immune to free-riding temptations because their choices are to some extent inspired by pan-German solidarity. Free-riding, however, may become irresistible in times of fiscal tightening. More ominously, current EU law forces German hospitals to charge the same price to all EU citizens. In practice, this may make it necessary for German hospital construction costs to be covered by the price of services, thus effectively eliminating an instrument of public subsidization. The problem arises because the current definition of European citizenship applies to the citizen-consumer of services, but largely neglects the fact that citizens are also taxpayers. The lack of coincidence between the tax-paying and service-consuming sets of European citizens is further complicated by the European Court of Justice view that the health service fees (subsidized or not) should be covered by the citizen’s national plan regardless of where services are performed in the EU.37 The mobility of the unemployed. If mobility has to enhance efficiency this should be particularly true about the mobility of the unemployed, who should be encouraged to move from depressed regions to more productive ones. This is far from being the case within each European nation; in southern Italy, southern Spain, and East Germany extraordinarily high local unemployment is supported by a variety of explicit

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and implicit transfers, which effectively prevent mobility toward tighter regional labor markets and sustain high-wage equilibria in each country’s better developed regions. The strong antimobility bias of national regulators’ and social partners’ attitudes is compounded at the EU level where institutional arrangements are even less favorable to mobility. The duration of unemployment benefits is limited to a maximum of three months if an unemployed person moves away from the country where the job was lost (European Commission 1997). This is meant to prevent “vacationing” by the unemployed—a real danger, since German unemployment benefits could finance a very pleasant life in Ireland or in Portugal. As seen in section 1, however, national unemployment benefits typically last much longer than three months; hence, current arrangements discourage international mobility even more strongly than within-nation mobility. The level of social security contributions. Social security systems differ across EU countries (see, for example, European Commission 1997), but also within each of them. Individuals working in different professions and under different employment contracts are subject to different contributions, and they are entitled to benefits that differ not only from each other but also from standard actuarial accruals of their contributions. The extent of such heterogeneity may increase, if “marginal” labor market reforms introduce new, nonstandard forms of employment contracts. From our perspective, it is also important to note that the coexistence of different old-age pension schemes poses important challenges to the sustainability of national retirement systems. Until recently, for example, Italian workers could pay no pension contributions if their employment contract was configured as a collaborazione coordinata e continuativa, that is, as nominal self-employment, rather than as a regular dependent-labor contract. Similarly, in Germany many young workers escape social security coverage by drawing from each employer less than the minimum income above which contributions are mandatory. In many countries, the occupation-specific pension schemes of declining professions need to impose high contributions on active workers, and thus they accelerate their own demise as individual workers choose different professions to escape contribution burdens. Social policy interventions can hardly survive unless participation is mandatory and coverage is comprehensive. Hence, each European country addresses pension sustainability issues by eliminating the possibility of opting out (Italian collaborazione workers now pay

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contributions, if only at about a third of the standard rate) and/or by reducing contributions and benefits for covered workers. At the EU level, the interaction of complex social security arrangements multiplies opportunities to opt out. Existing arrangements attempt to ensure that individuals are not penalized by mobility across national boundaries. In the case of defined-benefit public pensions, workers’ entitlements accrue in proportion to the length of working careers in each of several countries (see Bean et al. 1998, for a discussion of the details of the scheme). Appropriate mobility incentives are easier to provide in the case of defined-contribution schemes, especially if fully funded, at least if similar returns accrue to pension wealth in each country’s scheme (as should but need not be the case since national constraints may be imposed on pension fund portfolios). Thus, the current tendency to reform pensions in the direction of actuarial fairness (i.e., to equate benefits to the market return of contributions) favors mobility across EU countries. Even if national systems were fully funded, legal restriction stipulating minimum contributions could hardly be binding if they are different across countries. Within the EU, workers are currently bound by the rules of the country where they work. Alternatively, workers could be bound by the rules of the country of origin (as is sometimes the case, on the basis of bilateral treaties, for non-EU immigrants, such as Turks working in Germany, who often make contributions to and mature benefits in the social security scheme of Turkey rather than Germany). As long as contributions are not voluntary (i.e., as long as it is about “policy” rather than about market arrangements), however, workers would move to constituencies where contributions are low, or employers would prefer workers bound to lower social security payments, in both cases initiating a race to the bottom and eroding the sustainability of high-contribution, highbenefit configurations. Unfortunately, the familiar character of these problems does not imply that we know how to deal with them. What is new in the EU context is the scope of interactions and, especially, the unclear standing of “solidarity” feelings that might support redistribution across the national boundaries of member countries. Any attempt to deal with the complex and difficult challenges posed by EU interactions to national welfare systems needs to take into account three classes of problems. First, it should be recognized that markets cannot provide adequate protection. Clearly, the issues here would be rather trivial if markets

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could provide adequate levels of insurance and services; social policy would just need to remove legal restrictions that prevent markets from functioning. In a way, this is the rationale of negative integration measures, that is, executive elimination of heterogeneous policies and unfair barriers to trade and labor mobility. But social policy does address market failures and implements transfers and redistribution that could never be achieved except through collective action. Second, it is necessary to commit to (and enforce) social policies. Individuals would always want to free ride on each other in the provision of welfare (or public goods) no matter how attractive socialpolicy arrangements might be from a collective point of view. Given enough commitment to the enforcement of a common set of legal restrictions, however, a homogeneous society should be able to design collectively an agreeable set of social policies and enforce them at whatever jurisdictional tier is most suitable to their implementation. The design and implementation of social policies is further complicated by heterogeneity of preferences for and consequences of social policies. Unfortunately, the EU is very heterogeneous, both in the social problems to be addressed, which in turn reflect different levels of economic development and different social and family structures, and in the solutions devised in the various countries, which feature a bewilderingly diverse array of policies and institutions. If the EU could be viewed as a “fractal society,” in the sense that the same social patterns (i.e., of employment, inequality, etc.) were present at all different levels, then agreement would clearly be possible. At the level of regions, nations, or EU, the problems to be addressed by collective intervention would be similar and so should the solutions. Not surprisingly, the current configuration of EU supranational institutions and national policymaking authorities deals with this challenging situation in rather complex and often less than satisfactory ways. The basic tension arises from the coexistence of generous but increasingly less sustainable national welfare systems with their own peculiarities on the one hand, and increasingly integrated economic interactions on the other. The difficulty of reconciling these broad trends, and the likely resolution of the current conundrum, are sometimes quite apparent. The resolution of the peculiar situation faced by the German construction industry in the aftermath of the Single Market’s implementation is a case in point. As mentioned, the generous unemployment scheme covering German construction workers was clearly incompat-

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ible with free labor mobility, since Portuguese, British, and Italian “posted workers” were willing to work at wages lower than German unemployment benefits. The issue was resolved by a mix of labor market deregulation and limits to economic integration. German unemployment benefits were reduced and, at the same time, a binding minimum wage was introduced for all construction work on German soil, effectively imposing a quota on German imports of construction services. After a long and politically complicated process, a Directive stated that, despite its obvious contrast with the EU’s Single Market ethos, such national legislation was allowed. This example illustrates the tension between labor market regulation and economic integration. Its outcome indicates that national deregulation is a natural response when increased market pressure makes national policies too expensive. Although the very limited extent and character of state and local social policies within the U.S. gives evidence of the practical relevance of such “welfare magnet” effects (see, for example, Bean et al. 1998 for a discussion and further references), neither globalization nor EU economic integration appear to put much pressure yet on European national welfare systems. The posted-worker example, however, does indicate how EU-level regulation may play a role in the broader European politico-economic arena. Similar tensions are apparent in other examples, such as Länder-level provision of health services in Germany. Unfortunately, if the tensions arising from European mobility are not properly addressed, mobility of contributors and beneficiaries of (national) social polices would unavoidably reduce social policy to a minimum common factor, all the more undesirably in the absence of an EU-wide safety net even remotely comparable to that provided by federal programs in the United States. Currently, EU-wide legal restrictions do not recognize this danger. In particular, it is common practice of the European Court of Justice (ECJ) to consider that “EU citizens—service consumers—are free to consume (social) services in any member state” (Leibfried and Pierson 1995).38 Given this, preservation of national or regional welfare systems may need to rely on more or less implicit limitations on mobility, for example, by emphasizing linguistic and ethnic barriers to mobility so as to delimit clearly, if along far from justifiable lines, the scope of solidarity. Such undesirable developments would not only hamper economic efficiency, much like the minimum-wage provision that alleviated pressures on the German construction workers’ unemployment insurance scheme, they would also effectively increase social exclusion

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in possibly much more effective and certainly less expensive ways than in the case of poor-region subsidization along Italian, German, or Spanish lines. How well is the EU institutional structure equipped to deal with the twin dangers of excessive race-to-the-bottom tensions and equally unwelcome limits to economic integration and social cohesion? To answer, one needs to recall that shared decision-making is a crucial feature of the current social-policy configuration in the EU. Despite the stated subsidiarity of social policies at the national level, both economic-integration constraints and explicit “negative integration” supranational powers of intervention have deprived national governments of full control of their welfare systems. Hence, we now discuss theoretical perspectives on suitable decision process in the EU framework. 3.3 Sharing Decisions on Social Policy The analysis of the decision process is a central element in understanding social policies and their possible reforms in Europe. On the one hand, it is no longer possible to think of national welfare systems as independent entities; national governments are far from free to decide autonomously their preferred welfare policies. On the other hand, no central EU government is now or even envisioned to be responsible for a European welfare system. Furthermore, the current decision process cannot be viewed as a stable arrangement, if only because the EU consolidated treaties themselves contain provisions for a transition to qualified majority voting on many issues in the next few years (European Commission 1998a). It is more appropriate to view the current configuration as a temporary stage in an evolutionary process that may hopefully converge toward a stable and rational arrangement sometime in the twenty-first century. Hence, we need to understand which institutional arrangements are more suitable for a positive evolution of social-policy provision in the EU. The discussion of the decision process starts by summarizing some traditional and more recent views on how policies should be decentralized. These views are then compared with the current EU institutional framework, with an eye to identifying its strengths and weaknesses. Traditional fiscal federalism theory (e.g., Oates 1972) assigns different public policies to different tiers of government following an efficiency principle for internalizing economic externalities. For example,

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public goods with large economies of scale (like military defense expenditure) or with important spillovers across jurisdictions (like those affecting labor mobility incentives) are assigned to the central government. Local public goods, conversely, are assigned to local governments to ensure that they are better tailored to local needs.39 Under these classical principles, many social welfare policies are more efficiently decided at the central level to appropriately internalize spillovers, and/or implemented centrally to pursue economies of scale. In particular, redistributional policies should be agreed to at the central level to avoid “welfare shopping” and race-to-the-bottom tensions. And, since risks are better pooled on a larger scale, it should be more efficient to implement social insurance policies at the EU level. By the same principles, some social services may be more efficiently provided at a subnational level. In summary, traditional fiscal federalism theory would call for a radical change from the current status quo of European national welfare systems. Policies now left to national governments may be more efficiently decided either at the EU level or, possibly, at more local levels, as is the case in the United States, where basic safety-net provisions are decided and financed at the federal level while other social services are provided at the state or lower levels. This view, however, is questionable. Recent estimates show that the economies-of-scale benefits of an EU-wide social insurance and tax system may be fairly small (see Fatas 1998).40 As to theoretical arguments based on policy spillovers, new theories of federalism emphasize that it may be naïve to model each tier of government as a benevolent social planner who efficiently implements the corresponding policy.41 When there are multiple tiers of government, voters delegate the choice and enforcement of policies to representatives, and the process by which representatives are selected and interact is an important component of the design and implementation policy. These aspects appear particularly relevant in the EU context, in light of three anomalies of its institutional framework. First, it assigns a predominant role to national representation and national institutions, according to the subsidiarity principle. Second, Member States feature very different institutions, in particular on the degree of within-country federalism. This makes it undesirable, if even possible, to prescribe EUwide norms as to how policies should be decided at lower-thannational levels. Third, the central EU authority does not reside with a president or with a parliament even though the European Parliament

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is gaining more prominence over time, at the expense of the agendasetting powers of the European Commission. Much of the executive power, however, is in the hands of the European Council, which is not under the control of the European Parliament. The members of the European Council are national ministers, hence, they are neither elected by the European citizens at large (as in presidential systems), nor by elected European representatives in the parliament (as in parliamentary systems). In this respect, the EU conforms to a model of cooperative federalism,42 such as Switzerland’s unique national democracy with a collegiate executive that does not depend on legislative confidence.43 3.3.1 The EU as Cooperative Federalism: Strengths and Weaknesses The EU institutional structure can be rationalized on the principle of cooperative federalism, “preferring the most decentralized structure of government capable of internalizing all externalities, subject to the constitutional constraint that all central government policies are agreed unanimously by the elected representatives from each of the lower-tier governments” (Inman and Rubinfeld 1997). Since some decisions can be taken by majority-rule, the EU can also be said to follow the principle of majority-rule federalism. On social policies, however, the Consolidated Treaties (European Commission 1998a, article 137) dictate that the European Council should act unanimously, that is, according to the principle of cooperative federalism. It follows that the EU design features the strengths and weaknesses of a cooperative federalist model with extensive policymaking authority across many government tiers. As the discussion proceeds on some of the problems that democracies face in deciding and implementing social policies, the focus stays on how a cooperative federalist structure may address or aggravate these problems, and on whether the current structure of policy delegation within the EU is appropriate from this perspective. The traditional federalist view would call for redistributional policy choices to be made at the central level, supposedly by policymakers elected through a federationwide democratic election. Redistribution, however, typically features both winners and losers. When the status of winners and losers is clearly associated with well-defined groups within a society, decisions based on a simple majority would violate the basic principle that constitutions must be self-enforcing (see Ordeshook 1991). This simple insight, and the substantial heterogene-

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ity among EU member countries, rationalize the unanimity principle applied to social-policy decisions at the EU level. Allowing EU social policies to be decided by majority rule within the European Council could easily force a “losing” country to transfer resources to “winning” countries and, to the extent that heterogeneity is both wide and persistent, to do so permanently. Thus, unanimity requirements do prevent central EU institutions from engaging in substantial socialpolicy action, but they also play an essential role in guaranteeing the stability of EU-level policy. The discussions of new EU budgets agreements in 1999 (Agenda 2000) are a good illustration of how net-contributor countries are unwilling to play the role of permanent losers. Rich countries showed their unwillingness to support the existing configuration of regional and agricultural policies, while some of the current net-recipient countries were unwilling to apply the same rules in the aftermath of EU accession by poor eastern countries. Centralized decision-making by some form of majority rule would lead to permanent winners and losers, threatening the stability of the EU. Under the current unanimity principle, this danger was avoided, but the discussion did not lead to decisive action on either reforms of current schemes, or on the exact timing of accession. This is a typical example of EU decision processes in the social-policy area. It would be futile to complain about its indecisiveness without realizing that lack of action does not result from unanimity rules per se, but rather from the underlying conflict of interest that rationalizes them. The Agenda 2000 discussions also offer a good illustration of another important feature of EU “cooperative-federalist” decision processes. European Council members do not represent EU-wide constituencies, but act as country advocates. The conservative Spanish representatives were in favor of regional redistribution because funds would flow to Spain; German social democrats rallied against EU-wide redistribution because Germany is a net contributor. The fact that, within each country, redistribution would favor relatively poor citizens was immaterial; representatives acted as advocates of their countries’ interests, regardless of their own ideology. In a cooperative federalist model, the central government is a committee of representatives. Although cooperative federalism reduces the risk of having permanent winners and losers, it may aggravate the tendency of elected representatives from each of the lower-tier governments to trade policies (or engage in log-rolling). Further, voters have

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incentives to behave strategically when electing their representatives to such committees, and “pork-barrel” distortions may be very strong when representatives act as advocates of local interests.44 “Log-rolling” distortions may be particularly important in the case of subsidy or regulation policies that are meant to affect a specific jurisdiction; through spill-over of their economic effects or through interjurisdictional transfers, however, they are not purely local policies. The traditional federalist view suggests that the choice of such policies should be centralized. A distorted decision process, however, may well eliminate the advantages of centralization. For example, policies aimed at guaranteeing minimum welfare standards can hardly avoid subsidizing relatively poor regions or countries; their representatives may convince richer countries’ representatives to support such subsidies by agreeing to support policies favored by the median voters in rich countries. Clearly, such log-rolling need not take into account the EU-wide repercussions of the overall policy package. As to “pork-barrel” distortions, it is only natural that voters choose extreme advocates as their delegates in cooperative federalist committees or councils—those who are better at “bringing home the bacon.” For example, voters may not particularly like subsidies when they are granted and financed in their own jurisdictions. Nevertheless, they may choose a representative who supports subsidies if the subsidy to local agriculture is financed by all jurisdictions.45 As a result, interactions among committee members may feature log-rolling of expensive policies, since elected representatives are nore inclined to spend than their constituents. Log-rolling and strategic delegation problems are not unique to cooperative federalism. They are present, for example, in the legislatures of presidential systems (see Ferejohn 1983). In other institutional frameworks, however, a balance of power between popular representation and locally based representation (for example, between the legislature of locally elected representatives and the president in the United States) tends to reduce the possible inefficiencies that these distortions can typically generate.46 In the context of the EU, such a balance of power does not exist; the European Council and European Parliament, elected through national political processes, are not likely to aggregate and represent the preferences of European citizens. With redistributional policies, a balance of power exists though unanimity requirements. Nevertheless, decision processes could only too easily lead to excessive intervention and

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spending on other policies. To prevent overspending and other decision-making inefficiencies, the scope of central policies can be credibly limited ex ante. Overspending is severely constrained in the EU by the commitment to maintain the EU budget (hence, a fortiori, the socially oriented expenditure funds in title V, part III of the EU treaties) below 1.27 percent of the EU GDP. Such a low level contrasts sharply with the size and scope of public expenditures at national and regional levels, and it certainly does not correspond to what might be an efficient distribution of public expenditures across government tiers from the traditional federalist view. The limited budget of the EU, however, is easy to rationalize in light of the weaknesses and strengths of its cooperative federalist model. On the one hand, an overall budget cap is advisable if a decision process prone to pork-barrel and other distortions would otherwise have free rein. On the other hand, precommitment to low levels of spending and policy activity is indeed credible, inasmuch as it is enforced by unanimity requirements and checks-and-balances throughout the complex codecision process of the European Parliament, the European Council, and the European Commission. Rather than constraining the overall budget, distortions may also be reduced when decision processes on different policies are isolated. This is well understood by economists on monetary policy: for example, a high degree of commitment is ensured by the European Central Bank’s high degree of independence. In effect, European Central Bank independence isolates a specific line item in the overall government budget and a specific issue within the wider scope of macroeconomic policies, and in doing so it aims at eliminating unwelcome spill-over influences between fiscal and monetary policies. The same principle applies to other policies and is particularly relevant for policies that redistribute resources across identifiable groups of “winners” and “losers.” If such policies must be discussed separately from others, any inclination of the winners’ representatives to overspend can be balanced by opposition by the losers’ representatives. Therefore, decision-process distortions may be minimized if social policies cannot be traded with other policies. 3.3.2 Advantages and Disadvantages of Centralization and Decentralization In summary, without a centrally elected executive, as in presidential or parliamentary systems, it is difficult to argue that all social policies can be democratically decided by majority vote within the European

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Council. Unanimity requirements are readily rationalized from this perspective. Their main weakness, is the difficulty of reaching decisions. In the context of European integration, this does not amount to freezing the status quo. Rather, it reinforces the dualism between negative and positive integration. While unanimity is not necessary to enhance market integration and allow tax competition across jurisdictions (negative integration), implementation of some social policies at the EU level (positive integration) is difficult because of unanimity requirements which, in turn, reflect the persistent heterogeneity of member countries. The structure of representation of citizens’ interests also matters in this context. In most democracies, forms of direct popular representation typically coexist with forms of indirect or local representation, by which citizens of a jurisdiction (or social group) are jointly represented by a delegate or institution. A characteristic feature of the EU is the predominance of national representation (rather than, for example, aggregation of voters’ interest around other, nonnational lines).47 We take this feature as given and do not explore issues of EU constitutional design. Here, it suffices to emphasize the implications that the current configuration of EU institutions is likely to have in deciding and implementing social policies. This form of representation has two main advantages. First, it makes it possible to identify clearly the preferences to be represented (and defended) by local advocates. Second, representatives of a well-defined local jurisdiction should be more responsive to their constituents and more accountable. Both of these features may allow a smooth evolution from a system of sovereign states and cultures toward a more integrated EU. Besides the strategic delegation problems discussed, however, a system of national representation also implies that decisions almost never correspond to one-citizen-one-vote principles. Typically, citizens from smaller jurisdictions tend to be overrepresented in central institutions and decisions.48 This asymmetry has not played an important role in social policies up to now. Poor and rich countries have their own share of small and large representatives. Social welfare models— with the exception of the Scandinavian model—are not associated with size. In the future, however, the size asymmetry problem may become more relevant. First, because EU enlargement is expected to bring in poor and relatively small countries. Second, because the difference between large regions and small countries is only historical, and if

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European regions gain predominance this asymmetry may become an issue.49 Advantages and disadvantages of different degrees of centralization are also apparent in the ability of different government tiers to commit. A problem with shared decision-making is that a particular decision may never be important enough in any particular government tier, even if it should be implemented from an overall point of view. For example, spending on minimum social protection or on family support measures may be crowded out by policies receiving stronger support at each decision level, despite its desirability from an ex ante point of view. In such cases (as in the case of monetary policy delegated to an accountable and independent central bank), the government tier or institution with the highest degree of commitment should be identified at an equally ex ante constitutional stage and receive a clear mandate to target a specific problem. Finally, social-policy decentralization is desirable to the extent that it allows local governments to adapt to local conditions, creating competition among jurisdictions and allowing people to “vote with their feet” (Tiebout 1956, Bewley 1981). Although policies designed through a centralized process are often uniform, decentralized decision-making allows for diversity. In the EU there is wide diversity in social and economic conditions at the local level, hence experimentation and adaptation of social policies is desirable. Coordination of social policies may address obvious spillovers across jurisdictions, but moves toward harmonisation tend to diminish experimentation. Unfortunately, the strengths and weaknesses of the EU’s cooperative federalism are very intimately related. The main strength, namely the responsiveness of decision-making to national peculiarities, is achieved at the expense of a lack of commitment at the supranational level, resulting in potential policy distortions. Next, a discussion of welfare policies takes these political economy aspects into consideration. 4 A framework for Welfare-Provision Coordination and Competition in Europe The discussion of desirable and undesirable social-policy effects has identified a variety of evaluation criteria, such as social protection, equity, efficiency (especially as regards labor market participation, labor mobility, and full economic integration), democratic

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representation, and accountability. It has also highlighted obvious and less obvious trade-offs along these dimensions, especially on the complex decision process in the cooperative-federalist configuration of the EU. Additionally, EU social-policy provision would be greatly enhanced if it could achieve the simplicity and stability envisioned by Madison’s quote at the head of this chapter. On the basis of this discussion, we can outline a framework for discussion of EU social-policy reform. The aim is not to discuss a detailed, ideal list of EU social policies but rather to identify a configuration of decision processes that may lead to coherent assignment of policy choices among the EU institutions. Here, the social policy instruments listed in section 1 are regrouped and consider in turn: 1. Transfers and services guaranteeing a minimum welfare level to citizens, configured as basic security benefits (entitlement to which is granted as a right of citizenship) and those among targeted benefits (aimed at providing assistance to those in proven need) that can be considered part of the basic safety net. 2. Contingent insurance provisions (pensions, unemployment and certain forms of health insurance). That is, most corporatist benefits (for which eligibility is based on previous employment, and which are paid in relation to previous income). 3. Other social services, namely most encompassing benefits (for which eligibility is determined by both citizenship and employment, and benefits are paid on a flat-rate and income-related basis) and those among targeted benefits that are not directly aimed at preventing extreme poverty. This classification of social policies and elements of social welfare provision systems is somewhat different from, though intimately related to, those we and our references found useful in discussing past historical experiences and current welfare state configurations. It recommends itself, however, for a constructive discussion of crucial politico-economic tensions in the EU. The complexity of the politicaleconomic interactions in the EU context—and the need, in the cooperative-federalist spirit, to reach unanimous agreement to prevent externalities—decreases as we move through the following three policy discussions.

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Transfers and services guaranteeing a minimum welfare level to citizens. This aspect of welfare systems easily generates interjurisdictional spillovers. When the relevant policy instruments are implemented and financed locally, poor people have incentives to move toward more generous jurisdictions, rich taxpayers have incentives to move out of them, and competition among jurisdictions is unavoidable. Labor mobility is limited in current EU experience. Capital is already quite mobile, however, and goods-market integration has much the same implication as factor mobility inasmuch as factor-price equalization holds. Most importantly, a central aim of EU policy is to facilitate mobility among European citizens. From this perspective, the danger of a race to the bottom cannot be disregarded; despite current immobility, policies must be configured as if Europeans were already completely mobile. The relevant issues need to be addressed explicitly, and the minimum social rights of European citizens must be defined and guaranteed by EU policies. Leaving the relevant choices to local jurisdictions can only result in either unacceptably low levels of welfare provision and social cohesion, or in more or less implicit limitations of economic integration as local constituencies try to defend their welfare systems. We are not the first to make the point that harmonization of minimum welfare standards is needed (see, for example, Bean et al. 1998 and their references), or that there are a variety of reasons to advocate an EU-wide minimum welfare floor (see Atkinson 1998). This discussion of political decision-making in the cooperativefederalism framework of a still heterogeneous EU suggests, however, that minimum EU-wide welfare levels should be defined as explicitly as possible. The diverse levels of economic development and welfare systems among current and prospective EU members have two implications in this context. First, the different income levels of EU countries and regions imply that some interjurisdictional redistribution is hardly avoidable. Hence, minimum-welfare transfers and services should be cofinanced by a specific budget line item at the EU level. In light of the limited amounts needed to prevent social exclusion within each national welfare system (see section 1), the size of the relevant budget line could be smaller than that of the Structural, Cohesion, or Common Agricultural Policy funds (which currently amount to some 60 billion euro and, as noted by Schmitter 1999, would more than suffice to lift all Europeans out of poverty). Unlike these programs, the EU minimum welfare program

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should be clearly targeted at easing European poverty with the least possible negative impact on employment. Second, to prevent welfare shopping from distorting mobility incentives and reducing the political feasibility of welfare provision, the minimum standard needs to be specified in absolute terms (rather than in relation to local incomes). It cannot, however, take the form of a uniform cash amount in all of Europe; “harmonization” efforts should be targeted to the effects of policy instruments not to the details of their implementation. Hence, cost-of-living differentials and the character of social-service provision should be taken into account by the definition of country- and region-specific minimum levels of welfare provision. The definition of such minima is essentially a technical problem, albeit a very difficult one. It would be necessary to account for cost-of-living differentials in large cities or in the countryside, even within each country, and to take a stand on whether individual or family welfare levels should be protected from falling below minimum standards. The definition and specification of minimum-welfare policies might be a suitable task for the European Commission’s technocratic structure, which should be tasked with monitoring local welfare programs to ensure that no European citizen, regardless of his or her residency, employment history, and nationality is allowed to fall through the cracks of an EU-wide safety net. This discussion of the labor-market impact of social policies suggests that guidelines should be specified and implementation should be monitored to encourage labor-market participation and labor mobility. It also makes clear, however, that the conflict between social protection and high employment objectives can in general be solved only by active measures whose costs can hardly be sustained by independent fiscal constituencies within an integrated economic area. Unconditional levels of support, such as negative income taxes or basic-income proposals, cannot avoid negative labor-supply effects if they are generous. Work-tested benefits, such as the U.S. Temporary Assistance for Needy Families (TANF), clearly reduce poverty at the same time as they increase work incentives.50 The employment side-effects of generous income-support policies, however, are in principle quite different within an integrated economy. Were nonemployment and access to social assistance the only alternative to labor market participation, a uniform minimum absolute welfare levels would likely have the most negative employment effects in relatively poor countries or regions. Minimum assistance levels should then be specified on a relative basis, as a proportion of local

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average earnings, and they would be much lower in Portugal than in Germany. Inasmuch as full labor mobility is an essential component of EU design, however, benefits should be specified to prevent absolute poverty at the EU-wide level to prevent welfare shopping. Benefits should be adjusted to reflect local price levels. Such PPP adjustment is a difficult exercise but, to the extent that prices of nontraded goods are lower in the same locations where labor productivity and wages are low, it would go some way toward reducing disincentive effects on local labor supply.51 These considerations may suggest that income support levels be specified as an average of local and EU-wide relative poverty levels (see Atkinson 1998, p. 29). From a labor-market perspective, the weight of local average incomes should reflect the extent of personal mobility across the boundaries of local labor markets (that need not correspond to those of nations or regions). It should tend to zero as labor mobility becomes perfect. In the interest of clarity and stability, however, it may be advisable to configure this and other policies as if desirably perfect labor mobility already characterized the EU. The location of the EU-wide poverty prevention programs along the fundamental trade-off between poverty prevention and employment is an essentially political decision. As argued by Atkinson (1998, sect. 3.1) a clear commitment to an official policy in this respect would have beneficial politico-economic implications within each country. Inasmuch as unhindered mobility is a basic building block of the EU, however, the issue must be discussed at the central level; to ensure that actual or potential problems are addressed clearly and to minimize political distortions, the relevant funds should be clearly isolated in the EU budget. Central cofinancing of social assistance programs would also provide means for enforcement of EU-wide guidelines. The minimum-welfare guidelines envisioned here, however carefully crafted from a technical viewpoint, could easily remain on paper (just like the current declarations of principle) if free-rider constituencies were allowed to circumvent them by lax means-testing procedures. As in the U.S. TANF program, the availability of central matching funds should be conditional on satisfactory implementation of minimum welfare provisions, and the enforcement power afforded by this financial lever should be exercised by central supervisory bodies. It is also essential in this context to reach agreement on the definition of EU citizenship, especially about entitlements of non-EU immigrants and refugees. In the spirit of social cohesion, all EU legal residents should be fully integrated in the minimal, centrally cofunded welfare program envisioned here. To address the obvious coordination problems that arise when

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EU-wide citizenship entitlements are granted by local constituencies,52 entry into the EU should be centrally regulated, as is envisioned (albeit after a long transition process) by the provisions added in Amsterdam under Title IV of the EU Consolidated Treaties (European Commission 1998a). Contingent insurance provision. Programs meant to cover workers against income losses due to old-age, disability, or unemployment are an important component of all welfare states. These corporatist programs, like programs that provide health insurance to citizens at large as well as to workers specifically, specify benefits contingent on verifiable conditions (such as health, age, or employment loss) and on past contributions (which, like benefits, depend in turn on employment histories and income levels). Hence, they differ from the minimumwelfare policies envisioned above because they are supposed to increase productivity and because they do not necessarily redistribute resources ex ante. In terms of section 2’s general framework, this class of social policy is meant to address market failures and, in principle, it could be fully financed by appropriately designed contributions. Thus, even in a very heterogeneous EU, no central-budget line item need be devoted to financing these policies. As made clear by our discussion of subsidized German hospital prices and of regional effects of unemployment insurance schemes, however, the quasi-market nature of such arrangements is very often intertwined with redistributive aspects. Efficient provision of collective insurance in the EU context must emphasize the link between contributions and benefits that is currently too often relaxed by solidaritybased or political redistribution of resources. Individual entitlement to benefits should be explicitly based on past and potential contributions, emphasizing the quasi-contractual character of these schemes and reinstating the link between citizen-taxpayers and citizen-beneficiaries that is essential to ensure the continued political legitimacy of this class of policies. One might address the German hospital problem, for example, by applying different prices to patients who are citizens of the constituency on which taxes are levied and those who are not. Just as patients’ expenses are typically covered only partially by private insurance companies, so could national health plans be configured as insurance contracts for the mobile European citizen. More generally, EU-wide arrangements in this field should be reformed in the direction of actuarial fairness. This is desirable even in

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country-specific contexts, inasmuch as each national welfare scheme is hardly sustainable when insurance contracts are inappropriately used as vehicles for unfettered redistribution. It is even more desirable in the EU context, where country-specific sustainability problems can have systemic effects in the case of pensions just as much as in the case of public debt, and where distributional tensions can distort location and mobility decisions within the integrated economy unless appropriately addressed in the context of policies discussed above. Actuarial fairness is necessary to prevent collective insurance programs from distorting individual decisions and efficiency properties are particularly desirable in the EU context. Atkinson (1998, p. 144) points out that social insurance need not be subject to downward pressure from fiscal competition when there is a clear link between contributions and benefits. And Orszag and Snower (1997) propose the introduction of European welfare accounts (for retirement, unemployment, education, and health purposes) with mandatory contributions and contingent withdrawals, but they allow for redistribution through income-contingent transfers into and out of welfare accounts. The political interactions entailed by redistribution, however, are quite complex within the diverse integrated economy of the EU, and are arguably better addressed by minimum welfare programs envisioned above or perhaps through the local arrangements discussed under other social policies below. A proper configuration of contingent insurance programs needs to be discussed at the EU level, though along different lines from those relevant to the minimum-welfare schemes discussed above. Participation in such schemes, must be mandatory whenever they are meant to address a real market imperfection. Agreement must be reached at the central EU level on minimum required contributions since—no matter how close to actuarial fairness the schemes are—some individuals would have incentives to opt out and generate race-to-the-bottom tensions unless the scope of mandatory programs spans the single market. Besides minimum contribution levels, broad EU guidelines should be specified for the character of nonmandatory programs to be made available by appropriately accountable authorities within each country, which—continuing current efforts in the old-age pension field—should ensure that individuals who move across national programs or participate in multiple programs are not penalized. Central interference, however, should not go beyond the specification of minimum contribution rates and regulation of the overall character of collective contingent-insurance schemes—more specifically,

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central cofinancing of expenditures is not desirable in this context. Rather, an appropriate definition of local financing should ensure that social benefits preserve economic incentives. The scheme should not be contingent on an individual’s nationality, nor on residency unless it bears on economic incentives. Unemployment insurance policies could be harmonized through minimum contribution rates, for example, but their financing should not be centralized; rather, their budgets should balance locally on a cyclical basis. This would avoid interjurisdictional redistribution through the scheme, leaving it to more appropriate policy instruments, and it would introduce appropriate mobility incentives for local governments, firms, and unemployed workers; persistently high unemployment would imply low average benefits, downward wage pressure, and out-migration. Clearly, such a scheme would be quite different from that currently in force within EU countries where regional subsidies ensure low-migration and high-wage configuration in all (rich and poor) regions. It is equally clear, however, that the current configuration of regional unemployment rates could not possibly be extrapolated to the whole EU without implementing politically unpalatable cross-national transfers. The definition of local budgets would not necessarily coincide with the current regional boundaries of EU nations, nor should it be allowed to conform to ethnic and linguistic divides. Rather, the boundaries of local economic interactions should be defined with reference to desirable interregional and interoccupational labor mobility. Other social policies: Services and labor-market institutions. A proper definition of local economic interactions also identifies a broad class of collective social policies whose effects are closely confined within local boundaries. For example, preferences and resources may justify heterogeneous provision of such social services as child, old-age, and health care.53 Regardless of how successful a specific set of policies might be in Scandinavian countries, there is little reason to expect it to work well in countries with less homogeneous populations and very different family structures. As in the case of local public goods outside the narrow scope of social policies, such collective nonmarket intervention should be completely deregulated, but also completely financed at the local level and allowed to be contingent on residenceto-date, to reap the advantages of decentralization and competition. Even with complete integration, local tax rates and local public services can very well be heterogeneous, as is the case within the United States.

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Local financing would allow individuals to “vote with their feet” and select the configuration of local social policies that best conforms to their preferences, resources, and comparative advantage.54 Local social policy intervention may best take the form of regulation of private provisions, blurring the boundaries of public and private economic interactions.55 As emphasized in section 1, labor-market institutions may pursue the same goals as other social policies without a direct impact on public budgets. The poor performance of most European labor markets demonstrates the need for reforms in this policy area. The heterogeneous character and pervasive nature of labor market institutions in EU member countries, however, suggests that their reform might best be pursued by allowing competition among systems rather than by central interference. The wide variety of status quo policies and reform proposals suggest that there is ample room for experimentation and adaptation to local conditions. Active labor market policies, for example, need not be equally advisable for all EU countries. Some features of each institutional setting will certainly be made obsolete by enhanced competitive pressure within the Single Market. Others, however, may survive and possible remain heterogeneous if their effects on efficiency and distribution grounds depend on industrial structure, on the structure of family interactions, or on other local specificities.56 On these local policies, the role of central EU institutions is limited, but far from irrelevant in two respects. First, to exploit fully the advantages of experimentation, central institutions should not specify uniform guidelines, but they should play a role in monitoring local policies and disseminating clear information on their experiences. Second, it may be advisable to specify minimum EU-wide tax rates on the income of mobile factors of production in each local constituency. Mobility is desirable, but it should not be driven by tax differentials. Otherwise, race-to-the-bottom tensions would make it necessary to fund local public expenditures with property taxes only (i.e., taxes on land, the immobile factor of production). Notes 1. For helpful comments we thank Tony Atkinson, Charlie Bean, Tito Boeri, Andrea Brandolini, Richard Breen, Gøsta Esping-Andersen, Alan Krueger, and Paolo Onofri. We are also grateful to Jessica Spataro and Roberta Marcaletti for editorial assistance.

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2. In the words of von Weizsacker et al. (1999), “the fact that most Europeans do not understand the working of our institutions is surely a problem governments should consider.” The need for constitutional clarity is well understood by legal scholars (see, for example, European University Institute 1999), but less often stressed about social policy reforms. 3. Esping-Andersen (1999) describes the social risks insured by “traditional” welfare states, and how they may be changing in recent experience (see our section 2). 4. Data come from the European System of Integrated Social Protection Statistics (ESSPROS), 1996 methodology (see Eurostat 1999). ESSPROS aims at collecting information that “encompasses all interventions from public or private bodies intended to relieve households and individuals of a defined set of risks or needs, provided that there is neither a reciprocal simultaneous nor an individual arrangement involved.” ESSPROS includes the financing and provision of benefits (cash transfers, benefits in kind) and the related administrative costs. 5. See OECD Social Expenditure Database, 1980–1996 and Adema et al. (1996). The corresponding figures for gross direct public social expenditure were, as a percentage of national GDP: Denmark, 37.6, Sweden, 36.4, Germany, 31.4, the Netherlands, 31.2, United Kingdom, 25.9, and the United States, 17.1; for net social protection expenditures: Germany, 27.9, Sweden, 25.6, Denmark 23.9, United Kingdom, 22.6, the Netherlands, 21.9, and United States, 18. 6. The broad functions in the ESSPROS classification are: Sickness/health care: Income maintenance and support in cash for physical or mental illness, excluding disability, intended to maintain, restore, or improve health irrespective of the origin of the ailment. • Disability: Income maintenance and support in cash or kind (except health care) for people with physical or mental disabilities who are unable to engage in economic and social activities. • Old age and survivors: Income maintenance and support in cash or kind (except health care) for old age or the death of a family member. • Family/children: Support in cash or kind (except health care) for the costs of pregnancy, childbirth and adoption, bringing up children, and caring for other family members. • Unemployment: Income maintenance and support in cash or kind for unemployment. • Housing: Help toward the cost of housing. • Social exclusion and others: Benefits in cash or kind (except health care) intended to combat social exclusion where they are not covered by one of the other functions. •

7. Eardley et al. (1996a and 1996b) provide a very detailed description of the characteristics of social assistance schemes in OECD countries. 8. A more detailed review of recent changes in the distribution of earnings in some EU countries, although based on country-specific data sets, is OECD (1999b), chapter 3. In future work, it will be extremely interesting to scrutinize more closely the ECHP data. A discussion of the limited evidence made available by early studies, however, such as Vogel’s (1997), does offer interesting insights. 9. Like other equivalence scales, this may or may not adequately capture the role of family composition in determining household welfare levels (see, for example, Atkinson 1998, p. 37). Once again, complete EU coverage on a comparable basis is the reason we

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choose to rely on Vogel’s (1997) estimates. We should note, however, that the appropriateness of this and any other equivalence scale depends on the structure of family costs, which in turn are not homogeneous across countries where, for example, the private costs of education and child health care vary substantially. 10. In France, “social security was never primarily conceived as a tool to fight poverty” (Jallade 1988, as quoted by Atkinson 1998, p. 120). 11. See Summers (1989) for a discussion of how collective welfare may be improved by regulation of private employment relationships, such as mandated health benefits and workplace safety rules. 12. For more information on the determination of pay in the public sectors of EU countries, see Elliott, Lucifora, and Meurs (1999). 13. The liberalization of temporary employment contracts increases the flow out of unemployment and job-to-job flows (see Boeri 1999, and García-Serrano and Jimeno 1999) but it also has negative effects on wages and productivity (see Bentolila and Dolado 1994, and Bertola and Ichino 1995). As shown by Boeri (1999), temporary workers compete with the unemployed for job vacancies and average unemployment duration may even increase as the proportion of temporary contracts increases. 14. Earmarked taxes have been recently introduced in Belgium, France, and Luxembourg. 15. See Esping-Andersen (1990, 1999). 16. ESSPROS data for Greece and Sweden are only available for 1993 onward. Lindbeck (1997a) provides an excellent description of the evolution of social polices in Sweden in the early 1990s, documenting a significant retrenchment in Swedish social policy. 17. For treatments of standard optimal-taxation problems, see Atkinson and Stiglitz (1980) or the original contributions of Mirrlees (1971) and Diamond and Mirrlees (1971). 18. See Rhodes and Meny (1998b) for further details and references. 19. See, for example, Esping-Andersen (1990), Pierson (1999), and references therein to the abundant political science literature on this subject. 20. The pre-tax and -transfer figures used in the chart are those computed by Kenworthy (1998). They are based on the LIS database “market income” variable, including cash receipts from all sources other than transfers or gifts, and they are adjusted for family size on a square-root equivalence scale basis. Unlike the figures reported in the table above, those plotted on the horizontal axis of the chart are relative poverty measures, that is, computed as the percentage of individuals falling below a country-specific percentile of adjusted per-capita income measures. This is a more appropriate measure of the extent to which social policy affects the country-specific indicators on the vertical axis. 21. The t-statistic of the (positive) coefficient of the levels regression is 0.93; that of the negative coefficient of the growth-rate regression is 2.2 in absolute value, slightly above the 5 percent one-sided critical value with 13 degrees of freedom. 22. “Decommodification” is defined in Esping-Andersen (1990) as the extent to which individuals can uphold a socially acceptable standard of living independent of market participation and is measured by taking into account rules governing access to pension,

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sickness, and unemployment benefits; the amount of income replacement afforded by such benefits; and the range of entitlements they encompass. 23. See Gruber and Wise (1997) for comprehensive evidence on the relationship between the generosity of pension arrangements and labor-market participation of older men. 24. This can of course be beneficial to some extent if workers do not have adequate incentives to search in laissez-faire equilibrium, as may be the case in matching models with two-sided heterogeneity (Marimon and Zilibotti, 1999). 25. For direct evidence on this issue see Lockwood and Manning (1993). 26. For analyses specifically dealing with Sweden see Calmfors (1993), Edin and Holmlund (1991), and Forslund and Krueger (1994). 27. See the OECD Jobs Study (1994a). Krugman (1994) neatly summarizes the conventional view on the unemployment-inequality trade-off. For empirical studies of the rise in inequality see Katz and Murphy (1992), Freeman and Katz (1995), Blau and Kahn (1996), Nickell and Bell (1995). 28. Nickell and Bell (1995). See Bertola and Rogerson (1997) and Marimon and Zilibotti (1999) for a discussion of how dynamic labor-market interactions may explain this finding in light of realistic institutional differences across countries. 29. Both unemployment and low-wage work, are associated with poverty and “social exclusion.” There is, however, very little relation between the increase of unemployment and that of poverty (Atkinson 1998, figure 2.4). This may indicate that the largest increases in unemployment occurred in countries where state and family transfers offer the most generous support to nonemployed individuals. 30. See Wildasin (1995). Owners of immobile region-specific factors, however, are likely to face more income uncertainty in an integrated economy. This may rationalize the positive empirical relationship between trade intensities and government expenditure (Rodrik, 1998) or the stringency of labor-market regulation (Agell 1999), inasmuch as either reflects insurance-oriented social policy configurations. 31. The “welfare magnet” effect may explain why U.S. social policies are mostly implemented at the federal level. Benefit-induced migration has modest relevance in the United States; see Meyer (1998). Borjas (1998) finds that the effects of welfare-system generosity differentials across states, however, are quire relevant for new immigrants from outside the United States. 32. See also the more extensive discussion in Bean et al. (1998), Betten et al. (1989), Ross (1995). 33. Currently, a “qualified” majority requires sixty-two votes: France, Italy, Germany, and the United Kingdom have ten votes each; Spain has eight; Belgium, Greece, the Netherlands, and Portugal have five votes; Austria and Sweden have four; Denmark, Finland, Ireland have three; and Luxembourg has two. See Widgrén and Kirman (1995) for a detailed discussion of voting rules and the implication of the national weights for the decision process. 34. This orthodox approach was challenged during Lafontaine’s brief tenure as Germany’s chief economic policymaker, when an effort was made to create a consensus for coordinated demand and wage management at the EU level. A document signed under the German presidency of the EU at the Cologne meeting of the Council on 3–4 June, 1999, preserves some of the flavor of this alternative approach but, as in the case

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of structural policies, does no more than state general principles and set up a forum for macroeconomic policy discussions among the EU’s social partners and policymakers. 35. The principle of subsidiarity is defined in article 3b of the Treaty of the European Union: “The Community shall take action . . . only if and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Community.” 36. See, for example, Huang et al. (1997). 37. Traditionally, previous approval by the patient’s health authorities was required for nonemergency health care, a provision used for example by Italian citizens to pay for surgical procedures performed in France (and, presumably, charged at marginal cost by the French hospitals). The right of European citizens to receive health care anywhere in the EU, however and charge the expense to their country’s social health plan is asserted by two recent sentences of the European Court of Justice on dental work done in Germany on Raymond Kohl and optician services performed on Nicolas Decker in Belgium (La Vanguardia, 27–5–99). 38. Social policies other than direct service provision may or may not be affected by similar mechanisms. In France and Germany, access to social assistance is conditional on the inability of obtaining support from ascendant and descendant relatives (Atkinson 1998, p. 105, and references therein). In the United Kingdom, there is no such “liability to maintain” and all EU nationals might in principle draw the (limited) social assistance benefits available to British citizens. 39. On standard fiscal externalities that arise in providing public goods to heterogeneous constituencies, and on possible solutions in a traditional federalist context, see Piketty (1996), Wellish and Wildasin (1996), other contributions to the same special issue, Persson and Tabellini (1999a), and references therein. 40. In several policy areas, the benefits of centralization are quite apparent and well recognized by public opinion. In the commission’s Eurobarometer survey results, over 65 percent of respondents think that “policy should be decided jointly within the European Community” in the areas of “cooperation with developing countries, scientific and technological research, foreign policy toward non-EU countries,” and “protection of the environment.” In social policy areas, conversely, agreement is in general below 50 percent (see Dalton and Eichenberg 1998). 41. See, for example, Qian and Weingast (1997) for a perspective of the new federalism view and Besley and Coate (1999) for an analysis of fiscal federalism prescriptions taking into account the political economy process. 42. See Inman and Rubinfeld (1997) for a comparison of different forms of federalism. 43. See, for example, Lijphart (1992) for a comparative study of parliamentary versus presidential systems. 44. The term “pork-barrel” politics comes from Colonial America. It was a custom for the store of a typical village to have a barrel of pork and shoppers were allowed to take as much pork as they could get with one hand. Therefore, families sent whoever had the largest hands to the store to “bring home the bacon.” 45. On this issue of strategic delegation see: Chari, Jones, and Marimon (1997), Besley and Coate (1999), and Brueckner (1999).

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46. Persson and Tabellini (1999b) provide evidence that presidential systems tend to have lower public expenditure. This may indicate the relevance of overspending distortions in parliamentary systems. 47. This feature may itself limit the central EU institutions’ power to decide. A majority of a committee elected by national constituencies, rather than by European citizens at large, should not be allowed to impose decisions on a minority that has not lost an election on the basis of ex ante democratic rules. 48. Such asymmetries may accentuate strategic delegation problems. See, for example, Brueckner (1999). 49. As a matter of fact, regions with institutional representation are starting to develop their own initiatives independently of the Committee of the Regions, which also includes cities and does not have a well-defined democratic status of their members. 50. Adults receiving TANF funds must “engage in work” within two years. Inman and Rubinfeld (1997) discuss the Welfare Reform Act of 1996 and the introduction of TANF as an example of cooperative federalism in the current U.S. system. With the Welfare Reform Act, the United States moved from a central policy of matching grants to states for different conditional minimum welfare policies (families, job training, and homeless children) to a decentralized policy (with a single central block grant: TANF). 51. While gross average wages per employee are over 70 percent lower in Portugal than in Germany when expressed in a common currency (OECD, Main Economic Indicators on CD-ROM), the per capita GDP of Portugal is less than 40 percent lower than its German counterpart on the PPP-adjusted basis of the data used in section 1. 52. See, for example, Wellish and Wildasin (1996). 53. We have chosen not to discuss education policy. Like many other policies that could be dubbed “social,” education and possible fertility-oriented interventions may well have effects that trespass “local” boundaries; see Esping-Andersen’s discussion in this book. 54. Accommodating heterogeneity may require decentralization to very low levels of government, which may in turn reintroduce interjurisdictional externalities. See Bewley (1981) for a formal critique to Tiebout’s argument along these lines. 55. See, for example, Buti (1998) and his references. 56. Krueger (1999) notes that institutional features (such as mandated benefits) are often very different across the labor markets of U.S. states, and he argues that the character and stringency of labor-market regulation may similarly remain very heterogeneous within a completely integrated EU.

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Comments Charles Bean

It is helpful to begin by recalling the objectives of social policy. First, they can address economic inefficiencies. This study makes much of the role of social policies in filling the gap that results from incomplete insurance markets, particularly against unemployment. However, such policies can also be seen as addressing capital market failures that prevent individuals from effectively self-insuring against adverse events (such as job loss) by borrowing against future income. Equally important, social policies can be directed at dealing with externalities, especially the positive externalities associated with human capital. Thus expenditure on education is one of the most potent tools of social policy, although it gets barely a mention here. This appears to be a rather notable omission. Second, social policy can be directed at achieving distributional ends. Within this broad objective the report identifies three aims: the relief of poverty; the reduction of income inequality; and improving the returns to work. Of these three aims, the first and second appear to me to be distinguished by differences in degree rather than kind, while the third surely represents a means to an end—namely reduced poverty or inequality—rather than an end in itself. The pursuit of these two objectives—improving efficiency and achieving a better distribution of welfare—need not always conflict, although in practice they often will. One can foresee an efficiency-equity frontier, but given the way social policies are formulated and implemented, it is more likely that policy lies within the frontier and improvements in both equity and efficiency are possible. This is a policy design issue on which economists have much to contribute. Once one gets onto that efficiency-equity frontier, however, and must decide how to balance one against the other, one leaves the realm of economics and moves into that of social philosophy and political science.

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Turning to the substance of the report, after a useful presentation of key facts about social protection in different countries, four welfare state models are identified: (1) Anglo-Saxon/liberal/Beveridigean; (2) continental/conservative/Bismarkian; (3) Nordic/Social-Democrat; (4) and Mediterranean/southern. To some extent the differences among these models are of degree rather than kind. Nevertheless, classification in this way is still useful as it reflects important philosophical differences on the relationship between the citizen and the state. I wonder whether the Mediterranean group, however, identified on the basis of high inequality and low levels of social protection, is distinct. The data here are likely to be especially misleading as the countries in this group have a large rural sector, and typically those identified as being poor there work in that sector. But rural incomes are liable to be understated because of significant levels of unrecorded economic activity, such as living off one’s own produce. Furthermore, the cost of living is usually lower in rural than urban areas, but these price differences are not allowed for in constructing the income and inequality measures. The result in both cases is thus to overstate inequality. To the extent that there is a characteristic Mediterranean model, it surely hinges around the key role of the extended family rather than the state as a supplier of social insurance. The research then goes on to consider the relationship between the welfare state and economic performance, giving a very fair and complete discussion of the efficiency effects, both good and bad, of unemployment insurance, although the authors are lenient on universal rather than means-tested benefits, as the former require higher taxes to finance them. The main lacuna here, though, is not considering the effects of social policies on markets other than the labor market. The most obvious omission here is the effect of unfunded pension schemes on national savings and investment rates as well as the effects of education policies on human capital formation and innovation. The research finds that social policy does not end up increasing inequality through general equilibrium interactions, but it goes on to take a rather sanguine view of its impact on economic performance. This analysis is based on some simple scatter plots and simple univariate regressions. It is known that the results of growth regressions tend to be sensitive to what other controls are included, and omitted variable biases are likely to be a serious problem. Furthermore, even a small effect of social policies on growth would cumulate up to a large effect on income levels over a number of years. Finally, and most

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importantly from a methodological perspective, there is no good reason for believing that all these countries have located on the efficiency-equity frontier. To the extent that some countries are operating inside this frontier, the nature of any efficiency-equity trade-off will be clouded, while improvements in policy design in those countries inside the frontier could indeed achieve an improvement in economic performance without any deterioration in social protection (or vice versa). The research takes the view that Europe’s welfare states were suitable enough for the pre–1973 golden age of robust growth and modest cyclical fluctuations, but that they have proven less well designed for coping with the post–1973 world of slower growth, oil price shocks, globalization and skill-biased technical change. Consequently some degree of liberalization is called for. This is a conclusion I agree with, although one must note that it runs against the Maddisonian dictate that such regimes should exhibit constancy; some believe that we are about to embark on a new period of golden-age style growth and perhaps continental-style welfare states will become sustainable again. But, in the absence of such a deus ex machina, what are likely to be the special challenges for European social policies in the future? On the one hand, economic integration both in Europe and the world economy is likely to lead to increased restructuring, thus raising the demand for social protection. On the other hand, increased mobility of capital and skilled labor is likely to produce race-to-the-bottom pressures to reduce taxes and social protection, leading to a fall in the supply of protection. Preventing such a process is likely to require a greater degree of coordination in EU social policies than is presently the case. Overall it appears that discussion and disputes about social policies are likely to become more common in the future. The way that these conflicting forces will work themselves out is hard to predict. The research argues that the political structure of the EU favors negative integration rather than positive integration in social policies and thus will result in movements in the direction of liberalization. I regard this as generally being preferable to the alternative, but I am not as confident as the authors that this is what will happen. The research concludes with three key policy recommendations. The first is for an EU-wide basic safety net income with regional and/or national variation. This would require internation fiscal flows, but these flows would be capped by identifying them as a specific line item in the EU accounts. The authors suggest that the size of this item would

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be on the order of the Cohesion Funds or the Common Agricultural Policy. But how do we know this would be large enough, and what basic income levels in each country would such a fund imply? A few illustrative numbers would be helpful here. Furthermore the (economically reasonable) requirement that the safety net income varies geographically conflicts with the Maddisonian objective of simplicity and potentially opens the door to all sorts of lobbying and log-rolling activities. The key here appears to be the extent of EU solidarity. So long as urban consumers in Berlin or Copenhagen feel little in common with the rural unemployed of the Italian mezzogiorno, I find it difficult to believe that such interregional fiscal flows will ever be allowed to amount to much. The second recommendation is that contingent benefits be made more nearly actuarially fair, with coordination on parameters such as contribution rates. But a key issue is exactly which parameters are set. The research discusses fixing contribution rates so that benefits automatically fall when unemployment rise, providing an automatic corrective feedback mechanism. Efficient risk shifting, however, requires that contribution rates rise and that future generations bear some of the burden of adverse shocks through increased borrowing; the fund should not be required to balance continuously. One also needs to recognize that such arrangements compensate individuals for temporary shocks but not for permanent ones and will thus tend to leave individuals vulnerable to a possible lifetime of bad luck. The third and final recommendation is that subsidiarity should be the guiding principle in social services and encompassing benefits. This appears to be sensible on normative grounds to cater to differences in national tastes as well as a positive prediction as to what is likely to happen. In summary, let me commend the authors for providing a fascinating and thought-provoking contribution to the debate about the future of EU welfare states. It is sure to provide an essential benchmark for future work in the area.

Comments Gøsta Esping-Andersen

European harmonization of social welfare policy is the kind of issue that usually makes one’s eyes glaze over. There is little of interest to say because little of substance exists or can, conceivably, evolve. The EU’s principle of subsidiarity bears testimony to the historical impermeability of Europe’s diverse welfare states, notwithstanding decades of successively stronger economic integration. By refusing to allow majority voting on social questions, and by freezing the EU’s social budget to less than 2 percent of European GDP, the member nations are evidently not enthusiastic about surrending their welfare states. To a political scientist or sociologist this makes sense from the voter’s point of view: Scandinavian women might fear that harmonization implies a return to housewifery; German workers, that it might imply British-level entitlements. Social policy is about minimizing risks and it is to be expected that each nation’s voters will fear a convergence that is, on one or another policy, inferior to what they now enjoy. Europe, as this study (from now on, Bertola et al.) makes clear, combines a plethora of welfare state models, each one amazingly resistant even to massive external shocks. Since this is well known, Bertola et al. would have to provide something more to maintain our interest. In fact, they do. Their research should be applauded for its thorough description of a heterogeneous social policy status quo. Indeed, here is a course book on comparative social protection systems, vastly enhanced by its interdisciplinar approach, bringing together research in economics, sociology, and political science. As the study moves from description to diagnosis, analysis and, then, treatment of the ills of existing national welfare systems, Bertola et al. narrow the perspective substantially by concentrating on the labor market-social policy nexus. The consequence is that key issues

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arguably are left on the roadside. Any system of social protection combines inputs from the state (which they describe well), the market (also), and the family (largely ignored), and it is how these three are combined that defines a nation’s welfare model. “Failure” in one, let alone two, of these components will obviously overload the third. The authors, as economists, see the current problems of Europe’s welfare systems as largely related to the inevitable tensions that emerge when work, mobility, or savings incentives are modified—and perhaps perverted—in the just cause of overcoming market failures. I would qualify this view by asserting that European welfare states are in trouble because labor markets and families work badly. Even the softest sociologist would agree that the contemporary welfare state nourishes a collectively suboptimal incentive structure, ranging from excessive early retirement to poverty traps among single mothers. Ideological differences have diminished as, now, virtually all left, center, and right governments embrace the traditional Scandinavian social democratic ideals of “productivist” social policy, of “workfriendly,” “social investment-driven,” and life-long learning based strategies. So far, so good. But Bertola et al. are, like many proponents of the work-friendly line, too blind to the household’s role in the equation. Some welfare systems especially in southern Europe, are exceedingly “familialistic”—the original, Catholic, meaning of subsidiarity, namely delegating the chief welfare responsibilities to families themselves. Take a key issue in the Bertola et al. account—unemployment and welfare. The lion’s share of European unemployment (with few exceptions) is shouldered by youth. In northern Europe, they live independently (poor in Britain, adequately in Scandinavia), in the south they are absorbed in the parental family (Bison and Esping-Andersen, forthcoming). A naked market-state analysis would never understand why unemployed Italian youth insist on a reservation wage that is equal to a full-time job in the postal service when, in fact, they have absolutely no social entitlements. Their reservation wage is pegged to the implicit tax of leaving home (and to the expectation of one day landing a secure postal job). Or take the main issue that preoccupies all European governments today: how to sustain welfare commitments with population aging (an issue that, oddly, receives scant attention in the Bertola et al. study). Escaping from the low-fertility equilibrium in which most of Europe finds itself would help in the long haul and this, arguably, derives from the dilemmas within families between children or

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women’s employment. The main consensus is that sustainability can best be assured by raising participation rates (Thompson 1998; OECD 1998a). For most European nations, this means raising retirement age and female participation, hence, we are once again back to the family. If what is needed is maximum participation, marginal incentive effects of unemployment benefits and the like pale in comparison to two policies: actuarially encouraging delayed retirement and providing services to families so that they can increase labor supply. If our goal is a work-friendly welfare state, our attention ought to be much more focused on the welfare state—family nexus. According to Bertola et al. the welfare status quo performs poorly, first, because of the familiar effects of the new macroeconomic environment, slower productivity growth, shifts in skill demand (and associated rising inequalities), and demographics. Second, as one would expect from a group of economists, current social protection systems potentially nurture problematic supply and mobility incentives. To put it crudely, workers from poor countries will be induced to opt into more generous welfare systems, while the rich will be induced to move their assets to cheaper tax regimes. Hence, the Portuguese worker will be attracted by the welfare largesse of, say, Denmark or Germany; the Danish or German surgeon or company executive will opt for low taxation in Spain. In the case of capital, labor intensive firms preoccupied with marginal labor costs will be driven toward Portugal or Ireland. Were such welfare shopping to prevail on a substantially larger scale than is now the case, we would clearly confront problematic welfare disequilibria: severe social tensions and fractures in the solidarity that has so far upheld the generous welfare states, combined with a potential race toward the bottom as nations struggle to keep or attract jobs and valued human capital. To counter this double mobility and incentives jeopardy, Bertola et al. advocate a recast three-tier welfare system for Europe. To combat “social exclusion” (which here basically implies poverty) while minimizing distortionary incentives, they envisage a European-wide social minimum based on needs criteria—the first tier. Reflecting the heterogeneity of Europe’s national welfare systems, the second tier would, in the spirit of subsidiarity politics, be a continuation of existing employment based insurance, although preferably better harmonized and more actuarial. Their third tier, the provision of social services, would be financed nationally but also be more deregulated and subject to European-wide competition. Following my earlier comments,

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providing services and resources to families may be more important than standard income maintenance, and it is therefore frustrating that this issue receives little attention here. The Political Problem For the medium term, we can all agree with Bertola et al. that the political preconditions for a more ambitious EU welfare project are sorely lacking. The coordinated federalist model that they envisage will, almost by definition, lead to little more than a minimalist level of “positive integration.” Current constitutional practice allows for too many, and too powerful, veto points and these will inevitably be mobilized to safeguard national interests. The question is whether the power of the veto will wither or whether blocked decision-making will, conceivably, be circumvented. I can think of two tendencies that may favor the latter scenario. The first and most simple, yet least persuasive, has to do with the envisaged strengthening of the EU parliament. The second has to do with governments’ difficulty in implementing badly needed reforms. As is well-known, the existing welfare edifice enjoys overwhelming popular support, especially on pensions and health. Since EU societies are aging, so is the median voter with his or her preferences. The pension-bias solidifies evermore. If the median voter insists on maintaining generous pensions, ruinous early retirement schemes, and so forth, no politician is likely to call for meaningful rollbacks, more actuarialism, or tighter eligibility rules even if the system is de facto unsustainable. But, as Bertola et al. clearly put it, many contemporary welfare systems are basically unsustainable, and what better political solution than shift the responsibility for unpopular policies to the EU level? That was exactly the belt-tightening formula used to qualify for monetary union membership across Europe. The ability to reform pensions or labor markets is vastly enhanced when they can be negotiated through encompassing interest intermediation and social pacts. The 1990s have witnessed a major resurgence of national social pacts and neocorporatist bargaining. Yet, after monetary union, neocorporatism in one country will be decreasingly viable as business cycles become more synchronized and macroeconomic policy options diminish. This alone, all else being equal, should give a strong push toward pan-European neocorporatism. Consider the following scenario: one nation (say, the Netherlands) manages to main-

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tain egalitarianism and eradicate unemployment via durable social pacts. The strategy is successful because most of its competitors do not follow suit. Now, if one country after another does begin to successfully emulate the Dutch miracle, and many are indeed doing so today, the Dutch will lose much of their competitive edge. Is there a likely convergence of social pact strategies across Europe under way? This will depend on individual nations’ ability to reform their industrial relations system. Is this happening? As of yet, only sporadically. Some nations, notably France and Spain, have poorly developed social partnership structures. Yet, the incentive to strengthen these is there, as witnessed in Italy since the early 1990s but also in France and Spain where the government is taking the lead in persuading unions and employers to engage in social pacts. The incentive is clear since governments need acquiescence to undertake radical and necessary, yet unpopular, reform measures. Also unions and employers should have strong incentives considering the ability of each actor to veto reforms and the diminished efficacy of alternative policy instruments. In brief, a shift toward positive integration policy at the EU level has some chance of emerging because many nations need to recast their welfare edifices and labor markets in the face of entrenched interests. The Goals of Social Policy Unlike many economists, Bertola et al. recognize that the welfare state is, and must be, much more than a stop-gap solution to abject market failure. It is also a means to cement broad social solidarities, to build nationhood, to eradicate social cleavages, and to pursue equality. Their definition of the goals of welfare policy remains, nonetheless, somewhat narrow: combating social exclusion, reducing overall inequality, and increasing rewards from labor market participation. This view of social policy is, paradoxically, both too general and too narrow at the same time. It is too general in the sense that social exclusion and inequality remain vague and undefined; hence we can interpret the goals as we wish. It is too narrow in a double sense. First Bertola et al.’s treatment of social exclusion is, rather oddly, equated with the clienteles of social assistance programs, whereas most people would probably entertain a broader notion, for example including the long-term unemployed or workers trapped in precarious employment. To design good policy it is important to be more clear about what precisely are the risks and potential clienteles involved. Second, their view is narrow

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because it rather conventionally echoes the ways in which social policymakers defined the issues way back in the Golden Age of welfare state construction. In my view, a very strong argument can be made that, in today’s society, the configuration of risks has changed dramatically and, with it, the kinds of interventions that are required. Commitments to minimize poverty or reduce inequalities are perennials, but the meaning of these phenomena changes. To illustrate, let us make a stylized comparison of the 1960s and today. In the 1960s, the most effective antidote to poverty was a solid job for the male breadwinner. Today, this is not enough; in part because the conventional family is now minoritarian; in part because, today, the only genuinely effective bulwark against poverty is the double-income family or, minimally, an employed single parent. Poverty and exclusion today has to do with households’ access to a much broader array of resources, including services above all. Day care services are probably a vastly more effective instrument against child poverty than is income maintenance. And here, once again, we are back to Bertola et al.’s blind eye on the family. Why worry so much about the potential negative incentive effects of assistance programs when, in reality, their relevance will decline dramatically with a guarantee of affordable child care? Bertola et al. are certainly justified in emphasizing that markets are imperfect, and that social exclusion and too much inequality are a threat to social stability, but that the remedy (social welfare) will influence incentives to work and save. Leaving aside the massive literature and its mixed evidence on observable labor-supply distortions, the real issue is whether the risks-incentives nexus captures the real gist of what the welfare state is, or ought to be, about. First, incentives are a Janus-headed animal. It is not always clear who gains and loses when we induce people not to work. If we put a high value on children, the collective well-being might be better off inducing parents to take parental leave. If generational skill-differentials are huge and technological change is rapid, we might all benefit from inducing older workers to take early retirement (Sala-i-Martin 1992). The bottom line here, is a question of public choice, of how to value alternatives. Incentives that matter form part of individuals’ and families’ life cycle calculus. Take the controversial study by Rosen (1996) on Swedish women’s absenteeism and the cost of day care. In his view, the collective cost far outweighs the gain since women with small children are essentially negatively productive. In a snapshot view, surely yes; in a dynamic calculus, probably not. We know from life-cycle earn-

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ings models that full withdrawal from the labor market reduces lifetime earnings (and thus tax revenue) dramatically. Public finances actually gain in the long haul by subsidizing Swedish mothers to have high absenteeism and their children in subsidized day care. No analysis of European social policy is adequate unless examined as potentially both enabling and creating negative incentives. This brings me back to Bertola et al.’s problematic definition of socialpolicy goals. With the exception of active labor-market policies, they simply do not consider social policy as “activating,” as “enabling,” as productivity-enhancing, as a means of redistributing resources. The interesting thing about European diversity is that some welfare systems are more enabling than others, while others are so more inclined to encourage passivity. There is a long and strong tradition of viewing social protection as a question of resources (as the Scandinavians put it) and capacities (as Amartya Sen puts it), one that enables people to be productive and adaptive as well as “solidaristic” and cooperative. Small open economies embraced generous social entitlements back in the 1950s to assure that workers would cooperate in rapid industrial adaptation even if it meant a risk of layoffs. The Nordic countries promoted generous leave arrangements, day care, and services to the aged not merely to placate the women’s movement or generate gender equality but also to maximize employment and fertility. Unless we have a measuring rod that is more dynamic than that used by Rosen, it is difficult to conclude whether paid absence, or other supplyreducing behavior, is negative or positive. The goals of social policy cannot be static, frozen in history. They must be assessed by how the risk and needs structure is changing. When European welfare states were erected, the dominant risks were poverty in old age and income needs among large families; most unskilled workers could count on a steady well-paid job that covered even the costs of a full-time housewife. Today’s risk and needsstructure is powerfully driven by family instability, by the exigencies of two-earner households, by high risks of prolonged unemployment, and by the collapse in demand for low-skilled and untrainable workers. What unites most of these trends is that the relevant social policy has less to do with income maintenance than with guaranteeing resources and providing services. To give a handful examples: Swedish single mothers do well not because of luxurious social transfers but because they work; child poverty rates are two to three times lower in dual-earner households than in conventional single-earner families

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(Esping-Andersen 1999, table 8.4).1 The probability of escaping from social exclusion (meaning here long-term unemployment) jumps by 30 percentage points with some vocational training, and by 50 points with some theoretical training (Bjorn 1995). It is my firm conviction that the incentives debate must be systematically connected to resources and capacities. Mobility Incentives and Social Policy Bertola et al. are preoccupied with incentives for people or firms to opt out of expensive welfare systems, and shop around for the cheapest deal. Surely, we all know that Swedish millionaires move to Monte Carlo; that the top decile households, buy into private pension and health schemes. There may even be some occasional across-border opportunism, such as free-riding on superior health care systems. Nonetheless, why would most people have an incentive to opt out? They usually do not. For one, cheaper tax regimes go together with lower social benefits, inferior health care and services. This means that more needs to be purchase of in the market. And, as Bertola et al.’s graphs (figures 1.1a and 1.1b) demonstrate, welfare spending and GDP per capita correlate strongly. This implies that less taxes mean less GDP per capita. It would make little sense for individuals to change country to avoid taxation if this also implies lower real income. One of the most important assets that a surgeon or an unskilled worker commands is his social networks; his private social capital. The reason why European labor is immobile, regardless of incentive margins, surely has something to do with this. Export industries, on the other hand, might be lured to cheaper tax regimes, especially if their principal incentive is to dodge high wage costs. But cheap tax regimes probably provide a less educated and qualified labor force, so the incentive will be of major relevance for labor intensive firms. What would be the collective welfare gain if, say, Denmark or Germany maintained textiles or leather goods manufacturing by lowering wage costs? My reading of the situation is that everyone, including Denmark, gains by leaving textiles to Portugal or, more likely, Malaysia. The only condition under which opting out appears to be a real threat would be if EU harmonization imposes equal welfare standards everywhere, but not equal payments. The other side of the coin is the incentive for the “poor” to benefit from the generosity of rich countries’ welfare systems. This cannot be

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a major problem. First, because social entitlements are generally conditional upon residence and/or tax contributions. Second, because higher social benefits reflect prevailing living standards (and the cost of living). The Portuguese worker who moves to Dusseldorf will have to pay German rents and food prices. The margin he saves may buy a lot back home and this is exactly what drives the migrant worker. But Europe’s migrant workers today are not fellow Europeans but extracommunitarians. And, again, there is a heavy “family price” to be paid for the mobile welfare shopper. Besides losing one’s strong and weak social ties, the Portuguese worker will have difficulty finding a Portuguese school for his children in Dusseldorf. Realistically speaking, do we know anything at all about the marginal utility of a 30 percent income gain against the loss of friends, family, language, and culture? Racing toward the bottom or top is not merely a question of comparative fiscal costs and social benefit standards, it is intrinsically connected to labor markets and production systems. Where economies mainly compete on price margins, there is clearly a downward pressure on wages that, inevitably, will also affect the reservation wage. This is the well-known American and, perhaps, British problem. Where, instead, economies seek to compete on quality and product differentiation, firms require cooperative and reliable workers which inevitably mean high labor costs. I doubt that the European countries that emphasize the latter strategy will be much inclined to race toward the bottom, thus jeopardizing their purported competitive edge. They might equally well prefer to use their “welfare edge” to lure highskilled labor from less welfarist countries. Generalizing the issue to the EU level raises an interesting question: Is it possible to identify a EUlevel strategic move toward high-road or low-road competition? Bertola et al. cite the notorious case of foreign construction workers undercutting the reservation wage of their unemployed German colleagues. On one hand, if we regard unemployment as a common European problem, then we should be neutral about who succeeds in escaping it, Italians, English, or Germans. On the other hand, since solidarities and social tensions remain largely nationally confined, equity issues will conflict.2 A simple regulatory act, such as imposing national wage minimum standards on foreign workers, should suffice to eliminate welfare erosion of this kind. In any case, the chief problem behind Europe’s unemployment problem is its sluggish service job growth.

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The Case for a European Welfare Policy To address such incentive problems, Bertola et al. believe that we need to develop a European-wide social protection policy. There are certainly good reasons to assume so. A united Europe is difficult to achieve without cultivating meaningful and real solidarities (just as Bismarck used social policy in his architecture for a unified Imperial Germany). It is also evident that social risks are ever less contained within national boundaries; that natural risk groups transcend frontiers. There is, then, a case to be made for EU-wide systems of risk pooling, except for the stubborn fact that those whose risks might be pooled identify their solidarities in the context of their nation-state. On the other hand, I do not see the opting-out issue, nor the incentives problem, as pushing toward any EU-level social policy logic. In fact, Bertola et al.’s incentivesdriven analysis needs more empirical substantiation. In practice, Bertola et al. envision a scenario that calls for one common European program: some kind of basic social minimum based on a means or income test, targeted to the poor—a recast first tier of social protection. It is not altogether clear whether they advocate this program for reasons of nurturing a common European-wide social solidarity or as a means to eliminate mobility incentive distortions. In either case, this proposal, bold as it is, appears problematic. The problem begins with what I see as an overly strong reliance on needs-tested social assistance to combat poverty. With some qualifiers, Bertola et al. treat assistance schemes as the natural policy against social exclusion. An important principle is at stake, here namely whether assistance-type schemes are, indeed, the best choice if the goal is to effectively combat exclusion. Comparative poverty analyses never fail to show that poverty is lowest (and the poverty-reduction effect strongest) where social assistance is most marginal. Income-tested assistance is an ineffectual tool against poverty or exclusion for wellknown reasons: it enjoys scant public support and is therefore miserly; it creates social stigma and take-up rates are therefore usually low; and it creates poverty traps. The superior instrument to combat poverty is therefore universal, comprehensive income maintenance programs and enabling social services. Welfare states that follow this philosophy have, therefore, deliberately marginalized social assistance programs. It would be much closer to the truth to view social assistance as a means to cover the holes in a nation’s main social safety net. Countries with

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comprehensive social safety nets, as Denmark or Sweden, spend little on assistance; where the main safety net is ungenerous or biased toward private provision, as in the United States or Britain, assistance becomes dominant; and where employment-based entitlements prevail, as in continental Europe, assistance serves as a stopgap measure for those without insurance entitlements. In all cases, they are widely unpopular. Hence, if the main objective of a pan-European targeted social minimum is to combat social exclusion in the name of pan-European social solidarity, one could hardly propose a more self-defeating policy than tested social assistance. If the main objective here is to avoid pathological mobility incentives, the open question remains of whether these exist to begin with and whether an income-tested social minimum is the way to cure them. The concrete proposal that Bertola et al. advocate is curious in the sense that it should not align benefit levels to local wage or income levels, only to cost-of-living differentials. Now, if this were implemented, it could result in major incentive problems, all depending on PPP-adjusted nation-based income differentials. Bertola et al.’s arithmetic suggests that such effects should be minor, but they also admit that the technical side of implementation may be a major headache. The real objective behind their proposal is, to be applauded. It is, at once, an effort to impose a basic welfare minimum across Europe and an attempt to redefine solidarities in a much broader way. Considering my objection that targeted assistance schemes are the worst possible instruments to cultivate positive solidarities, a similar objective could be obtained much easier: impose, via common EU-wide regulation, a stipulation that all citizens of the EU be guaranteed an income that is no lower than 50 percent of median, adjusted income within the nation in which they reside. Nonetheless, considering Bertola et al.’s emphasis on work-friendly incentives (which I fully share), the case for this guaranteed EU minimum proposal is not especially strong. Why not, as one alternative that would generally address similar goals, promote a EU-wide minimal wage subsidy scheme along the lines of, for example, Phelps’ (1997) proposal? If the goal of first-tier policy is to minimize social exclusion and poverty, a superior strategy does appear to present itself: either fill the gaps in existing social protection systems that, in the first place, necessitate ad hoc assistance programs; or put greater emphasis on policy, like labor-market regulation, training and education, that

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minimizes exclusion, and social services, like day care, which augment families’ capacity to respond to hardship with added labor supply. But exactly on these grounds, the Bertola et al. proposal confounds me. They advocate a second-tier that is nation-specific and employmentbased insurance. This inevitably creates huge welfare lacunae (which then require stopgap, assistance-type counter measures) unless nations arrive at close to maximum employment-population ratios. But to achieve this, at least in the case of women, the welfare state must guarantee affordable day: care services. Yet, in the Bertola et al. blueprint, services—the third tier—should be deregulated and competitive. This (as discussed below) contradicts their own stated objectives. The basic question remains: Why is a move from national to a more integrated European welfare state desirable? In my view the answer must be found along two dimensions. First, the commonality of risks and, therefore, the relevance of supranational risk-pooling. Second, the specification of what are, today, the fundamental dilemmas facing social protection and, as a consequence, emerging new risk profiles. But, basic to any policy change, we cannot avoid adopting some basic yardstick of justice and efficiency. Bertola et al. do not provide us with one. Yet, reading between the lines, one gets the impression that their yardstick is much closer to a Rawleasian than to a conventional Paretian optimization model, that is, the first-order objective that must underpin any efficiency improvement is to better the lot of the worstoff (the socially excluded). If I am right on this point, why not make it explicit? Then the question becomes, what—among alternatives— would be the superior way to improve Europe as a whole by first assuring that the worst-off will experience more welfare? The Dilemmas of Social Protection The case for a coordinated EU social policy depends on how best to respond to emerging challenges. The menu of dilemmas is well-known: aging populations, unstable families, the apparent trade-off between more equality and more jobs. Diagnosing these right is clearly decisive. Population aging is a function of two variables: low fertility and longevity. The former is primarily an issue related to families; the latter may tax our health and social care systems, and it signals longer years of pension recipiency for a given number of contribution years. Here we do have a convergent trend, but one that must be examined more dynamically. The real problem of longevity is one of life-course behav-

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ior (ever fewer contribution years, ever longer retirement) rather than disability (expected disability-free years are rising very fast, so that average males can now count on full abilities until age 75) (OECD 1998b). Clearly a case can be made for abolishing mandatory retirement and inducing delayed and flexible retirement, but we know that this is exceedingly difficult to accomplish within the national polities of Europe. Here is a candidate for EU policy, indeed one that involves the single most burdensome and problematic incentive issue of all. The demographic imbalance that comes from low fertility varies sharply by country. A case can be made that southern Europe finds itself in a low-fertility equilibrium because new family behavior and women’s desire for careers is not met with affordable day care and because of heavy youth unemployment and dependency on parental support. The fertility deficit does not reflect stated preferences (which is on average 2.2 children), but instead unaffordable private care and virtually no public provision. Resurrecting fertility levels and maximizing women’s employment is a win-win policy across-the-board: for families themselves, for national pension funds, and for long-term EU economic growth. Growing family instability is one of two major sources of the changing incidence of risk. Single parent families, separations, and divorce are associated with income decline and often poverty. Family “failure,” in turn, easily exacerbates problems of labor supply; mothers find it difficult to work unless they have access to affordable day care. The equality-jobs trade-off, insofar as it is associated with skills, has three basic dimensions. First is the problem of clearing markets of a sometimes huge stock of low-skilled workers (which can bundle if deruralization and deindustrialization coincide, and which can reproduce itself in countries with undeveloped skill formation systems). A second is related to the productivity lag in labor-intensive services, which are our main hope for massive job growth. And the third, once again, is a question of dynamics. Being in a low paid service job is no welfare problem if there is no entrapment. The trade-off disappears if citizens have some credible guarantee of mobility, implying again skills and resources. This extremely synthetic snapshot of the major dilemmas facing contemporary welfare states leads to two conclusions. First, the emerging concentration of social risks diverges dramatically from the profile that obtained in the epoch of welfare state construction. Existing welfare

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states were built on the assumption that most people would obtain most of their welfare most of their life in the market, and risks were bundled at the passive ends of the life cycle. Hence, many welfare states are essentially “pensioner states.” In contrast, the new risk profile is concentrated among younger age groups: unemployment, family instability, precarious jobs, and so forth tend to fall heavily within the 20 to 35 year age span. Most welfare states today offer little (other than passive measures) and, in Italy, almost nothing to remedy this new risk constellation. The second conclusion is that today’s primary welfare issues have to do with life chances, with life-course dynamics. Surely, as Bertola et al. emphasize, social benefits easily create poverty and dependency traps as is the case among single mothers in the United Kingdom. Marketizing, say, day care is not a realistic solution since the tax-wedge problem will remain. Even in the deregulated United States, quality day care is out of reach for households below the median income. And if the welfare state is genuinely about equality and also about productivity enhancement, as Bertola et al. argue, then it would be a counterproductive policy to permit the rich to send their children to quality day care while the poor must make do with the occasional lady down the street or, worse, no supervision at all—not a particularly good way to invest in our future human capital stock. The overriding problem is another, namely the resources that would enable people to work and to escape entrapment on either the unemployment or low-wage side of the trade-off coin. In fact, the kind of naked jobs-equality trade-off that emerges from static comparisons of the United States and Europe looks very different when we examine duration data: Americans may have jobs but they are more likely to get trapped in long spells of lowpay and poverty than are Europeans. Hence, the pressing objective of European social policy is not so much to lower financial costs of social protection or to combat shirking, but to redirect resources to where the real dilemmas are, namely from the aged to the young, from passive transfers to “enabling” resources like day care, aged care, skill formation, and education. If mothers can harmonize work and children, fertility will rise, the pensioner-employed ratio will improve, and household poverty will decline. And when housewives become workers, they create two collective goods: added tax revenue and additional service jobs. Here is, a far better policy candidate for a Rawlsian optimizer.

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One EU scenario is that the existing national social protection infrastructure be partially Europanized. Another one is that the EU concentrate on the lacunae that must be filled. I am personally not especially convinced of the former scenario. Is there a good case for the latter? Indirectly yes. The Political Deficit Revisited Considering the political preferences of median voters today, a major overhaul of the status quo is difficult to imagine as a strictly national project. Where reforms are blocked, national governments have with some success managed to delegate necessary decisions (or at least the blame) to the EU level. Admittedly, EU harmonization has, so far, been overwhelmingly of the “negative integration” type thus creating a deficit of legitimacy, as Sharpf (1999) puts it. Paradoxically, the very fact that the EU is democratically unrepresentative may, in the case of welfare reform, be a blessing in disguise: the median voters are circumvented and national veto-points canceled out. What could the EU then adopt as a promising field of social protection? On the one hand, those necessary but politically suicidal reforms, like eliminating early retirement. On the other hand, launch Europeanwide social policy initiatives that are simultaneously beneficial to households and to the common fate of EU economic performance, meaning for example fertility-incentives via universal, affordable daycare provision and uniform parental leave standards (which may only require regulatory intervention) or a Europe-level set of standards for education and skill formation. To pick up on Bertola et al.’s idea of the Europe-wide social minimum (which does not convince me) one might consider a Europe-wide basic guarantee against permanent entrapment. Alternatively, it is by now evident that a minimal commitment to “equality” requires subsidies to low-productivity, low-wage workers. In the Anglo-Saxon nations this takes the form of employment-conditional “earned income credit” subsidies. A growing stress is emerging in Europe on wage subsidies (or reducing employers’ fixed labor costs), mainly among youth workers. If we subsidize lowproductivity workers, young or old, we indirectly subsidize lowproductivity firms, and we may, in addition, nurture unwanted substitution effects. Nevertheless, as Gosta Rehn proposed two decades ago, a system of “marginal employment premiums,” as he called it

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then, could and perhaps should be an obvious candidate for EU-level implementation because the low-wage risk is Europe-wide and because this would not threaten trade unions’ wages policies directly. Again, the point to stress is the dynamics of policy. If, as I strongly believe, the real goal of social policy is to help maximize life chances and not equality for all, here and now, then we have a way of gauging what is a worthwhile policy of subsidization, of collective service delivery, or of income maintenance. These are loose ideas that, almost certainly, can be killed with one stone. And that is probably true of all ideas that go beyond the vacuous restatement of principles and wishful thinking that now characterizes European social policy debate. What I would like to emphasize is the underlying guiding principle: it is much easier to imagine “positive integration” at the EU level on policy that is, as yet, nonexistent rather than harmonizing and synchronizing existing national schemes or even outright transporting myriad national programs to the EU level. It is also much easier to imagine the EU as responsible for those unpopular reforms that national politicians cannot undertake rather than in the role of competing with national politicians for popular programs. Notes 1. In the Nordic model, of course, the ability of mothers to work is vastly enhanced by the fact that they mainly work in the public sector. American mothers, too, are able to remain employed without much benefit from a welfare state, mainly because cheap private care is available, a consequence of a low-wage labor market that is an unrealistic prospect for Europe. 2. The large Danish-Swedish bridge project is also being undertaken by Italian and English workers, but without the kinds of tensions that arose in the case of Berlin.

References Bison, I., and G. Esping-Andersen. “Income Packaging and Poverty among Europe’s Unemployed.” In D. Gallie and S. Paugham, eds. (forthcoming). Unemployment and Social Exclusion in Europe. Oxford: Clarendon Press. Bjorn, L. 1995. Causes and Consequences of Persistent Unemployment. Ph.D. dissertation, Department of Economics, Copenhagen University. Esping-Andersen, G. 1999. Social Foundations of Postindustrial Economies. Oxford: Oxford University Press. OECD. 1998a. Maintaining Prosperity in an Aging Society. Paris: OECD. OECD. 1998b. The Caring World. Paris: OECD.

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Phelps, E. 1997. “Wage Subsidy Programmes: Alternative Designs.” In D. Snower and G. De la Dehesa, eds. Unemployment Policy: Government Options for the Labor Market. Cambridge: Cambridge University Press. Rosen, S. 1996. “Public Employment and the Welfare State in Sweden.” Journal of Economic Literature 34: 729–740. Sala-i-Martin, X. 1992. “Transfers.” NBER Working Paper, no. 4186. Scharpf, F. 1999. Governare l’Europa. Bologna: Il Mulino. Thompson, L. 1998. Older and Wiser: The Economics of Public Pensions. Washington, D.C.: The Urban Institute.

II

European Integration, Liberalization, and LaborMarket Performance Giuseppe Nicoletti, Robert C. G. Haffner, Stephen Nickell, Stefano Scarpetta, and Gylfi Zoega The construction of a unified Europe is one of the principal long-term movements in postwar history.1,2 The main driving force for this essentially political objective has been its compelling economic rationale. The creation of a single European market has been seen as advantageous for all participants and beneficial to living standards of European citizens. Many EU governments willingly took the steps toward establishing the European monetary union (EMU) because they were seen as bringing about beneficial political consequences, such as creating a consensus for implementing some of the changes in institutions and policies that are needed to ensure long-run sustainable growth in the European economies. The movement toward unification, however, has failed so far to contribute significantly to the economic objective of reducing high and persistent unemployment, which is most important for maintaining the momentum and the social cohesion of the European project. Indeed, structural unemployment among EMU members is still much higher than in other OECD countries and, more important, European labor markets do not appear to be able to face the challenges posed by developments in the world economy with the dynamism shown by the United States economy. The main objective here is to investigate whether there is any force inherent in European economic and monetary unification that is likely to affect the structural weaknesses bridling the employment performance of European economies by inducing changes in behavior or policies. Alternatively, an additional effort would be required of European institutions and the member governments to implement the structural policies that are believed to be effective in reducing unemployment. Several conjectures have been made as to the causes of and remedies for European unemployment: the lack of employment flexibility, the tax burdens and distorted incentives created by unbalanced welfare

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systems, the weaknesses in human capital formation, the constraints to the business environment created by excessively restrictive and obsolete regulations, and so forth. Here we focus mainly on weak product-market competition and regulations causing it, as a potential explanation for the disappointing employment performance of many European economies. Our working hypothesis is that product-market competition, or the lack of it, interacts with labor-market regulations and institutions to affect the functioning of the labor market.3 The question is whether market integration, the competition policies of the European Commission (EC), and the EMU provide sufficient constraints and/or incentives to private agents and member governments for increasing competitive pressures in European product markets, inducing at the same time the institutional changes and reforms needed to make labor markets more flexible. At present, tension exists among European-wide harmonization and liberalization of product markets, the persistence of domestic impediments to product market competition, which often remain unaffected by EC initiatives, and the essentially domestic nature of institutions and policies determining industrial relations. Spurred by the EC, European economies have taken steps to make the business environment, especially in utility industries, friendlier to competition. The action of the EC is bound by the Treaty of Rome, however, and, despite the increasing role played by the European Court of Justice in broadening the range of national policies considered to be obstacles to internal trade, there are a number of areas that remain largely under the realm of domestic policies that are often unfriendly to competition (such as the dismantling of legal barriers to entry in certain service activities, regulations constraining the provision of business and personal services, and administrative measures de facto limiting the number of competitors in local and public procurement markets). The so-called Cardiff process, which is partly concerned with EU-wide developments in product-market competition, is mainly a monitoring initiative that does not see an enlargement of the EC role or stringent guidelines on product-market reforms by member governments. National prerogatives are even stronger in labor-market policies, where the so-called Luxembourg process is confined to providing only general guidelines within which governments are required to reform their domestic policies. This tension raises a number of interesting questions that are addressed in the following sections. Are trade integration, the EC effort

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to liberalize product markets, and the creation of the single currency sufficient to raise significantly competitive pressures in the EU? Will product-market competition become sufficiently intensive to have sizeable effects on European unemployment? How will labormarket institutions and regulations interact with the more competitive product-market environment in determining labor-market outcomes? Will the new competitive environment lead to changes in those institutions and regulations? Is there any evidence of a systematic relationship between national regulatory approaches in the labor and product markets? What will be the effects of the single currency on incentives for institutional change and structural reform? Given that EU-wide liberalization and monetary integration are relatively new, answers to these questions are somewhat speculative. Following the approach outlined in the introduction to this book, we often concentrate on the historical experience of those EU countries that most consistently pegged their currency to the D-mark, creating a de facto (and ante litteram) integrated monetary area. We begin by reviewing the status of cross-border and domestic competition in the EU (section 1). Market integration and product-market competition are concepts that are difficult to measure empirically. At the risk of oversimplifying a complex issue, however, we look at developments in the degree of integration and competition, focusing on a few indicators for which data are available: similarities and convergence over time of price structures, differences in price levels, and estimates of the levels and trends of profit margins. Our analysis is based on the data on purchasing power parities (PPP) collected by Eurostat and the OECD in the context of the United Nations International Comparisons Project, which also account for variations in exchange rates. As cross-border and domestic competitive pressures increase, we assume that price structures should become more similar through a price convergence process. As a result, not only price level differences should decrease, but prices themselves should decline as price-cost margins shrink in competitive industries and efficiency gains are more easily transferred to consumers. We therefore consider a lack of price similarity and convergence, and abnormally high mark-ups and product prices, as indicators that market integration and productmarket competition are insufficiently strong. Our results suggest that price structures within the EU are more similar than among other OECD countries, especially for consumer goods and tradables, and that a long period of price convergence has

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been in motion over the past two decades, even for services and other nontradables. It is unclear, however, what is the right level of similarity for economies that want to form an economic and monetary union. Evidence on price structures within the United States would suggest that, even though EU cross-border and domestic competition is increasing, the remaining cross-country price disparities are a symptom of insufficient competitive pressures. The relative weakness of the competitive environment tends to be confirmed by the fact that on average EU price levels are significantly higher (in PPP terms) than prices prevailing in the best performing countries, leaving European consumers worse off relative to their peers in North America. This phenomenon can partly be related to the continuing presence of significant market power by European firms even in competitive manufacturing industries. It is particularly worrisome that the price convergence process appears to have slowed down after the establishment of the single market in 1992. One interpretation of this phenomenon is that while private agents have adjusted to the new economic environment, public policies still provide firms with large opportunities to exploit market power originating from regulatory barriers to entry in domestic markets and nontariff barriers to trade and investment. What are the potential consequences of insufficient competitive pressures in product markets for the performance of the labor market? Is there any relationship between the institutional and policy factors influencing the structure of product markets and those affecting the functioning of labor markets? In section 2 we draw on economic theory to find answers to these questions. We argue that there are sound reasons to expect an increase in product-market competition to result in higher employment at both the firm level and at the aggregate level: in essence, a comparatively high degree of product-market competition will make labor demand more elastic and shift it outwards. Therefore, ceteris paribus, we should observe higher employment rates in countries with higher overall levels of product-market competition. The analysis of wage behavior is more complex. Due to rent sharing behavior, wage rates can be expected to be inversely related to productmarket competition at the firm level. In the aggregate, however, the relationship between wages and product-market competition is ambiguous since higher aggregate labor demand could well increase economywide wages. Therefore, more intense product-market competition can result in both higher employment and higher wages. The structure of product markets can also affect the optimal composition of

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employment. Economies with higher overall levels of product-market competition, may exhibit higher levels of self-employment. If the general regulatory framework is less onerous for small firms than for larger corporations, however, then we may observe a positive overall relationship between self-employment and the strictness of regulation, to the extent that the latter changes the relative prices of different kinds of labor. Higher levels of product-market competition should also be associated with higher levels of macroeconomic stability. This is because increased real flexibility tends to reduce the impact of both demand and supply shocks, lowering as well their persistence over time. Finally, we expect increases in product-market competition to create the conditions for more flexibility in labor markets, since firms facing more competition are under pressure to respond more rapidly to fluctuations in the markets in which they operate. Therefore, we may observe a positive association between the stringency of productmarket regulations, which affect the overall degree of market competition, and regulations reducing the flexibility of labor markets. Although there is a consensus that increased product-market competition is likely to have a positive effect on employment, there is no agreement on its empirical relevance. Section 3 attempts to check some of the predictions of the theoretical analysis by looking at the comparative experience of OECD countries over the past two decades. To take into account the potential interactions between the features of labor and product markets, we look at factors affecting both product-market competition and labor-market flexibility. To date, the empirical analysis of the linkages between product-market competition and labor-market performance stumbled upon the lack of adequate indicators expressing the intensity of competition, especially in a cross-country context. In addition, the finding of an empirical relationship between productmarket competition and labor-market outcomes has been sometimes difficult to interpret and is often of dubious policy relevance. Difficulties in interpretation generally arise from the fact that labor-market variables and product-market competition measures are often endogenous to each other (e.g., wages and measures of market power). Policy irrelevance occurred because indicators of the intensity of productmarket competition (such as industry concentration indices) are generally not useful for competition authorities which operate at the level of micromarkets. To overcome some of these problems, we take a different approach. Since the degree of competition in the product market is not directly measurable, we use some of its policy determinants as

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proxies, such as regulatory provisions affecting entry and favoring large, possibly state-controlled, incumbents and trade regulations. We also explore the influence of labor-market regulations on performance and assess their relationship with regulations in the product market. This is made possible by the use of a novel set of quantitative indicators of cross-country differences in the stringency of the product and labor-market regulatory environments in OECD economies. Productmarket indicators have no ambition to measure the quality or the effectiveness (e.g., to achieve stated public policy goals) of existing regulatory environments, but they focus exclusively on their friendliness to market mechanisms. Their aim is to measure to what extent competition and firm choices are restricted in industries and areas where there are no a priori reasons to expect the government to interfere or where regulatory goals could be achieved by less coercive means. Overall, the empirical results lend support to the theoretical considerations discussed in the previous section. We find that countries tend to adopt similar regulatory approaches in the labor and product markets: where product-market regulations restrict competition and state interference in the business sector is high, labor markets tend as well to have tight legislation protecting workers, especially those under permanent contracts. One interpretation of this finding is that policies aimed at making labor markets more flexible are better implemented in a liberal product market environment. Moreover, even controlling for a number of policy and institutional factors affecting the labor market, it is possible to detect significant effects of the summary indicators of both employment protection legislation (EPL) and productmarket regulation on the level and the composition of the employment rates of OECD countries. Countries with tight EPL and restrictive product-market regulation tend to have lower employment rates in the nonagricultural business sector. At the same time, biases in the regulatory environment will tend to distort the composition of employment. In particular, higher regulatory and administrative burdens for corporations relative to sole proprietor companies tend to increase the proportion of self-employed in the nonagricultural business sector. There is also some evidence that strict regulations in the product and labor markets may lead to wage premia in the manufacturing sector, as firms may share part of the rents with workers. There are, however, significant differences across industries that are likely to depend on the specific market structures in which they operate and thus on the effec-

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tiveness of regulations to protect incumbents from domestic and foreign competition. The available evidence suggests that there is scope for increasing product-market competition in the EU and that such an endeavor would most probably have positive repercussions on labor market performance. Section 4 investigates whether the major institutional change brought about by the EMU is likely to favor an increase in cross-border and domestic competitive pressures. We explore two avenues through which the EMU could affect product-market competition: an increase in competitive pressures through enhanced price transparency (which makes it easier for agents to arbitrage between tradables and for firms to compare labor costs); and a change in the willingness of workers to accept, of firms to lobby for, and of governments to implement reforms in labor-market institutions and in labor and product-market regulations. In doing so, we continue to draw from the historical experience of quasi-monetary unions, such as the D-mark area and the European Monetary System (EMS). Looking at cross-border price differences, we find that countries in the D-mark area have a higher level of price similarity, but even controlling for a number of factors (such as initial conditions, trade intensity, and preferences) we find no evidence of stronger price convergence than in other EU countries. Thus, it is the similarity of economic structures (and the corresponding cost-price combinations) that favored membership in the hard-currency area rather than participation in the D-mark area that led to price similarity. Even though the impact of the EMU could be different, notably because it is a much more credible monetary arrangement, these results cast doubt on the hypothesis that monetary union by itself will increase significantly product-market competition. Turning to the second channel, we looked both at direct and indirect evidence of the relative significance of changes in government policies and union and employer behavior within hard-currency areas and in other OECD countries. Direct evidence involved a cursory review of institutional changes and structural policies observed in the past decade, while indirect evidence relied on estimates of cross-country differences and changes over time in the degree of nominal and real flexibility of the economy, under the assumption that these could be related to differences and/or changes in agents’ behaviors and policy approaches. Overall, we find reasonable evidence that contractual and bargaining arrangements favoring real wage flexibility go hand in hand with monetary integration. Since

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we did not find any change in behavior following access to a hardcurrency area, however, we cannot establish whether it is monetary integration that fosters changes in behavior or implementation of monetary integration that is easier for countries in which such arrangements already exist. At the same time there is very little evidence, and no clear indications from theory, that monetary integration in itself might increase the propensity of member governments to pursue the structural policies needed to make product markets more competitive and labor markets more flexible. Where does this analysis leave us in our initial question as to the ability of economic and monetary integration to improve the disappointing employment performance of the EU? There is evidence that both product-market competition and labor-market flexibility have been fostered by integration. There is still considerable scope, however, for increasing competitive pressures within the EU. Product-market competition could be promoted effectively by further streamlining, simplifying, and reforming product-market regulations. Our analysis suggests that the gains to be reaped from such a reform effort are twofold: increased product-market competition is likely to set the stage for a reduction in labor-market rigidities, and more flexible product and labor markets may improve significantly EU employment prospects. The overall impression, however, is that while private agents, unions and employers, have adjusted (and are adjusting) their behavior to meet the challenge of economic and monetary integration, national governments implement structural reforms at a much slower pace. Based on the review of past experiences in highly integrated areas, it is unlikely that the Single Market and EMU will be sufficient conditions to bolster the reform effort. Therefore, an acceleration of the EC initiatives to liberalize product markets as well as an increased commitment to structural reform by national governments is in order if labor-market performance is to be improved in the EU. 1 Integration, Liberalization, and Product-Market Competition The landmark of the past two decades of structural policies in Europe has been the move toward full trade integration (the single market) and the effort of the EC to remove obstacles to trade in the single market by stepping up the implementation of competition policies and pushing forward the liberalization of several industrial (especially utility) sectors. A detailed account of this reform process and of its (still

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controversial) impact on the EU economies is outside the scope of this study.4 It is widely believed that, once completed, this process will lead to significant benefits for European consumers in the quality, the variety, and the price of goods and services sold in the EU, improving overall living standards.5 These benefits are expected to result mainly from an increase in the intensity of cross-border and domestic competition in European product markets. Looking at some of the driving forces of EU-wide product-market competition suggests that competitive pressures are likely to have increased within the single market. First, external trade and foreign direct investment have continued to increase, exposing domestic firms to competition from foreign firms. External (intra-EU) trade in goods has increased, rising from 27 percent in 1993 to 32 percent in 1997, whereas intra-EU foreign direct investment inflows have risen from 0.8 percent of GDP to 1 percent GDP between 1992 and 1997 (see EC 1999a). Moreover, since 1970, there is also a clear trend toward increased intraindustry trade for most member states, pointing to an increasing similarity in their industrial structures. As trade is more and more often in similar products, the increase in trade flows may understate the actual increase in competition due to more market openness. Second, regulatory reform, including changes in (national and European) competition policies and EC directives liberalizing domestic service markets in areas such as telecommunications, postal services, air and railroad transport, electricity and gas, has reduced barriers to (foreign and domestic) competition. Third, the interaction of technological change and regulatory reform has also contributed to increasing competition, putting pressure on existing market structures.6 Despite these general trends, domestic regulatory barriers are still significant in many countries, especially in some service industries and public procurement, lessening the impact of trade integration and liberalization on product-market competition. In this book, which focuses on the effects of integration and liberalization on labor market outcomes, it is paramount to examine some direct evidence of the effects of the reform process on the degree of product market competition in EU markets. Unfortunately, the intensity of competition in markets for goods and services is intrinsically difficult to observe. Market competition is the result of a complex interaction of forces that influence both the playing field on which European firms operate and firm behavior itself. Moreover, the degree of competition should ideally be measured at the level of the relevant

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antitrust markets.7 As antitrust markets generally do not coincide with the statistical categorization of firms into industries, one necessarily has to rely on more general measures of competition at a relatively high level of aggregation, which may hide a considerable degree of heterogeneity at the level of individual firms and products.8 Here we look at three (admittedly imperfect) indicators of the progress achieved in fostering market mechanisms and increasing competitive pressures within the EU: price convergence, price levels, and profit margins. 1.1 Price Similarity and Convergence Reduced price differentials (or more similar price structures) among EU countries, in part, can be attributed to increased competition and market integration. The elimination of barriers to trade by the singlemarket program and other regulatory reforms should erode market power, thereby reducing the potential for price discrimination across EU markets. In the absence of new collusive behavior, therefore, increased integration should result in more active price competition (instead of firms relying on nonprice aspects and trade barriers). Even within fully integrated economies, however, consumer prices may vary to a certain extent due to differences in indirect taxation, exchange rate fluctuations, national preferences for different products, differences in the market structure of the retail and wholesale sectors, and transport costs. In addition, as the international comparison of prices is beset with methodological and statistical difficulties, estimates of price disparities should be interpreted with caution. For instance, data limitations may be masking differences in quality across goods. This could mean that the observed heterogeneity in prices is partly due to product differentiation. Therefore, the analysis of EU price differentials can only provide a rough indication of the intensity of productmarket competition and the remaining potential for improvement. Here, we focus on the similarity between price structures and their convergence over time, comparing developments in both EU and other OECD countries. We look at some of the factors potentially affecting similarity, such as the typology of products, their tradability, and the presence of trade barriers. The analysis is based on a comparison of price developments for a large set of products over a period of eleven years. To this end, we use the data on Purchasing Power Parities and Real Expenditures produced by Eurostat and the OECD in the context of the United Nations International Comparisons Project, which provides the

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prices of over 200 categories of goods and services observed in 1985, 1990, 1993, and 1996. Using the so-called Grubel-Lloyd index (familiar from trade literature, where it is used to measure the degree of intraindustry trade), we look directly at bilateral price similarities across countries.9 This approach has several advantages over earlier ones focusing on the degree of overall price dispersion, as measured for instance by the coefficient of variation (see EC 1997a). The similarity index, which approaches 100 as the price structures of two or more countries become more similar, makes it possible to summarize the differences in the price structures of two or more countries, isolating the country-specific from the product-specific effects. It allows for a more direct identification of the areas and product types in which progress has been made. In addition, the set of bilateral indices can be used to check whether convergence (or its lack) may be explained by economic factors, such as initial conditions, trade intensity, or barriers to trade. Table 1.1 summarizes unweighted (gross of tax) price similarities and their development over the 1985–1996 period for both EU and non-EU countries.10 In the table, goods and services are classified by basic expenditure heading and degree of tradability, consistent with EC’s (1997a) classification. The degree of price similarity is substantially higher among EU countries than among non-EU countries. Cross-area differences in similarity are particularly striking for consumer and tradable goods (two sets which broadly coincide), underscoring the effects of market integration on cross-border competition. The overall degree of price similarity is significantly lower for nontradable goods (80.6 for nontradables versus 86.3 for tradables within the EU), demonstrating the considerable scope for price convergence in the nontradable sector. For both EU and non-EU countries, the equipment goods sector has the highest degree of price similarity, indicating that it may have become an international or even global market. Regulatory barriers to trade and investment can be powerful obstacles to cross-border competition and may therefore contribute to explain price disparities, even within the single market. Table 1.2 presents similarity indices according to the degree of nontariff barriers (NTB), using the EC (1997a) classification of products into high, medium, and low NTB.11 The results show that prices within the EU are now relatively similar using this product categorization, while differences in prices between high- and low-NTB products remain significant in non-EU countries. A counterintuitive result is that, especially

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Table 1.1 Price similarity for some categories of products, 1985–1996 1985

1990

1993

1996

Change, 1985–1996

EU All products Consumer goods Equipment goods Construction Services Energy Tradables Nontradables

81.9 82.9 88.5 85.3 75.2 84.1 83.9 76.7

81.5 82.2 88.1 85.0 76.1 78.3 83.1 77.2

84.5 86.0 88.6 85.9 79.4 77.2 86.1 80.3

84.6 85.9 89.8 84.8 79.5 79.1 86.3 80.6

+2.6 +3.0 +1.2 -0.5 +4.2 -5.0 +2.4 +3.9

Other OECD All products Consumer goods Equipment goods Construction Services Energy Tradables Nontradables

75.3 77.1 80.0 70.9 69.2 76.1 77.4 69.8

78.2 79.9 80.7 81.4 72.7 73.4 79.8 74.3

75.7 76.9 82.0 75.8 70.2 71.0 77.5 71.0

76.4 76.7 85.7 79.3 71.0 72.3 78.0 72.6

+1.1 -0.4 +5.6 +8.4 +1.8 -3.9 +0.6 +2.8

Source: Authors’ estimates based on OECD Purchasing Power Parities and Real Expenditures. Notes: EU = Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the United Kingdom. Other OECD = Australia, Canada, Japan, Norway, New Zealand, Turkey, and the United States.

in the EU, price similarity is higher for the medium-NTB category than for the low-NTB category. This may happen because markets characterized by medium NTB’s are mainly equipment goods markets that show a higher similarity of prices due to their highly traded nature (see also table 1.1). Turning now to price convergence, we observe that over the 1985–1996 period, price similarity among EU countries has increased significantly in consumer goods and, especially, in services, while disparities have increased in construction and energy. More importantly, the overall increase in price similarity as well as the increase in consumer goods and services was higher in the EU than elsewhere. Price similarity among other OECD countries also increased substantially

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Table 1.2 Price similarity according to NTB categories, 1985–1996 1985

1990

1993

1996

Change, 1985–1996

EU High NTB Medium NTB Low NTB

82.0 88.0 82.2

81.3 86.8 81.9

85.1 88.1 85.9

85.5 88.5 85.8

+3.5 +0.5 +3.6

Other OECD High NTB Medium NTB Low NTB

76.7 76.7 76.4

80.4 77.2 79.1

78.9 80.3 76.7

81.3 80.6 76.2

+4.6 +3.9 -0.3

Source: Authors’ estimates based on OECD Purchasing Power Parities and Real Expenditures. Notes: EU = Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the United Kingdom. Other OECD = Australia, Canada, Japan, Norway, New Zealand, Turkey, and the United States.

over the same period, but only in construction and equipment goods (where initial disparities were largest both in absolute terms and relative to the EU). Although both EU and other OECD countries made significant progress in the area of nontradables, convergence in tradables was significantly stronger among EU countries. Finally, significant progress toward price similarity has been achieved in the EU for both high- and low-NTB sectors, while the other OECD countries mainly achieved progress in the high- and medium-NTB sectors.12 These results suggest that the single market program successfully increased EU market integration and succeeded in reducing price disparities in those markets that were more regulated at the start of the program. It is noteworthy, however, that price convergence in the EU mainly occurred in the 1990–1993 period, coming to a halt in virtually all categories of products after 1993. By contrast, prices in other OECD countries continued to converge, although at a slow pace. Can this wiggling convergence pattern be explained by initial price structures that were quite similar in EU countries at the beginning of the period, reducing the potential for further convergence? Or is it the result of a tension between the process of adjustment set in motion by private agents in anticipation of the 1992 single market and the persistence of significant policy and regulatory barriers to competition standing in the way of full market integration?

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The respective roles of initial conditions and EC integration and liberalization programs can be clarified by looking at the determinants of price convergence in a multivariate framework. To this end, for each couple of EU and other OECD countries, we model changes in bilateral price similarity as a function of initial bilateral similarity levels, bilateral trade intensity, the bilateral correlation between expenditure shares, a dummy for EU membership, and a series of other dummies identifying basic product headings, tradability, and the NTB classification.13 The equations were estimated using the aggregate similarity measures (including all products) as well as panels of similarity measures relative to goods included in specific product categories (i.e., consumer goods, construction, equipment goods, energy, services; or high NTB, medium NTB, low NTB; or tradables and nontradables). The sample size changes accordingly. The degree of price similarity at the start of the period is included to measure a “catch-up” effect. The assumption is that the prices of country pairs with a larger initial gap will converge faster than those of country pairs in which prices were quite similar at the beginning of the period. This may occur when the gap is due to a difference in initial development levels, since price levels in more highly developed countries tend to be relatively high.14 Faster convergence in income levels would also imply faster convergence in prices. Alternatively, it may reflect the fact that relatively more far-reaching and difficult reforms have to be implemented to achieve further progress in countries that have similar prices, thereby slowing down the rate of convergence. We therefore expect the coefficient of this variable to have a negative sign. The EU dummy is included to test whether, once controlling for initial conditions and other factors affecting the speed of convergence, prices have converged at a significantly higher rate among EU countries than among non-EU countries.15 Other factors potentially affecting the speed of convergence can be motivated as follows. The bilateral trade intensity variable (the sum of the bilateral imports, scaled with the sum of the bilateral GDPs) should catch the effect of bilateral trade relations on price convergence. Countries with intense trade relations are expected to be able to reach a higher degree of price similarity (e.g., due to price arbitrage) than countries that do not have such relations. The trade variable can also be seen as a proxy for such issues as relative distance, transport costs, and even cultural differences that may also act as trade barriers.16 The bilateral correlation between expenditure shares is used to control for the effect

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of differences in consumer preferences. For example, prices in one country may be higher simply because consumers have a relatively high demand for a particular product variety that is relatively expensive. Demand may be relatively inelastic, allowing producers to earn a relatively high profit margin. Including the correlation between the expenditure shares should (in part) correct for these effects. It should be noted, however, that a low correlation in expenditure shares between countries may also be the result of a lack of competition in one of the two countries and/or regulatory or other barriers preventing price arbitrage. In any case, we expect a positive sign for this variable. Finally, the dummy variables for the different product categories are included to control for the types of products (consumer goods, energy, services, construction, and equipment goods), the level of NTB’s (high, medium, or low) and the tradability features (tradable versus nontradables). The results of cross-section ordinary least squares (OLS) estimation of this equation using as the dependent variable the average change in (both unweighted and weighted) similarity over the 1985–1996 period are shown in table 1.3.17 Each column shows a different specification of the equation: columns 1 and 3 present the basic equation with unweighted and weighted similarity indices, respectively; columns 2 and 4 check the contribution of each basic heading category to convergence (in unweighted and weighted terms, respectively); columns 5 and 6 check the contribution of NTB levels and tradability to convergence (on unweighted indices); columns 7 and 8 check how the contribution of the EU changes when the dependent variable is restricted to tradables or nontradables only; and column 9 restricts the estimate to the 1993–1996 period. The following conclusions can be drawn from the analysis. As expected, the level of price similarity in 1985 has a significant negative effect on the increase in similarity. This effect proves to be particularly robust across all types of specifications and provides evidence for the catch-up hypothesis.18 Countries with relatively dissimilar price structures have therefore tended to achieve much more progress in price convergence than countries that already had a high level of similarity. Although not always significant, the intensity of bilateral trade relations plays a similar role: countries with intensive bilateral trade relations tend to show relatively little price convergence, because their level of similarity is generally high and, possibly, regulatory barriers impede further convergence. The bilateral correlation between the

3.9 (6.6)

EU dummy

Equipment goods

Construction

1.4 (1.2)

-0.3 (-1.4)

Trade intensity

Expenditure share

-0.3 (-6.9)

Unweighted

1

3.2 (5.1)

-0.4 (-0.6)

3.7 (5.3)

2.7

(6.6)

3.8 (2.6)

1.5

-0.6 (-2.1)

-0.3 (-5.4)

Weighted

3

(2.0)

-0.5 (-20.0)

2

3.9 (5.1)

0.8 (-1.0)

(7.4)

3.6

(3.5)

3.1

-0.5 (-21.1)

4

Change in price similarity (average 1985–1996)

Similarity 1985

Specification/ independent variables

Dependent variable

Table 1.3 Bilateral convergence equations

3.1 (6.7)

4.5 (12.5)

3.6 (2.1)

4.0

-0.3 (-9.5)

6

(3.8)

-0.6 (-21.0)

Unweighted

5

(8.1)

4.6

(0.3)

0.8

-0.5 (-8.1)

7

(3.4)

2.6

(2.9)

6.6

-0.2 (-6.1)

8

(6.7)

3.3

(2.3)

1.2

(3.8)

1.2

(5.7)

3.3

(-12.9)

-0.3

1993–1996

9

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42.3

20.2

F-statistic

88.3

1,050 15.0

210 82.3

1,050

(19.1)

46.7

105.1

630

(21.3)

27.7

420

(9.9)

38.6

40.5

210

(10.1)

14.4

210

(5.5)

16.1

33.4

1,050

(6.5)

23.4

-1.5 (-3.0)

-0.2 (-0.3)

Source: Authors’ estimates based on OECD Purchasing Power Parities and Real Expenditures. Notes: Specifications 3 and 4 use the expenditure weighted change in price similarity as dependent variable (and also the weighted similarity in 1985 as independent variable); specification 7 is for tradables only, whereas specification 8 is for nontradables; specification 9 is for 1993–1996. T-statistics in parentheses.

210

Observations

(4.7)

21.6

39.2

(19.7)

(6.6)

constant

24.2

0.5 (0.9)

(1.5) (3.6)

Medium NTB

Tradable

2.2 (5.3)

High NTB

17.6

-2.1

-2.6 (-4.0)

Services (2.6)

-5.0 (-6.9)

-6.3 (-10.4)

Energy

European Integration, Liberalization, and Labor-Market Performance 163

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expenditure shares (an indicator of closeness of preferences) is also significant and correctly signed in most specifications. The overall explanatory power of the weighted specifications tends to be slightly weaker, which may be due to the weights themselves being influenced by factors not included on the right-hand side (such as collusive behavior or regulatory barriers). As far as product categories are concerned, the results confirm that: Price convergence in equipment goods is significantly higher than for consumer goods, whereas performance in the energy sector and in services is lagging behind. •

High- and medium-NTB sectors have been able to achieve a more significant increase in price similarity compared to the low-NTB sectors; however, equality of the coefficients estimates for high- and medium-NTB levels cannot be rejected at the 5 percent level, indicating that after controlling for other factors, no significant differences in price convergence have occurred between high- and medium-NTB sectors. •

Once we correct for the effect of catch-up and EU-integration, prices of nontradable goods do not appear to have converged significantly more than those of tradable goods; indeed the reverse appears to be true within the EU. •

Most importantly, the EU dummy is highly significant in all specifications indicating that, even after controlling for initial similarity levels and other factors, prices have converged more rapidly in the EU than elsewhere. Moreover, this phenomenon appears to have persisted even in the most recent period, in contrast with the univariate findings of table 1.1. Looking at the various subperiods (1985–1990, 1990–1993, and 1993–1996) together, we find that the EU dummy is significant in ten out of twelve cases. Only for the specification tradables-nontradables, we find no significantly larger price convergence among EU countries than among other OECD countries during the periods 1985–1990 and 1993–1996, providing partial support for the results shown in table 1.1. Finally, in those cases where the EU dummy is significant, the coefficient tends to be the lowest for the subperiod 1993–1996, again providing some evidence that the rate of price convergence has declined in recent years. Overall, the evidence on price convergence within the EU in the most recent period is mixed, but it appears that progress in price convergence slowed down relative to convergence among other OECD countries.

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1.2 Price Levels and Profit Margins Even though price structures are increasingly similar in the EU, aggregate indicators of the level of product prices suggest that price disparities are still significantly larger and price levels are on average higher than in the United States (table 1.4).19 The cross-country comparison of prices at a more disaggregated level provides broadly the same picture: with the exception of southern Europe, product prices in EU countries are generally substantially higher than in North America both in manufacturing and service industries (figure 1.1). Some of the cross-country price differences may be explained by differences in indirect taxation, as the spread in aggregate net-of-tax price levels is somewhat smaller. Moreover, differences in price levels across the EU may also be partly explained by differences in GDP per capita. Indeed, preliminary regressions show that up to 47 percent of the variation in aggregate price levels (excluding taxes) in the EU can be explained by differences in (the logarithm of) GDP per capita. Probably due to lagging productivity in services, countries with a relatively higher living standard (and a higher share of the service sector) tend to have a relatively higher Table 1.4 Price levels and standards of living (1996, EU15 = 100)

Country

Aggregate price level (including tax)

Aggregate price level (excluding tax)

GDP per capita

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom United States

110 102 123 109 110 115 76 92 88 110 104 68 83 123 86 85

108 100 117 108 107 115 82 93 87 108 106 74 87 119 87 NA

113 113 116 95 104 110 68 95 104 162 104 70 78 100 98 146

Source: EC (1999b) and OECD.

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160 Jpn

Manufacturing

140

Ice

120

100 Por 80

Den

Swi

WGer Fin Fra Aut Net OECD Swe Bel Aus Lux Gre Ita UK NZ Spa Can USA

Tur 60 40

Nor

60

80

100

120

140

160 Services

Figure 1.1 Comparative price levels in manufacturing and services Notes: 1. Services defined as non-primary, non-manufacturing industries. 1993 sectoral PPPS.

price level. The United States performance shows that this cannot be the whole story, however, as aggregate prices are 15 percent lower in the United States than in Europe, whereas GDP per capita is substantially above the EU average. Altogether, the evidence on aggregate and industry-specific price levels suggests that market integration and product-market competition is still not sufficient in the EU. Increasing competition within Europe should also lead to changes in price-cost margins and a downward convergence in markups (van Bergeijk and Haffner 1996, chapters 3 and 4). The markup of product prices over marginal costs can therefore be seen as an inverse indicator of the intensity of product-market competition. Unfortunately, measuring markups is problematic because marginal costs are difficult to observe. In addition, a lack of competition may also result in relatively high costs due to rent sharing with employees or other inefficiencies. In spite of these difficulties, a number of measures have been developed that may provide a crude indication of the level and change in markups over time.20 For example, EC (1997b) estimates the effect of the single market program on margins. Price-cost margins are found to

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be declining across sectors and across countries in the period 1985–1992 (the reduction varying between 0.2 and 0.8 percent annually, depending on the margin definition used). Assuming that these changes can be attributed to changes in policies, the results may be taken as evidence that the single-market program has had a significant cumulative impact on price-cost margins in the EU. Alternative estimates of margins by Oliveira-Martins et al. (1996), however, lead to somewhat different conclusions (table 1.5). Average markups within the EU tend to be higher than in the United States in both manufacturing and service sectors, and no generalized decline can be observed in the spread of markups in three-digit manufacturing industries over the 1970–1980 and 1980–1992 subperiods. For example, markups are rising in Germany, where markups in manufacturing are already above average, while they are declining in countries where markups are already relatively low, such as in the United Kingdom and France. By contrast, markups declined in the United States over the same period. Table 1.5 also shows that cross-country differences in markups are especially high in sheltered industries, such as electricity, gas, and water, and in the wholesale and retail sector. In the transport and construction sectors, spreads in markups are lower, but still substantially higher than in the manufacturing sector. Taken together, these figures confirm the results of the previous section, indicating that the level of price similarity and the degree of competition in sheltered sectors such as services and energy (but also in construction) display considerable differences. Even in more integrated markets such as manufacturing, convergence is far from complete. 2 Competition and Labor-Market Performance: Some Theoretical Considerations Despite the operation of the free-trade area and the single market, firms in the European countries are likely to still enjoy significant market power and this is related (see next section) to the persistence of strict regulations on entry in domestic markets and nontariff barriers to trade and investment. This section provides some theoretical underpinning to the relationships among product market competition, regulations, and economic performance, while the following section offers some empirical evidence on these relationships. The consensus among economists is that monopoly power undermines economic performance. We consider a number of channels

› fl

1.26 1.20

0.11

fl fl

›

1.50

fl › fl

1.29

2.54

1.34 1.58

1.55 1.56

1.28 1.34

1.52 1.36 1.29 1.25 2.07 1.39

› › fl fl fl ›

1.20 1.18 1.15

1.15

1.16 1.18

1.16 1.21

1.21

1.17 1.15 1.24

Electricity, gas, and water

0.22

1.26 1.16

1.09 1.17

1.28

1.39 1.25

1.19

1.26 1.09 1.19 1.06 1.12 1.23

Construction

0.8

not sign. 1.28

not sign. 1.25

not sign.

1.96 1.37

1.48

1.80 1.64 1.24 1.45 1.16 1.34

Wholesale, retail, restaurants, and hotels

0.48

1.29 1.37

1.47 1.25 1.33

1.35 1.39 1.37 1.25

1.68 1.29 1.36 1.45 1.20

Transport, storage, and communicationb

Source: Oliveira-Martins et al. (1996). Notes: a. Estimates are adjusted for material inputs and are net of net indirect taxes. Average for manufacturing based on ISIC three-digit sectoral markups (weighted by 1990 production shares). b. tTendency based on comparison of subperiods 1970–1980 and 1980–1992.

Spread

Canada

United States Japan

Non-EU Australia Norway

Italy United Kingdom

France

Denmark Finland Netherlands Sweden Germany

EU members Belgium

Manufacturing (level and tendency)b

Table 1.5 Average markups for selected sectors, 1980–1992a

168 Nicoletti, Haffner, Nickell, Scarpetta, and Zoega

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through which this could occur. First, we look at the direct effects via labor demand and wage determination, analyzing the partial and general equilibrium effects on wages and employment. Second, we investigate the impact of product-market competition on the responsiveness of wages and prices to market conditions and thus on the response of employment to macroeconomic shocks. Finally, we consider briefly the effect of product-market competition on various labormarket institutions. 2.1 The Impact of Product Market Competition on Wages and Employment This section analyzes the role of product-market competition in the long-run determination of wages and employment, both at the firm and aggregate levels. We begin by looking at labor demand. 2.1.1 Product Market Competition and Labor Demand An increase in product-market competition will typically affect labor demand in two ways. First, it will tend to make labor demand more elastic with respect to wages. This comes about because a rise in product-market competition is typically associated with a rise in the elasticity of product demand facing the firm. It immediately follows that the wage elasticity of the derived demand for labor also rises (see Hicks 1932, appendix). The second effect is simply to shift the demand for labor schedule outwards because the rise in the product demand elasticity raises the marginal revenue product of labor at given wages. To illustrate these effects, consider a simple model where firm i has a Cobb-Douglas production function and faces a constant elasticity labor demand curve. So we have production: Yi = Nai Ki1-a

(1)

demand: Yi = Pi-hYdi

(2)

where Y is valued-added output, K is the (fixed) capital stock, P is the real price of the firm’s value-added (relative to the price of GDP), Yd is a demand index. To maximize profits, the firm sets the marginal revenue product of labor equal to the wage to obtain: akPiKi1-aNia-1 = Wi

(3)

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where k = (1 - 1/h), which serves as our indicator of product-market competition (note k -1 is the mark-up of price on marginal cost). Equations (1), (2), (3) then determine Pi, Yi, Ni at the level of the firm. The solution for employment has the form 1h

N i K i = (Wi K i

1 h -1 ( 1-ak )

akYdi

)

(4)

and reveals that the wage elasticity is (1 - ak)-1, which is increasing in k, and further that a rise in k raises the right-hand side of (4) and hence shifts the firm’s labor demand outward. These outcomes are important for the determination of both wages and employment, as will be seen in subsequent sections. 2.1.2 Product Market Competition, Wage, and Employment Determination: Partial Equilibrium The question that needs to be addressed here is whether firms with market power will pay higher wages or not. Market power generates monopoly rents and these may be captured by the employees in the form of higher wages. If the labor market is perfectly competitive and the firm takes wages as given, this rent capture obviously does not occur. So if wages are to be influenced by market power, then wage determination must be noncompetitive. At this point, we are not concerned with the impact on wages if the market power of all firms in the economy changes. In this case, it is possible for wages to shift even if the labor market is perfectly competitive. If we assume that wages in the firm are bargained collectively, then, more or less whichever model of union bargaining one takes, the bargained wage is decreasing in the elasticity of labor demand. The higher the labor demand elasticity, the bigger the adverse impact on both employment and profits of any rise in wage; this leads to a lower bargained wage. For example, in the model above, if n is the labor demand elasticity (note n > 1), the elasticity of profits with respect to wages is -(n - 1). If we suppose a simple Nash bargaining model where the firm contribution to the Nash objective is profits, Pi, and the union contribution is (W - A)Ni, A being the alternative reward available in the outside labor market, the mark up of the bargained wage over A is given by (2n - 1)-1. More general models have much the same implications (see, for example, Dowrick 1989 or Layard et al. 1991, chapter 2). It is safe to argue therefore that if a single unionized firm faces increased product-market competition, its labor demand elasticity will tend to rise and its bargained wage will tend to fall. Given both the fall

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in the wage and the outward shift in the labor demand curve mentioned earlier, employment in the firm may also be expected to rise (at a given level of capital). If wages are bargained collectively within a firm, we may expect a rise in product-market competition to lead to the firm paying lower wages and employing more workers. Since most workers in Europe are covered by collectively bargained wages, this is the most relevant framework. It is worth investigating, however, whether the same outcome arises in firms where wages are set unilaterally by managers, as in the efficiency wage model. In fact, in most standard forms of the efficiency wage model, the wage outcome is independent of the market power of the firm. For example, consider the standard effort model where real revenue is R(Ei Ni), Ei being effort. Then if effort depends on wages relative to outside opportunities, so Ei = e(Wi/A), e¢ > 0, wages are determined by the Solow condition e(Wi A) = e ¢(Wi A)Wi A

(5)

This implies that wages are a fixed markup on outside opportunities with the markup depending only on the arguments of the effort function. Similarly, efficiency wage models that assume higher wages are paid to reduce the costs of quitting (or the costs of turnover more generally) lead to wages being a markup on outside opportunities, with the markup depending only on the arguments of the quit or turnover functions. For example, in models of the Shapiro and Stiglitz (1984) type, the firm’s wage is based on the no shirking condition and depends on outside opportunities and the factors determining the monitoring technology. In none of these cases does there appear to be any obvious mechanism by which the market power of the firm can enter the story. Even in this context, however, there are two, possibly remote, cases in which firms might chose to pay higher wages when they have market power and are earning higher monopoly rents. First, the effort function may depend negatively on the level of market power, and workers will put less effort into production activity if they do not share in the monopoly rents. The second alternative is that managers spend part of the monopoly rents on higher wages to make their lives more tranquil. This is an aspect of expense-preference theory (see Smirlock and Marshall 1983) and requires the existence of some mechanism whereby managers can act against the best interests of shareholders.

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In summary, it is perfectly plausible that in firms where wages are bargained collectively, an increase in product-market competition will tend to lower wages and raise employment in the firm. In firms where wages are determined competitively or are set by managers, however, this outcome is far less likely. These are partial equilibrium results. So what happens if all firms in the economy face an increase in productmarket competition? 2.1.3 Product Market Competition, Wage, and Employment Determination: General Equilibrium At the firm level it is natural to think that an increase in product market competition leads to a fall in wages and an increase in employment. And the amount by which employment increases depends on the labor demand elasticity. It is argued that in a world of unionized firms, however, where the unions bargain over employment as well as wages, if there is a general rise in product-market competition the loss of rents would be shared by the firms and workers with no overall impact on employment (see Geroski et al. 1997, for example). This argument can be readily dismissed. In a general equilibrium framework, the outside option, A, becomes endogenous. Thus, as Layard and Nickell (1990) demonstrate, the equilibrium unemployment rate in a world where unions bargain on wages and employment can be either lower or higher than that where unions bargain only over wages and the firm sets employment. Indeed, in a Cobb-Douglas constant elasticity world, equilibrium employment is exactly the same in both cases. Furthermore, it is decreasing in union power and increasing in product-market competition (see also Gersbach 1998). Another interesting general equilibrium question concerns the impact on wages of a universal increase in product-market competition throughout the economy. While an increase in product-market competition can lead to a reduction in wages at the individual firm level, this is not likely to occur in the case of an economywide increase in competition. Product-market competition reduces wages relative to the outside option, but a universal rise in product-market competition (rise in demand elasticities) also raises aggregate labor demand via the outward shifts of the firm’s labor demand curves. This leads to a large initial fall in unemployment that drives up wages across the board and in the new equilibrium, while unemployment is somewhat lower, labor demand is high enough to imply higher wages and lower profits. Thus while a rise in product market competition at the individual firm level

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can be detrimental to workers in that firm, an overall rise appears to benefit all the workers in the economy by raising both employment and wages.21 2.2 The Impact of Product-Market Competition on Macroeconomic Stability The previous section focused on a comparative static analysis in which we assumed an exogenous change in product-market competition. Labor and product-market dynamics, however, are also important. Product-market competition affects the way in which both prices and wages respond to market pressures and, in the presence of rigidities in the labor market, a slower adjustment of prices and wages may transform cyclical variations in unemployment and employment into structural changes. With price-setting, demand effects on prices tend to be stronger if firms operate in a more competitive environment (see, for example, Encaoua and Geroski 1986, or Brack 1987). Similarly, on the wages front, a higher degree of product-market competition will reduce the power of insiders in wage bargaining and thus outside conditions will have a greater impact on the wage bargain (see Layard et al. 1991, chapter 4). To see how this could affect macroeconomic stability and labor-market performance, we focus on a simple macroeconomic model. Consider the following log-linear model: aggregate demand

y=m-p

production (Okun’s law) y = -u price-setting

p - w = b 0 + b 1 y + b 11 Dy - b 2 (p - p e ) + z p

wage-setting

w - p = g 0 - g 1u - g 11 Du - g 2 (p - p e ) + zw

where y is the deviation of real output from trend, m is the money stock, p is the price level, u is the unemployment rate, zp is the supply shock to prices, zw is the supply shock to wages. This is a standard framework that is explained in detail in Layard et al. (1991), chapter 8. The key parameters are b2, g2 which capture the extent of nominal inertia (pricewage stickiness), b11, g11 which reflect the temporary impact of market tightness on prices and wages, and b1, g1 which capture the permanent effect of market tightness on prices and wages. These two latter parameters are positively influenced by the extent of product market competition.

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To analyze macroeconomic stability in the context of this model we suppose that it is subject to the following shocks: money supply supply shock

m = m-1 + em zp = z w + ep; zw = z w + ew

where em, ep, ew are iid random variables. Then if we define equilibrium unemployment, u*, as the value of u for which Du = 0, p - pe = 0, ep = ew = 0 we find u* = (b 0 + g 0 + z p + zw ) (b 1 + g 1 ) It is then possible to show that under rational expectations, the response of unemployment to the various shocks is given by:

(u - u*) =

e p + e w (b 2 + g 2 ) b 11 + g 11 (u-1 - u*) + em , b 1 + g 1 + b 11 + g 11 D D

D = b 2 + g 2 + b 1 + g 1 + b 11 + g 11 So, if b1 and g1 are increasing in product-market competition, we find that a rise in product market competition will: (1) reduce the real impact of all the shocks, since D is increasing in b1 and g1; and (2) reduce the degree of persistence of all the shocks, since the coefficient on the lagged dependent variable is decreasing in b1 and g1. It is plausible that a rise in product-market competition, therefore, increases the stability of the macroeconomy by reducing the impact of both demand and supply shocks and by lowering the persistence of these shocks (see section 4). In turn, stable macroeconomic conditions are likely to contribute to falling unemployment in countries with rigidities in the labor market where increases in unemployment that are initially cyclical tend, over time, to become structural.22 Indeed, across countries there is a positive correlation between the degree of annual volatility of unemployment and the extent of the rise over time in structural unemployment (Elmeskov et al. 1998). 2.2.1 Product-Market Competition and Self-employment In the previous section, the analysis was exclusively concerned with dependent employment. The relationship between product-market competition and self-employment is rather different. In so far as increases in product-market competition arise from the easing of product-market regulations that impose restrictions on entry, then increases in self-employment may well follow. The mechanism is

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straightforward. Product-market regulations, in the form of regulatory and administrative barriers, are likely to inhibit the creation and development of new businesses and so impede the growth of selfemployment. In many instances, however, relatively high levels of selfemployment result from the attempt to avoid excessive regulations on corporations (concerning either employment protection or administrative procedures). In these cases, regulatory reform and administrative simplification may well lead to a reduction in the share of those who are self-employed. The share of self-employment will often be more sensitive to the existence of regulatory distortions than to the overall stringency of the regulatory framework. The net effect of the latter on self-employment depends crucially on the way in which the creation of dependent and independent employment is affected by different regulations and administrative procedures. If, as is often the case, product-market and employment protection regulations as well as administrative burdens are relatively less onerous for small firms, this will encourage selfemployment and the extent of this encouragement will be reduced if these regulations are eliminated. 2.2.2 Product-Market Competition and Labor-Market Institutions Market structure and competition are likely to interact with regulations in the labor market. When firms face more competition, they are under pressure to respond more rapidly to fluctuations in the markets in which they operate. Furthermore, they have fewer monopoly rents to distribute to their employees in the form of higher wages or lower effort. This may have consequences for a number of labor-market institutions, notably unions, employment protection, and unemployment benefits. It is clear that an increase in product-market competition will reduce the rewards that unions are able to extract from firms on behalf of their members. This could lead to a fall in membership that would be reinforced if the fall in entry barriers to traditionally unionized sectors led to an increase in the number of new nonunion firms. This would be particularly important in those countries where unions are essentially synonymous with their membership, as in the United Kingdom or the United States. By contrast, in those countries where unions have a wider social or political role, as in most of continental Europe, we might expect increases in product-market competition to have less of an impact. A good example of the impact of product-market competition

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is provided by the sharp decline in union membership in the United Kingdom since 1980, which has been almost exclusively due to the exit of unionized establishment and the entry of nonunion establishments. Changes in the status of continuing establishments from unionized to nonunionized are extremely rare. Another aspect of union wage bargaining that might be influenced by product-market competition is the degree of centralization. Any form of cross-firm coordination in wage bargaining is likely to come under more pressure if the firms face higher levels of competition. This is true because, as each firm faces more competitive pressure, the likelihood that it will pay a firm to break away from a coordinated agreement will increase. For example, having a lower wage than that agreed to by the group may be the only way of surviving for less efficient firms. Thus, we might expect to see increasing pressure for decentralized wage bargaining as product market competition increases as well as the possibility of a decline in trade unionism. Turning now to employment protection legislation, if increased competition means that firms have to respond more rapidly to shocks, they will press for more flexibility in employment contracts. Workers, on the other hand, will feel that their jobs are less secure and may press for more protection, especially when the unemployment rate is high. One way around this would be for governments simultaneously to weaken employment protection legislation and raise the generosity of the unemployment benefit system. This passes on the costs of increased flexibility to the taxpayer. If this hypothesis is correct, we would expect to observe lower levels of employment protection and perhaps higher levels of benefits in those countries that encourage product-market competition by having lower levels of product-market regulation. The relationship between product-market competition/regulatory reforms and employment protection legislation (EPL) also works in the other direction. For example, the existence of thresholds for the application of EPL to collective or individual dismissals may affect the minimum efficient scale of firms (after accounting for the cost of regulations) and favor particular kinds of company structures (such as sole proprietor firms). This effect can be reinforced (or weakened) by a profile of administrative burdens favoring (or discouraging) the creation of individual firms. Different combinations of the regulatory regimes in the labor and product market, therefore, can be expected to result in different labor-market equilibrium configurations, potentially distorting the optimal level and composition of employment (e.g., between

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dependent and self-employment). At the same time, the effects of regulatory reform are likely to be different depending on the initial combination of regimes and on the sequencing of the reforms in the two markets. 3 The Impact of Product and Labor-Market Regulations on Labor Market Performance: An Empirical Investigation This section provides some empirical evidence on the relationship among product-market competition, regulations, and economic performance. It should be stressed that the degree of product-market competition is not observable and the available proxies are often endogenous to the economic performance variables to be explained.23 Here, therefore, indicators of labor-market performance are directly related to some of the policy determinants of market structure and product-market competition, such as regulatory provisions restricting entry and favoring large, possibly state-controlled, incumbents. Moreover, we consider certain regulations in the labor market (e.g., EPL) that are assumed to affect the behavior of agents in the product market, interact with product market regulations, and affect labor-market outcomes. The potential linkages between the regulatory environment in the product and labor markets and outcomes in the labor market are manifold and complex. Product-market regulations may affect firm behavior in three main ways: by increasing the costs of producing any given level of output (e.g., compliance or avoidance costs); by affecting market structure (e.g., legal limitations on the number of competitors); and by changing the incentive structure (e.g., public ownership). In general, the influence of product-market regulation will be reflected in labor demand and/or wage determination. Labor-market regulations can have a powerful impact on labor-market outcomes by changing the set of constraints under which labor demand and supply decisions are taken. This section has two main objectives: (1) to assess whether available indicators of product and labor-market regulations help to explain cross-country/sector differences in performance in OECD countries; and (2) to empirically identify some of the channels through which the impact of regulation on performance may come about. The analysis is based on a novel set of cross-country comparable indicators of regulation in the labor and product markets. These

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indicators have been constructed using data collected from a variety of national and published sources (see box 1).24 Product-market indicators provide information on the degree of state control, barriers to entrepreneurial activity, and barriers to trade and investment. Labor-market indicators provide information on EPL for permanent and temporary workers and on other policies affecting the use of labor (such as the tax and benefit systems) as well as on institutional characteristics of the labor market, such as wage bargaining systems and unionization. It should be stressed at the outset that these indicators are rough approximations of the regulatory and institutional stance across OECD countries. They concern only economic and administrative regulations, ignoring other important regulatory areas in which the available crosscountry information is scarce, such as health, safety and environment, and they do not include information on financial market and land-use regulations. In addition, the indicators deal only with formal regulations and, therefore, cannot account for enforcement issues. Taking into account these additional factors could have repercussions on the country rankings in the different regulatory areas. It is also important to note that, with a few exceptions, the indicators of product market regulation used in this section concern the Box 1 A Classification of Product and Labor-Market Regulations This analysis is based on families of indicators established according to a taxonomy of regulatory interventions in the product and labor markets. The indicators have a pyramidal structure. At the top they summarize the regulatory environment in either the product or the labor market (as far as employment-protection legislation is concerned). At the next level they summarize information about broad classes of regulatory interventions (e.g., inward- or outward-oriented product-market regulations, EPL for permanent or temporary workers). At the intermediate and lower levels, they summarize information about types of interventions within these broad classes (e.g., state control of business-sector activity) as well as their specific modalities (e.g., public ownership or interference in private firms); at the bottom they coincide with individual features of the regulatory regimes (e.g., scope of the public enterprise sector or use of command and control regulations). The bottom level generally corresponds with the basic units contained in the regulation database. To minimize discretion in the weighting procedures, the summary indicators were constructed aggregating their lower-level components by means of factor-analysis techniques. Aggregation through factor analysis ensures

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that the weights assigned to the detailed indicators depend on the contribution of each indicator to the explanation of the total variance in the data. As a result, the amount of variance explained by the summary indicators is maximized. Up to seventy indicators on specific regulatory measures were used in the construction of the overall product and labor-market indicators. All indicators were ranked on a 0–6 scale going from least to most restrictive regulatory environments. See Nicoletti et al. (1999) for more details on the methodology used to construct the summary indicators. The following hierarchy of indicators was established: Product-market regulation Inward-oriented policies State control Public ownership Size of public enterprise sector Scope of public enterprise sector Control by legislative bodies Interference in private firms Special voting rights Use of command and control regulation Barriers to entrepreneurship Administrative Licenses and permits system Existence of simplification programs Communication and enforcement of procedures Administrative burdens on business Administrative burdens for corporations Administrative burdens for sole proprietor firms Legal barriers to entry Outward-oriented policies Barriers to trade and investment Regulatory and tariff barriers Regulatory barriers Tariffs Other trade barriers Non tariff barriers Ownership barriers Discriminatory procedures

Employment-protection legislation EPL for permanent workers Regular procedural inconveniences Procedures Delay to start a notice Notice and severance Notice period Severance pay Difficulty of dismissal Definition of unfair dismissal Trial period Difficulty at 20 years tenure Reinstatement obligations EPL for temporary workers Fixed-term contracts Valid dismissal other than “objective” Max. n. of successive contracts Max. cumulated duration Temporary work agency employment Types of authorised work Restrictions on n. of renewals Maximum cumulated duration

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nation-wide level and refer to a single year (1997 or 1998, depending on the country and the indicator). This makes it impossible to relate labor market outcomes to the evolution of the regulatory environment over time and to observed differences in industry-specific regulations, somewhat constraining the empirical analysis. On the other hand, more information on time patterns of labor market regulations and institutions is available, although full time-series are sometimes lacking. Specifically, indicators of EPL exist for the late 1980s and the late 1990s, but these data were supplemented with information about the timing of major reforms to construct a time-varying indicator for each country. 3.1 Regulation and Performance Patterns Across the OECD Despite regulatory reforms in most OECD countries over the past decade, product-market regulations still vary substantially across the OECD. Figure 3.1 shows cross-country differences in the overall regulatory environments and along three axes of regulation: state control, barriers to entrepreneurial activity, and barriers to trade and investment. The state control indicator summarizes public ownership patterns and command and control measures; the indicator of barriers to entrepreneurship summarizes legal and administrative obstacles to entry into product markets, such as limitations on the allowed number of competitors and administrative burdens on the creation of businesses; the indicator of barriers to trade and investment includes tariff and nontariff barriers as well as legal, regulatory, and procedural restrictions on FDI (see box 1). The highest cross-country variations are found in state control and (although to a lesser extent) in barriers to entrepreneurship, whose most variable component concerns administrative burdens on business start-ups.25 These two indicators are also significantly correlated across countries.26 By contrast, with a few exceptions, countries are more homogeneous in their attitudes toward trade policies, not least because of the different rounds of trade negotiations and participation of many OECD countries in multilateral agreements and supranational institutions. Differences in labor-market regulations are equally significant. These regulations are still determined essentially at the domestic level even in the EU, and (as shown in the next section) their convergence across countries can hardly be induced by market pressures from rising economic integration. Figure 3.2 shows the evolution of indicators of EPL for permanent and temporary workers during the past decade. Broadly

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Product-market regulation2

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Figure 3.1 Differences in product-market regulation1 Notes: 1. Country scores reflect the results of factor analysis. Summary indicators are obtained weighting factors by their relative contributions in explaining the total variance of the factors. All variables were cast in 0–6 scale from least to most regulated. 2. Factor analysis applied to summary indicators of state control, barriers to entrepreneurial activity, and barriers to trade and investment. 3. Factor analysis applied to basic indicators.

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Panel A. Regular and temporary contracts Strictness of EPL in 1998 5

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Figure 3.2 Differences in employment-protection legislation Notes: 1. The indicator is the weighted sum of indicators referring to several aspects of employment protection legislation for regular contracts as well as for fixed-term and TWA contracts. The indicators range from 0 (least restrictive) to 6 (most restrictive). The weights are extracted from a factor analysis of basic indicators. Source: Nicoletti et al. (1999).

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speaking, there has been a tendency for a significant deregulation of temporary contracts, while only modest changes have been recorded for permanent contracts. Only Finland and Spain have significantly eased regulation for permanent workers. In a number of countries (e.g., Japan, Germany, Italy, Belgium, Finland, New Zealand, and Sweden) fixed-term contracts can now be used in a wider range of situations than at the beginning of the 1990s. Moreover, in Denmark and Sweden, all restrictions on the types of work for which temporary work agency employment is legal have been removed and in Italy and Spain temporary work agencies have become legal for certain types of work although they previously were illegal under all circumstances.27 Interestingly, restrictive product-market environments are matched by restrictive employment-protection policies (see figure 3.3). There is a strong correlation across countries between the overall indicator of product market regulation (including several of the specific regulations described above) and a summary indicator of EPL (including measures for both permanent and temporary workers).28 This finding tends to confirm the line of reasoning proposed in the previous section concerning the possible linkages between regulatory policies in the two markets. For example, restrictive product market regulations may make it less urgent for entrepreneurs to lobby for and for workers to accept an easing of EPL. On the other hand, by increasing the speed of Employment-protection legislation 4 Por 3.5 3

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labor market adjustment, less restrictive EPL may make regulatory reform in the product market easier to implement.29 The strong correlation between regulatory regimes in the labor and product markets also suggests that their influence may have compounded effects on labor market outcomes, making regulatory reform in only one market less effective than simultaneous reform in the two markets.30 In any event, the high correlation of the summary dimensions of regulation makes it difficult to identify empirically their specific effects on labor market performance. 3.2 The Impact of Regulation on Labor-Market Performance As argued in the previous section, overly restrictive product-market regulations may shift and twist the aggregate labor-demand curve possibly leading to lower aggregate employment. Similarly, unduly restrictive EPL can reduce the equilibrium level of employment and affect its dynamics over the business cycle (see box 2). The influence of regulation on the dependent and independent segments of the labor market, however, should also be distinguished. Labor-market regulations are likely to have a direct effect on dependent employment, while productmarket regulations can be expected to affect dependent employment indirectly through their effect on market structure and product-market competition. On the other hand, independent employment may suffer directly from overly restrictive product-market regulations, since regulatory and administrative barriers are likely to make the creation and development (and sometimes even exit) of businesses difficult. Labormarket regulations may only affect independent employment indirectly, especially when they are asymmetric, as is the case when regulations apply to workers in firms above an employment threshold which may encourage the creation of smaller-sized enterprises. Another way to look at the potential effects of regulations on labormarket performance is to focus on wages. Regulations on the labor and product markets affect wage formation by creating product-market rents that could be eventually shared with employees in the form of high wages. It is, however, difficult to disentangle the effects on wages of product-market rents from those stemming from other factors. Labor is not homogeneous and different industries require labor inputs of varying skill levels and other worker-specific characteristics. It is first necessary to adjust for the characteristics of the work force across industries, although such adjustment is bound to be incomplete. If such

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Box 2 Employment-Protection Empirical Evidence

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Performance:

In all OECD countries, rules and regulations govern the employment relationship between workers and firms. Those referring to hiring and firing practices are often referred to as employment-protection legislation (EPL). They concern unfair dismissals, restrictions on layoffs for economic reasons, compulsory severance payments, minimum notice periods, and administrative authorizations. EPL may affect the equilibrium level of employment as well as its dynamics over the business cycle in different ways. By reinforcing job security, EPL may enhance productivity performance as workers will be more willing to cooperate with employers in the development of the production process (Akerlof 1984). To the extent that EPL leads to long-lasting work relationships, it may encourage employers to provide training to workers with potentially beneficial effects on human capital and labor productivity. EPL may also be a way to internalize the social costs of dismissals by moving the social burden of reallocating a worker to another job closer to the firm’s profitability criteria (Lindbeck and Snower 1988). If these regulations are strict, however, as in many European countries, firms may become more cautious about adjusting their work force with the ultimate effect of reducing labor turnover, that is, movements from employment to unemployment and from unemployment back to employment (Bertola 1992). In addition, if hiring and firing costs are not transferred into lower wages, total labor costs for the firms increase and this may lead to a lower level of employment, other things being equal. Empirical evidence on the impact of employment protection legislation is mixed, not least because of the lack of suitable data on the enforcement and evolutions of regulations over time (Bertola et al. 1999). A clear distinction exists between the potential effects of EPL on employment turnover as distinguished from the equilibrium level of employment (unemployment) and its composition (temporary/permanent; youths /prime-age workers, etc.). There is consistent empirical evidence that strict employment protection legislation reduces unemployment turnover. Under strict EPL provisions, the unemployment pool is more stagnant, with fewer people being laid off, but also fewer unemployed people getting new jobs (Bentolila and Bertola 1990; Blanchard and Portugal 1998; and Nickell and Layard 1998). The effects on employment turnover are less clear cut: Bertola and Rogerson (1997) and Boeri (1999) found similar job creation and job destruction rates across countries with different EPL regimes but lower unemployment inflows in flexible labor markets. As stressed in Boeri (1999) and OECD (1999c), a possible explanation is that strict EPL may foster job-to-job shifts rather than overall (continued)

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employment turnover insofar as employers and workers will seek direct shifts from one job to another without intervening unemployment spells to avoid the associated dismissal and search costs. Some studies (e.g., Scarpetta 1996) suggest a detrimental effect of strict EPL on the level of employment to working-age population ratios. Nickell and Layard (1998) indicate that this may be partially due to the low participation rates in southern European countries, which also have strict EPL. Participation rates may be low, especially among youths, however, precisely because employment prospects are lower the stricter the EPL system. No consensus exists on the overall impact of EPL on unemployment. Part of the disagreement stems from the use of different models and/or indicators. Disagreement persists, however, even among authors using the same indicator (the OECD summary index, see OECD 1994a, 1994b, 1999a). A recent study (Elmeskov, Martin, and Scarpetta 1998) suggests a somewhat more robust effect, however, on unemployment if changes in EPL over the past two decades are taken into account. These studies are based on formal EPL but do not take into account the enforcement of this legislation. Here, Blanchard and Jimeno (1995) point to the very different degree of enforcement in Spain compared with Portugal despite similar summary indicators of the stringency of EPL. Di Tella and MacCulloch (1998) use data based on surveys of businesspeople over the 1980s and suggests a significant effect of strict EPL regulations on both unemployment and long-term unemployment. Their results, however, may be sensitive to changes in business’s perceptions over the cycle. Boeri (1999) also suggests that countries with stronger employment protection for regular contracts tend to display a bimodal tenure distribution with either very short or very long tenures. In countries where fixed-term contracts are liberalized, a large number of employees with fixed-term contracts tend to insulate permanent workers from adjustment (Bentolila and Dolado 1994), thereby increasing their bargaining power and the corresponding wage pressures.

adjustment still indicates the existence of wage premia, it may be that they arise from “efficiency wages” whereby employers voluntarily pay high wages to attract more committed and reliable workers. Higher wage rates are traded off against higher productivity and lower personnel administration costs. In that case, marginal costs in the long run might not be higher than if lower wages were paid to a lower quality work force. It is therefore also important to determine not only whether or not wage premia exist but also whether they arise from the sharing of rents from imperfect competition or efficiency wages being paid in an essentially competitive environment. In either case, though, (and the

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two are not mutually exclusive), there are likely to be interactions with labor markets that will vary in size and severity depending on institutional arrangements on wage bargaining and rigidities in labor markets. To test empirically the effects of regulations in the product and labor markets on performance we use simple bivariate correlations and econometric techniques. In the latter case, a two-stage approach has been used based on cross-country and sectoral data. In the first stage, we apply panel data techniques to estimate reduced-form or “structural” models accounting for those determinants of employment and wages for which time-series and/or sector-specific information is available. The aggregate employment equation includes policy and institutional factors as well as the time-varying indicator of EPL. The industry-specific wage equations include only “structural” factors (such as productivity), since no sectoral detail is available for EPL. In the second stage, unexplained country-specific effects are related (by means of simple bivariate correlations) to the indicators of labor and/or product market regulations. The analysis is performed on a sample of OECD countries (excluding Korea, Mexico, and the central and eastern European members, for which time-series data were lacking or unreliable) over the 1982–1995 period. Cross-sector estimates are based on a panel of eleven manufacturing and nonmanufacturing industries (at the two-digit level) and four service industries (at the one-digit level). The two-stage approach has the advantage of making the best use of the available information. The first stage exploits the cross-country, time-series—and for the wage equation the cross-industry—dimensions and makes it possible to identify the part of labor-market performance that can be explained by available structural indicators. The second stage relates the unexplained cross-country component to labor and/or product market regulations, for which only the economywide and cross-sectional information is available. The two-stage approach creates an implicit (and somewhat arbitrary) hierarchy between the effects of regulations on the product and labor markets. The existence of a time dimension in the EPL variable, however, makes it preferable to use it in the first stage since it is likely to lead to better identified estimates of the parameters of interest. The lack of the time dimension in the indicators of product-market regulation implies that only a random-effects specification might be estimated in one stage. The

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results of such a regression would suffer from multicollinearity due to the high correlation between the indicators of product market regulation and EPL. To assess empirically the impact of regulations in the labor and product markets on the composition of employment we look at the share of self-employment in total employment in the overall business sector as well as in industry and services.31 In this context, a single-stag approach seemed to be more appropriate, since the focus is on the determinants of cross-country differences in the long-run composition of employment, which are unlikely to be affected in the short run by changes in regulations. 3.2.1 Regulation and Employment Figure 3.4 considers the employment rates (employment over the working age population) in the total economy as well as in the nonagricultural sector and in the non-agricultural business sector in 1995. These employment rates are plotted against the summary indicators of labor and product market regulations. There are several reasons for excluding the agricultural sector. First, our regulatory indicators do not include provisions (such as those contained in national and supranational agricultural policies) that are most relevant for explaining employment in this sector. Second, the sensitivity of employment to economywide regulations is likely to have peculiar features in agriculture due to the predominant presence of self-employment. Finally, the exclusion of agriculture allows avoiding spurious relationships between employment and regulations insofar as, over the sample period, the largest declines in agricultural employment have been experienced by countries characterized by restrictive regulatory environments. We also focus on the business sector because this is where regulations are most likely to affect employment decisions.32 In the econometric analysis done thereafter we estimate a reduced-form employment equation in which we consider total employment but also control for the size of government sector employment. The bivariate plots suggest that countries with restrictive EPL and product-market regulation tend to have lower employment rates and the negative relationship is even stronger if nonagricultural business sector employment rates are considered. The inverse relationship between employment rates and labor and product-market regulations is confirmed by the calculation of the simple correlation coefficients of the nonagricultural business-sector employment rate (in 1995) and its

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growth rate against several indicators of product-market regulations and EPL (see table 3.1).33 Interestingly, both the level and the rate of growth of the employment rate display a significantly negative correlation across countries with the summary indicators of product and labor-market regulations. In particular, EPL regulations for both permanent and temporary workers are negatively correlated with the employment rates and those for permanent workers appear to affect negatively the changes in employment over the past decade. Inwardoriented product-market regulations are associated with both a lower Table 3.1 Simple correlations between regulatory indicators and employment rates (nonagricultural business sector)

Regulatory indicators

Employment rate, 1995

Growth in employment rate, 1982–1995

EPL Regular workers Temporary workers

-0.61* -0.44* -0.64*

-0.45* -0.46* -0.37*

Product market regulation Inward-oriented policies Outward-oriented policies

-0.71* -0.72* -0.08

-0.43* -0.42* -0.10

State control Public ownership Interference in private firms Size of public enterprise sector Scope of public enterprise sector Special voting rights Use of command and control regulation

-0.73* -0.71* -0.55* -0.62* -0.61* -0.43* -0.48*

-0.39* -0.44* -0.23 -0.69* -0.40* -0.04 -0.23

Barriers to entrepreneurship Administrative transparency Administrative burdens on business startups Legal barriers to entry Administrative burdens for corporations Administrative burdens for sole proprietor firms

-0.17 -0.04 -0.25 0.05 -0.37 0.06

-0.44* -0.55* -0.26 0.12 -0.15 -0.29

Barriers to trade and investment Regulatory and tariff barriers Other trade barriers

-0.20 -0.14 -0.18

-0.12 0.07 -0.49*

Source: Authors’ estimates. Note: * indicates significance at the 10 percent level. Observations range from 19 to 22 depending on the indicator.

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level and a slower growth of employment in the business sector. Unsurprisingly, state-control regulations display a particularly strong negative correlation with the level of employment, while employment growth seems to be more affected by barriers to entrepreneurship and regulatory barriers in the area of trade and foreign direct investment. The correlations shown in table 3.1 are at best only suggestive of an underlying relationship, since employment rates and regulatory indicators may be all driven by other factors ignored in the bivariate analysis, which are either unrelated to public policies (such as institutional features of the labor market) or related to public policies not considered above (such as taxation and social policies). To account for some of these factors in exploring the possible linkages between regulation and the employment rate, the following reduced-form equation was specified: erit = m 0 + m i + a ergit + Â b k x kit + g zit + j git + n it

(6)

k

where i indexes countries, t the years, erit is the nonagricultural employment rate, ergit is the share of public employees in the working-age population (the public employment rate), xit is a k ¥ 1 vector of policy and institutional variables, zit is the summary measure of EPL, git is the output gap included to account for changes in the business cycle,34 m0 is a constant, mi is the country-specific effect not accounted for by the available explanatory variables, and nit is the usual error term. All explanatory variables are time varying. The equation can be interpreted as the reduced-form deriving from a labor-market equilibrium condition in wages and, therefore, relates employment to labor-market institutions, taxation and social policies, and regulations deemed likely to affect labor-market conditions. We include the public employment rate on the right-hand side of the equation to test for the hypothesis that only the business-sector employment rate is affected by policy institutions and labor and product-market regulations. In other words, a unitary coefficient on the publicemployment rate would fully justify the focus on the businesssector employment rate for the study of the effects of institutions and regulations on employment. Institutional variables include a measure of union density as well as a summary measure of wage bargaining that brings together the different features of coordination and the levels of bargaining into a single indicator. For example, the summary measure allows us to consider cases where cross-industry coordination

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between employers and unions in an industry bargaining setting (e.g., Germany and Austria and, more recently, Ireland and the Netherlands with centralized incomes policy agreements) may be an alternative, or functionally equivalent, to centralized systems. Tax and social variables include a measure of the tax wedge and a synthetic indicator of the generosity of the unemployment benefit system. The labor-market regulation variable has been constructed combining the 1990 and 1998 summary indicators of EPL with information about the timing of EPL reforms (concerning both temporary and regular workers) in OECD countries.35 Table 3.2 shows the estimates of equation (6) on a panel of nineteen OECD countries over the 1982–1995 period.36 The F-test at the bottom of the table suggests that the null hypothesis of a unitary coefficient for the public employment rate is rejected at the 5 percent level. There is some evidence that, over the period of time considered in the analysis, public employment crowds out private employment but the estimated effect is rather modest.37 This is obviously a partial analysis, and to the Table 3.2 Reduced-form employment rate equation, 1982–1995 (nonagricultural employment/ working age population, fixed effects) Independent variables Government sector employment rate Unemployment benefits: repl. rate Union density Corporatism (intermediate) Corporatism (high) Employment protection legislation Tax wedge Output gap

Coeff. 0.71 -0.11 -0.07 -1.77 0.74 -1.35 -0.09 0.61

Number of observations Number of countries

223 19

F-test (fixed effects) F-test (gov. sect. empl. = 1)1

129.1*** 6.1**

St. err.

T-stat.

0.12 2.66 0.03 0.44 0.41 0.71 0.05 0.04

6.03*** -4.22*** -2.67*** -4.05*** 1.81* -1.91* -1.73* 17.1***

Source: Authors’ estimates. Notes: Each coefficient represents the change in the employment rate implied by a unitary change in the independent variable. ***: statistically significant at the 1% level; **: at the 5% level; *: at the 10% level. 1. The null hypothesis is that the coefficient of the government sector employment rate is equal to 1.

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extent that public employment is financed by increased tax rates— whose coefficient is negative and statistically significant—the detrimental effect of public employment on business-sector employment may become larger. Moreover, the estimated coefficients for the measures of centralization-coordination (decentralized countries are the reference group) give some support to the hump-shaped hypothesis (Calmfors and Driffill 1988), whereby both highly centralizedcoordinated systems and fully decentralized systems help to restrain the wage claims of insiders, thereby leading to higher employment rates than in intermediate systems.38 The estimated coefficients of the other policy and institutional variables are generally significant and signed according to priors, with union density, unemployment benefits, and tax wedges having a negative impact on the employment rate. More importantly, even controlling for these factors, the time-varying measure of EPL retains a negative and significant (at the 10 percent level) impact on the employment rate, confirming the results of the bivariate analysis. Thus restrictive hiring and firing regulations appear to affect labor demand and supply in ways that reduce the equilibrium rate of employment. The influence of cross-country differences in product-market regulations on the comparative levels of the nonemployment rates were investigated by relating the estimated country-specific effects to the regulatory indicators. As expected, the significant correlations found in the previous bivariate analysis are weakened once controlling for several factors affecting cross-country differences in employment. Correlations generally remain correctly signed, however, and a few of them retain significance, especially when outliers are eliminated (table 3.3). Due to lags in the effects of structural policies on market outcomes, in countries (such as Ireland) where radical product-market reforms have been implemented toward the end of the sample period, the end-ofperiod measure of regulation necessarily bears little relationship with the average employment rate even if a strong causal link between regulations and employment were to exist. Therefore, bivariate correlations have been computed both with and without this country. Although the summary indicator of product-market regulation has a low level of significance, several of its components are significant at the 10 percent level (or less). The most important negative productmarket influences on the employment rate are the presence of a high degree of state control in business-sector activities, especially through regulations interfering in the activity of private (or privatized) business

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Table 3.3 The employment rate: Simple correlations between country-specific effects and regulation (nonagricultural business sector, 1982–1995)

Regulatory indicators

Including outliers

Excluding outliers

Product market regulation Inward-oriented policies Outward-oriented policies

-0.16 -0.30 0.38

-0.30 -0.40 0.31

State control Public ownership Interference in private firms Size of public enterprise sector Scope of public enterprise sector Special voting rights Use of command and control regulation

-0.32 -0.21 -0.34 0.05 -0.33 -0.60* -0.17

-0.42* -0.24 -0.49* 0.01 -0.39 -0.67* -0.33

Barriers to entrepreneurship Administrative transparency Administrative burdens on business startups Legal barriers to entry Administrative burdens for corporations Administrative burdens for sole proprietor firms

-0.02 0.24 -0.36 0.26 -0.54* -0.17

-0.08 0.28 -0.53* 0.35 -0.72* -0.42

Barriers to trade and investment Regulatory and tariff barriers Other trade barriers Regulatory barriers Nontariff barriers

0.38 0.31 0.22 0.10 -0.12

0.31 0.28 0.14 0.04 -0.08

Source: Authors’ estimates. Note: * indicates significance at 10 percent levels. Outlier country is Ireland.

enterprises and administrative burdens on business start-ups. Hence, entry restrictions due to costly and opaque administrative practices and the distortion of market mechanisms associated with the excessive presence of the state in the business sector would appear to explain the pattern of employment rates across OECD countries over and above the policy, regulatory, and institutional factors specific to the labor market. These results should be seen in the light of the strong positive correlation between the summary measures of EPL and productmarket regulation, which makes it difficult to identify their separate contribution to the explanation of cross-country differences in employment rates.

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3.2.2 Regulation and Wages Several empirical studies have found that wages differ systematically across sectors, even after controlling for observable worker characteristics.39 Evidence from micro studies suggests that industry-specific wage premia are a significant component of total compensation, particularly in Canada and the United States, while it is of lesser importance in many EU countries. Even in European countries, however, the industry-specific component in wages is estimated to be 10 percent or higher of total compensation of employees. Most studies also suggest that wage premia are persistent over time. Empirical studies devoted to wage premia often have a fine sectoral breakdown, focusing on the manufacturing sector in a given country. Significant differences exist across countries and sectors in real wages, however, even after controlling for labor productivity and differences in purchasing power (i.e., using comparative measures of unit labor costs). The principal aim here is to shed some light on the potential role played by EPL and product-market regulations in explaining crosscountry differences in industry-specific unit labor costs. To this end, we estimate wage premia across two-digit manufacturing sectors and across countries.40 The dependent variable is the log-wage (in US $) and the explanatory variables are the log-productivity (in sectoral PPPs), the expenditure for R&D, the share of self-employed in the industry, the degree of import penetration and an aggregate demand variable (the output gap).41 These estimates are certainly crude approximations of wage premia and are likely to offer only broad-brush indications, at least as compared with those obtained in other studies using microdata and much more detailed information on the human capital and demographic features of workers as well as work-place characteristics.42 Our analysis makes it possible, however, to relate the estimated wage premia to the available cross-country indicators of labor and productmarket regulations. As in the employment equations, we adopt a twostage approach in which industry-specific variables are used to estimate wage premia and the latter are correlated to the economywide indicators of EPL and product market regulation. The following equation was estimated for a panel of fifteen OECD countries in nine manufacturing industries over the 1982–95 period: rwist = ais + b1lpist + b2RDist + b3seist + b4impenist + b4gapist + eist

(7)

where: i indexes countries, s indexes the manufacturing industries, t indexes the year, rwist is the industry real wage (in PPP US $), lpist is the

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industry real value-added per worker (in sectoral PPPs), RDist is the share of R&D expenditure in value added, seist is the share of selfemployed in total employment, impenist is the indicator of import penetration (that is the ratio of import to absorption adjusted by country size by regressing the indicator over the absolute level of GDP and a constant), gapist is the output gap. Two specifications are presented in table 3.4: one using logarithms of both real wages and real productivity, and one using real wages and productivity relative to their average values in United States manufacturing. The equation was estimated by panel data techniques and includes fixed effects (country-industry) to control for omitted specific effects. In a second stage, the industry-specific fixed effects are correlated sector by sector across countries with indicators of labor and productmarket regulations. Estimates of the relative wage specification are somewhat different but do not change the basic conclusions of this exercise. Apart from the output gap, the equations include only explanatory variables that have a sectoral dimension, since the principal aim of these first-stage estimates is to account for as much sectoral variation as possible. The regression results for the two specifications are shown in table 3.4. The F-tests reported at the bottom of the table always reject the null hypothesis that the effect of country-industry dummies is jointly zero, suggesting that the country-industry affiliation has a large impact on real wages, even after controlling for labor productivity and other structural factors. As expected, differences in labor productivity explain a great deal of the variations in real wages across industries and countries. The coefficient on labor productivity is close to unity and, indeed, this restriction cannot be rejected by a Wald test at conventional levels of significance. Therefore, in our sample a specification of the equation in which the dependent variable is the labor share could be considered to be equivalent to equation (7). The other structural factors also play an important role. The results provide some empirical support for the hypothesis that the introduction of new products or processes—proxied by the R&D intensity— gives rise to temporary market power, and that the quasi-rents can show up in wages.43 Somewhat surprisingly, the results also indicate a positive (although not significant) association between the real wages and import penetration. Given the high level of intraindustry trade within the countries included in the sample, this could be explained by the fact that high-import sectors are often those with the widest

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Table 3.4 Wage equations, 1982–1995 (two digits manufacturing industries, fixed effects) Log equation1

Relative wage2

Independent variables

Coeff.

St. err.

T-stat.

Coeff.

St. err.

T-stat.

Labor productivity Research and development Share of self-employed Import penetration Output gap

0.97 2.84 -0.63 0.03 1.10

0.04 0.50 0.43 0.03 0.17

22.07 5.62 -1.47 1.24 6.32

0.33 0.27 0.15 0.03 1.07

0.07 0.03 0.30 0.02 0.12

5.05 9.66 0.49 1.41 8.98

Number of observations Number of sectors Number of countries

1,440 9 15

1,440 9 15

F-test (fixed effects)

12.6***

17.9***

Source: Authors’ estimates. Notes: ***: statistically significant at the 1 percent level; ** at the 5 percent level;* at the 10 percent level. 1. Real wages and labor productivity are in logarithm form. 2. Real wages and labor productivity are relative to the (PPP) U.S. manufacturing averages.

product differentiation, which may give rise to temporary market power much in the same way as in R & D intensive industries. Table 3.5 presents the simple correlations between the estimated country-sector specific effects and indicators of product and labormarket regulations for the nine two-digit manufacturing industries. The top panel includes correlations for all countries in the sample, while the bottom panel reports the same correlations excluding the countries that appeared to be outliers in the sample (Portugal in food and textile and Austria in basic metal industries). Overall, excess wages are positively correlated with both labor and product-market regulations. Many of the correlations, however, have relatively low levels of statistical significance. Using the whole sample of countries, correlations with product-market regulations are significant (at 10 percent levels) in the food industry, the paper and printing industry, the nonmetallic mineral industry, the fabricated metal products industry, and the other manufacturing industry, while significant correlations with EPL indicators can be detected in the food industry (after excluding the outlier country), the fabricated metal products industry, and the other manufacturing industry. Among

EPL (1998) EPL, permanent workers (1998) EPL, temporary workers (1998)

Barriers to trade and investment Regulatory and tariff barriers Nontariff barriers

Product market regulation State control Barriers to entrepreneurship Legal barriers to entry Administrative burdens for corporations Licences and pemits system Communication and enforcement of administrative procession

0.41 -0.45

0.46*

-0.49* 0.29 0.32

-0.05

-0.11

0.33

0.04

-0.08 0.41

0.05 0.25

0.03 0.04

0.13

0.29 0.40 0.17

0.27 0.43* -0.16

0.04

0.13

0.01 -0.05

-0.11 -0.08

-0.38 -0.26

0.24

-0.10 0.00

-0.02

0.18

0.36 0.30 0.36

0.37

0.16 0.09

0.13

0.01

-0.25 0.37 0.28 0.39

0.08

0.25

0.22 0.05

-0.54*

0.43 0.33 -0.05

3500 Chemical, petroleum, rubber, and plastic

0.58* 0.55* 0.05 0.47* -0.04

Paper and printing

3400

0.36 0.32 -0.16 -0.03

Wood furniture

Food, beverage, and tobacco

3300

3200 Textile, wearing, apparel, and leather

3100

Table 3.5 Regulation and wage premia1 (manufacturing industries, two digits)

0.10 0.24 0.27 0.16

-0.37 -0.26 -0.42

0.04

0.06

0.28 -0.26

0.15 -0.15

0.32 0.29 -0.02

Basic metal industries

3700

-0.66*

0.31

0.34

0.08 0.25

0.07 0.44* -0.50*

0.45* -0.63*

Nonmetallic, mineral

3600

0.66* 0.59* 0.61*

-0.54*

0.33

0.13

-0.17 -0.09

0.48* 0.13

0.56* 0.48* -0.02

Fabricated metal products

3800

0.67* 0.70* 0.55*

-0.42

0.60*

0.26

-0.06 0.61*

0.23

0.34 0.17 0.24 -0.08

Other manufacturing

3900

-0.45*

-0.59* 0.29 0.32

0.23

0.41

0.46*

0.33

-0.08

-0.05

0.16

0.52* 0.29

0.14

0.41

0.44*

0.05 -0.28

-0.08

0.11 0.21

0.48 0.24

0.39

0.22 -0.11

0.29 0.40 0.17

0.17 0.49* -0.17

0.49 0.46 -0.16

0.01 -0.05

0.12 0.04

Notes: * indicate significance at the 10 percent level. Observations range from 19 to 22 depending on the industry and the statistical significance is affected by the sample size. 1. The wage premia is the country-sector residual identified by the relative wage equation in Table 3.4. 2. The outliers are: Portugal in sectors 3100 and 3200; Austria in sector 3700.

EPL (1998) EPL, permanent workers (1998) EPL, temporary workers (1998)

Product market regulation State control Barriers to entrepreneurship Legal barriers to entry Administrative burdens for corporations Licences and permits system Communication and enforcement of administrative procession Barriers to trade and investment Regulatory and tariff barriers Nontariff barriers

Excluding outliers2

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product-market regulations, legal barriers to entry exert a strong effect on wage premia in both fragmented industries, such as food and nonmetallic mineral, and segmented industries, such as paper and printing. Regulatory and tariff barriers to trade are positively associated with wage premia in high import-high product differentiation industries, such as food and other manufacturing. And state control affects wage premia in the paper and printing and fabricated metal products industries. Surprisingly, some regulatory provisions display a significantly negative correlation with the estimated wage premia: nontariff barriers appear to be associated with lower wage premia in almost all sectors, while administrative burdens are associated with lower wage premia in the wood and nonmetallic mineral industries. Administrative burdens and opacities in fragmented industries may favor the development of individual enterprises for which costs and procedures are often lower (see below for more evidence on this), thereby lowering industry wages. On the other hand, the result on nontariff barriers appears harder to explain. 3.3 The Impact of Regulation on Employment Composition Differences in the regulatory environments faced by workers and firms may also affect the composition of employment (see box 2). Here we focus on the effect of EPL and certain kinds of product-market regulations on the share of self-employed in nonagricultural business employment (henceforth the self-employment rate). Specifically, we consider the effects of administrative burdens affecting the start-up of corporations and sole proprietor enterprises in an asymmetric way, thereby favoring the development of one or the other form of company structure. To the extent that excess burdens fall on corporations, the creation of individual enterprises will be encouraged, thereby increasing the self-employment rate. Figure 3.5 shows the cross-country bivariate plot of the selfemployment rate against an indicator of excess burdens on corporations.44 The self-employment rate appears to be positively related to excess burdens, safe for Belgium where self-employment is boosted by fiscal distortions despite the relatively high administrative burdens falling on start-ups of sole proprietor firms. Table 3.6 shows that the correlation between excess burdens and the self-employment rate is significant at the 10 percent level. This table points out that selfemployment rates are also significantly correlated with the summary indicator of product-market regulation, an indicator of the scope of the

Excess regulation for creation of corporations relative to sole proprietor firms1

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2

Gre

Spa

1

Ire

Swe Aut Den Net Jpn Fra GBR

0 –1

USA

201

Por

Ita

Deu Fin Aus

–2

Correlation=0.63 t-statistic=3.2

Bel –3 0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

Share of self-employment in nonagricultural business employment

Figure 3.5 The self-employment rate and regulation Notes: 1. The difference between the indicators of administrative burdens on the creation of corporations and sole proprietor firms.

Table 3.6 Simple correlations between regulatory indicators and self-employment rates (nonagricultural business sector, 1982–1995) Regulatory indicators

Self-employment rate

Product market regulation Excess burdens on corporations Scope of public enterprise sector

0.39* 0.47* 0.37*

EPL (1998) EPL, permanent workers (1998) EPL, temporary workers (1998)

0.42* 0.13 0.58*

Source: Authors’ estimates. Notes: * indicates significance at 10 percent level. Observations range from 19 to 22 depending on the indicator, affecting the significance threshold.

public enterprise sector and, most importantly, EPL. Interestingly, correlations are particularly strong with EPL for temporary workers, suggesting that rigidities affecting this kind of work may result, especially in service sectors, in the choice of organizational structures based on the use of consultants and/or franchising. These correlations may not be robust, however, when accounting for other factors that determine cross-country differences in self-employment rates.

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The determinants of self-employment are more difficult to pin down than those of dependent employment, partly due to the lack of comparative data. The ratio of self-employment to total employment can be affected by the stage of development and the structure of the economy as well as by policy and institutional variables that make selfemployment more advantageous relative to dependent employment. Unfortunately, little cross-country information is available on the role played by such variables as tax and benefit policies in the decision to be self-employed and, therefore, we focus solely on the effects of excess burdens and EPL. These factors capture the distortions in incentives caused by differences in the administrative treatment of the start-up of corporate firms versus sole proprietor firms and by differences in the legal treatment of dependent versus independent labor. Restrictive EPL and excess burdens on corporations should lead to a higher incidence of self employment. In any event, we expect that the effects of regulations on the employment mix differ in different sectors and compositional effects unfold slowly over time, with most of the information lying in the cross-country dimension of the data. Thus, we estimate equations for the overall business sector, manufacturing, and services and adopt a single-stage estimation approach in which regulatory indicators are introduced as fixed country-specific effects using the average values of EPL regulations over the two periods (1990 and 1998). The reduced-form equation for the self-employment rate was specified as follows: serit = m 0 + m i + Â b k w kit + dzi + g ri + jgit + n it

(8)

k

where serit is the self-employment rate, wki is a k ¥ 1 vector of variables on economic structure, zi is the summary indicator of EPL, and ri is the indicator of excess burdens for start-ups of corporate firms over soleproprietor firms. The other variables are defined as in equation (6). Structural variables include the share of agriculture in total GDP, the level of GDP per capita (in sectoral PPPs), and an indicator of the sectoral composition of nonagricultural GDP (value added mix), defined as an index (relative to the OECD average) of the extent to which the composition of GDP is twisted toward high-productivity sectors.45 The regression results are shown in table 3.7. Since regulatory variables lack the time dimension, a random effect specification was retained (the null hypothesis of lack of correlation between the specific effects and the explanatory variables could not be rejected at the 10

10.7**

1.4

Sources: Authors’ estimates. Notes: ***: statistically significant at the 1 percent level; ** at the 5 percent level.

B-P test Hausman test

14.1*** 949.9***

12.6*** 1,365.7***

F-test (fixed effects)

17

210

0.01 0.01 0.05

0.01 0.02

-0.01 0.04 0.00 0.03 0.04

St. err.

Coeff.

18

1.63 1.66 -0.30

14.42

T-stat.

235

0.03

0.05 0.01 0.02

St. err.

Number of countries

0.03 -0.01

0.02

0.66

Coeff.

Manufacturing

Number of observations

Output gap

Per capita GDP Composition of value added Share of agriculture EPL Excess regulation (corporate-sole proprietor)

Independent variables

Total economy

Table 3.7 Reduced-form self-employment rate equations, 1982–1995 (random effects)

2.40 0.85

9.3**

14.1*** 1,287.7***

18

217

0.04

0.04 0.02

0.03

1.53 0.37

0.01

-0.05

-0.97

0.02 0.02 0.04

0.02

St. err.

Coeff.

T-stat.

Services

2.65 1.00 1.24

-5.00 1.47

T-stat.

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percent level). As expected, the regression results show that the overall self-employment rate increases with the share of agricultural GDP, while the sectoral rates decrease with GDP per capita. There is also some evidence that producing in high-productivity service sectors increases the self-employment rate in both manufacturing and services. The business sector self-employment rate appears to be positively affected by both EPL and excess burdens, although the level of significance of these two variables is low. Restrictive hiring and firing procedures may favor the self-employment rate in two ways. First the creation of small individual enterprises may be encouraged, especially when there are low work-force thresholds above which EPL applies. Second, as suggested above, the equilibrium level of dependent employment may be reduced relative to self-employment, especially in services. On the other hand, the presence of high administrative barriers relative to those faced for the creation of sole-proprietor enterprises may raise the self-employment rate by favoring this kind of organizational structure. These effects are better identified at the sectoral level. As expected, the effect of regulations is different in manufacturing and services. In manufacturing, the effect of excess burdens dominates, encouraging the fragmentation of the production structure in micro units. In services, the effect of EPL is stronger, encouraging an organization of work based on the use of consultants and on franchising. This confirms previous findings based on more anecdotal evidence.46 The combination of restrictive EPL and heavy administrative burdens may therefore contribute to explain the relatively high self-employment rates in some OECD countries. 4 The Implications of EMU for European Product and Labor Markets It is important to ask whether the creation of the EMU will provide additional incentives to agents and governments to adjust behaviors and policies in a direction that favors a more competitive environment in the labor and product markets, with possible beneficial effects on employment. Although both increased competition and monetary integration are likely to have direct and distinct effects on the functioning of labor markets, they are also related in that monetary integration is likely to affect the level of competition, for example by facilitating price comparisons across countries. This section discusses some of the likely structural changes that may be brought about by the EMU. First, the

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possible direct effects of monetary integration on the degree of price competition are discussed and, second, the consequences of the single currency for the flexibility of product and labor markets. As underscored in the introduction to this book, these issues can be addressed empirically by looking at the past experience of subsets of EU countries that participated in exchange-rate stability zones, considering the latter as proxies for monetary unions. At the risk of oversimplifying complicated historical developments, in the following we distinguish between (1) the “D-mark area,” Germany and countries that succeeded in pegging their exchange rate to the D-mark over the past two decades (Austria, Belgium, the Netherlands, and Luxembourg); (2) the “core-EMS area” (D-mark area plus France); and (3) the “other EU area,” countries that entered EMS in 1979 but underwent frequent and significant adjustments of their parities within the exchange rate mechanism (eventually leading to their temporary or permanent exit from the system), countries that entered EMS at a late stage, and countries that never participated into the exchange rate agreement. In particular, we would like to detect if exchange-rate stability and the corresponding loss of monetary autonomy has brought about (1) a higher degree of price convergence than in other EU countries; (2) changes in behavior conducive to increased (nominal) wage and price flexibility; and (3) changes in institutions and structural policies that led to a reduction of real rigidities potentially affecting equilibrium unemployment. The presence of such changes could be interpreted as evidence that monetary integration encourages fundamental reforms in the labor and product markets, making the abandonment of independent monetary policy beneficial also on this ground. 4.1 Price Convergence The transition to a single currency should increase the transparency of prices for similar goods across countries participating in the currency union. In principle, increased transparency raises opportunities for arbitrage by consumers and competitive pressures for producers. As a result, the convergence of prices across countries should be accelerated, even though differences will remain due to factors related to location, tastes, and so forth (see section 1). Therefore, by looking at price convergence we can infer whether monetary integration has had any direct effect on product market competition.

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Looking back at the experience of EU countries, we check to what extent developments in price disparities have reflected differences in exchange-rate regimes. Specifically, it is useful to see whether those EU-countries where exchange rates have been relatively stable witnessed a stronger tendency for prices to converge (e.g., due to greater transparency of prices quoted in national currencies) than countries that have had relatively wide fluctuation bands or frequently adjusted central rates. Changes in exchange rates were particularly important at the beginning of the 1980s, with Portugal and Greece experiencing major depreciations of their currencies against the ECU. Exchange-rate fluctuations have remained important, however, in subsequent years in the majority of EU-countries, culminating in the EMS currency crisis of the early 1990s. Countries that witnessed relatively high stability in their bilateral exchange rates are Germany, the Netherlands, Belgium, Luxembourg, and Austria as the latter countries had essentially pegged their currencies to the Deutsche mark for more than a decade. As argued in section 1, an overall price convergence process took place in the EU over the 1985–1993 period. It is important to establish whether this overall process could have resulted merely from changes in exchange rates. While the countries in the D-mark area saw their currencies appreciate relative to the ECU since the mid–1980s, Greece, Portugal, Spain, and Italy experienced major depreciations against the ECU. According to the theory of (relative) purchasing power parities, changes in the exchange rate between two currencies should, in the long run, equal the difference in the percentage changes of the national price levels. Given that the countries with relatively low prices were typically the countries that experienced exchange rate depreciations, in the vast majority of cases changes in exchange rates have favored an increased divergence in prices. For example, in 1980, the lowest price countrieswere Portugal, Spain, Greece, and Italy, whereas the highest price countries were Denmark, France, and Germany. In 1993, the lowprice countries were Portugal, Greece, and the United Kingdom, while the high-price countries were still Denmark, France, and Germany. Therefore, the observed convergence in prices between the low-price and high-price countries cannot be attributed to exchange-rate variations (EC 1997a). Is it possible to identify groupings of EU countries where price structures have become more similar over the period 1985–1996? Following up on the analysis in section 1, we investigate the changes in the degree of similarity in price structures, using the Grubel-Lloyd indicator

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Table 4.1 Country pairs with most similar and most dissimilar price structures, all goods, 1996 Twelve most similar price structures (similarity index > 90.7 Austria-Germany Austria-Belgium Austria-France Belgium-France

Belgium-Netherlands Belgium-Germany Belgium-Luxembourg France-Germany

Denmark-Norway Denmark-Sweden Norway-Sweden Italy-Spain

Twelve least similar price structures (similarity index < 70) Japan-Turkey Norway-Turkey France-Turkey Luxembourg-Turkey

Denmark-Turkey Finland-Turkey Germany-Turkey Japan-United States

Sweden-Turkey Austria-Turkey Canada-Japan Belgium-Turkey

Source: Authors’ estimates based on OECD Purchasing Power Parties and Real Expenditures.

applied to the time-series of OECD Purchasing Power Parities and Real Expenditures database. Table 4.1 presents some indicative results, showing the twelve country pairs with the most similar price structures and the countries with the least similar ones. Not surprisingly, the countries with similar price structures are all close, highly integrated neighbors of each other (e.g., the Scandinavian countries, the southern European countries, and the countries of the D-mark area), while the dominance of both Turkey and Japan in the low-similarity category underscores their differing economic structure. The presence of the countries of the D-mark area among the countries with highly similar price structures would suggest that a stable exchange-rate regime may contribute to price convergence. Table 4.2 shows that the overall level of price similarity is indeed higher among the D-mark area countries than among the other EU countries. Prices are highly similar across all goods categories, with the possible exception of services. Similarity in price levels, however, should be distinguished from convergence. What is relevant here is whether convergence in the D-mark area has been stronger after controlling for initial conditions. Progress toward increasing price similarity has been relatively low among the D-mark area countries compared to the other EU countries, suggesting that relatively far reaching reforms are needed to achieve further price convergence. Table 4.2 also suggests that countries in the D-mark area already formed a relatively integrated group before the start of the pegged exchange-rate regimes. To see whether this result is

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Table 4.2 Price similarity indices at the basic goods heading, 1985–1996 1985

1990

1993

1996

Change, 1985–1996

D-mark area All products Consumer goods Equipment goods Construction Services Energy

90.0 91.2 91.0 92.5 85.7 91.6

90.7 91.7 92.0 90.7 87.8 88.9

90.4 92.1 90.2 90.4 86.9 86.4

90.8 92.5 90.1 90.8 87.0 91.8

+0.9 +1.3 -0.9 -1.7 +1.4 +0.3

Other EU All products Consumer goods Equipment goods Construction Services Energy

81.2 82.2 88.3 84.7 74.3 83.4

80.7 81.3 87.8 84.5 75.0 77.3

84.0 85.4 88.5 85.5 78.7 76.4

84.0 85.3 89.7 84.3 78.8 77.9

+2.8 +3.1 +1.4 -0.4 +4.5 -5.5

Source: Author’s estimates based on OECD Purchasing Power Parties and Real Expenditures. Notes: D-mark area = Belgium, Germany, Luxembourg, the Netherlands, Austria. Other EU = ten remaining EU countries.

robust, after correcting for factors such as trade intensity and the initial level of similarity, we present some regressions in table 4.3 that explicitly test for the presence of a “D-mark effect.” We look only at this group of countries (excluding Luxembourg) and use the other EUcountries as a control group. Interestingly, the coefficient of the D-mark dummy variable is always close to the coefficient of the non-D-mark dummy variable, although the D-mark coefficient is always higher than for the other countries. This suggests that an important part of the difference in price convergence may indeed be due to catching up and differences in trade intensity. To test whether the degree of price convergence of Austria, Germany, Belgium, and the Netherlands differed from that of the other EU countries, we tested the null-hypothesis that the coefficient of the D-mark dummy is equal to the coefficient of the non-D-mark dummy. An F-statistic was calculated to test this hypothesis for the various subperiods (1985–1990, 1990–1993, and 1993–1996) and goods categories (corresponding to the specifications one to four in table 4.3). We find that in only one case, the null-hypothesis could be rejected at the 5 percent significance level (but not at the 1 percent

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Table 4.3 Estimates of bilateral similarity equations including EMS dummies (dependent variable: change in price similarity over 1985–1996) Specification independent variables

1

2

3

4

Initial similarity

-0.3 (-6.9)

-0.5 (-20.0)

-0.6 (-20.9)

-0.3 (-9.4)

1.4 (1.1)

1.5 (1.9)

4.0 (3.8)

3.6 (2.1)

Expenditure share Trade intensity

-0.3 (-1.4)

D-mark dummy

4.5 (2.8)

4.6 (3.8)

5.6 (5.4)

3.4 (2.4)

Other EU dummy

3.8 (6.6)

2.6 (6.4)

4.5 (12.3)

3.1 (6.6)

-0.4 (-0.6)

Construction Equipment goods

3.3 (5.1)

Energy

-6.3 (-10.4)

Services

-2.6 (-4.0)

High NTB

2.2 (5.2)

Medium NTB

1.6 (3.7)

Tradable

0.5 (0.9)

constant

24.3 (6.6)

39.6 (19.8)

47.1 (21.2)

21.7 (9.9)

Number of observations

210

1,050

630

420

F-statistic

16.1

77.7

87.8

22.2

F-test for equality DM non-DM coefficients

0.18

2.65

1.15

0.04

Source: Author’s estimates based on OECD Purchasing Power Parities and Real Expenditures. Notes: The D-mark dummy has the value one if the dependent variable corresponds to two countries from the following group: Austria, Belgium, Germany, and the Netherlands. The other EU dummy has the value one for all pairs of EU countries not belonging to the core EMS group. The 5 percent significance level for the equality of DM and non-DM coefficients is 3.84.

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level). In particular, for specification three for the period 1993–1996, the hypothesis that both coefficients are equal could be rejected. This result however, is not representative. In the majority of cases, it must be concluded that the D-mark area countries have not been able to achieve a significantly higher degree of price convergence than other EU countries. Two possible explanations can be given for this result. First, private agents might not have considered the EMS arrangement (even in the countries with relatively stable bilateral exchange rates) a credible monetary union. Exchange-rate uncertainty and a lack of price transparency may therefore have persisted with only limited price convergence as a result. As EMU is a much more credible and irrevocable form of monetary union, it may have a more substantial impact on price convergence. Second, the participation in the EMS arrangement implied a convergence in inflation rates (see below). Inflation rates indeed displayed a significant convergence as the final stage of EMU came closer and closer. Given that price structures were different to begin with, this convergence in inflation rates may have slowed down the pace of relative price convergence. This may also partly explain the result found in section 1 that the rate of price convergence appears to have slowed down during the most recent period (1993–1996), a result that holds for both D-mark area countries and non-D-mark area countries. In any case, whether the lack of incremental price convergence in the D-mark area is representative of the possible effect EMU may have on prices is an open question. Our results cast doubts, however, on the hypothesis that monetary union by itself will increase competition and therefore price convergence across Europe. Structural reforms appear to be a necessary condition to achieve further progress in this area. 4.2 Monetary Integration and Incentives for Reform From a theoretical standpoint, it is optimal for a country to join a currency area under three conditions: (1) demand or supply shocks must be symmetric to those of the other countries participating in the agreement; (2) labor must be mobile across countries; and (3) real wages must be flexible.47 These conditions should be seen in a dynamic context, however, in which decision rules of private agents and government authorities may respond systematically to changes in the monetary regime. Changes in incentives for private agents and policymakers could lead to modifications in institutions, market mechanisms,

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and even in government approaches to public policy. Hence one cannot keep behavior—such as unions’ objective functions—constant while contemplating giving up monetary authority or joining a single currency. Austria and the Netherlands, two countries in the D-mark area, provide historical examples of the possible effect of monetary integration on agents’ incentives. Hochreiter and Winckler (1995) find that the optimality conditions for joining a currency area failed to hold in Austria in the late 1970s. By looking at the 1980s and early 1990s, however, they find that wages (and unit labor costs) behaved differently than in the 1970s in the sense that wage settlements responded to low growth and structural problems in the 1980s but rose at a rate that exceeded productivity growth in the 1970s. Due to this wage moderation, unemployment in the 1980s did not rise to the high levels seen in neighboring countries and the variance of real exchange rates, unemployment, and the current account balance was low in the 1980s in comparison with other European countries such as Belgium, France, and Italy. The Netherlands is another success story in the D-mark area. Following the Wassenaar agreement in 1982, progress has been made to reduce the generosity of the social-security system, increasing the flexibility of the labor market, and improving public finances. At Wassenaar, employers’ and unions agreed on wage moderation, which was further stimulated by tax cuts. The tax cuts were on the one hand financed by sobering some of the most generous welfare programs (e.g., the matching of wage increases with equal increases in minimum social benefits) and on the other hand by broadening the tax base and reducing government consumption. In fact, the budget deficit tended to fall in the ensuing years. As a result of these policies, the rate of job creation increased resulting in a steady fall in the unemployment rate. Thus not only did the Netherlands escape hardship upon pegging its exchange rate to the D-mark they also made progress toward better labor-market outcomes.48 To what extent are the significant reforms in these two countries linked to their choice to peg their currencies to the Deutsche mark? To account for a larger pool of country experiences, table 4.4 summarizes labor-market reforms and institutional changes in EU countries over the 1986–1997 period. We report reforms using two different indicators: the first five columns show “reform accounts,” providing the number of reforms by country over the 1985–1995 period in three main areas

8 1 1 3

Core-EMS Area Denmark Finland Greece

20 3 4 0

18 2

5

2

6 2

Total D-mark Area France

4 5 4

0 1 3

Austria Belgium Germany The Netherlands

14 1 4 2

11 3

2 2 2 5

42 5 9 5

35 7

6 8 9 12

59.4 41.2 39.4

19.7

42.4 45.4 36.8 61.2

Percent of total

Total

EPL Pensions

Number of reforms1 (1986–1997)

Net benefits

Follow-through of OECD recommendations2 (1990–1998)

Table 4.4 Institutional change and reform in Europe (1986–1997)

High High

Intermediate

High Intermediate High Intermediate

1980s

High Intermediate

Intermediate

High

Intermediate High

High

1990s

Centralization/coordination in

Changes in bargaining systems (1985–1997)

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4.5 4.0

2.8 3.2

1.5 1.6

2.1 1.9

2.8 2.8 2.0 2.3

18 32

0 5 1 1 3 1

8.8 8.4 6.9 7.4

62 104

5 11 4 7 10 6

46.5 41.1 47.2 45.0

64.5 47.9 26.9 35 26 84.8

Intermediate Low Intermediate High High Intermediate

Source: RodolfoDeBenedetti Foundation; OECD 1999c; Elmeskov et al. 1998. Notes: 1. Reforms increasing labor market flexibility or reducing the generosity of the unemployment benefit/pension systems. 2. Percent of recommendations implemented over the period.

Averages per area D-mark area Core-EMS Area Other EU countries Total EU Area

4

1

19 27

Other EU countries Total EU Area

25 45

4 2 0 3 5

1 4 3 3 2

Ireland Italy Portugal Spain Sweden United Kingdom Low

Intermediate Intermediate Intermediate

High High

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(EPL, unemployment benefits, and public pensions)49; the sixth column provides the percentage of the recommendations contained in the OECD Jobs Strategy implemented by each EU country over the 1990–1998 period.50 The last column shows changes in the level of centralization-coordination of the bargaining systems following the classification proposed by Calmfors and Driffill (1988). The evidence reported in table 4.4 does not lead to clear-cut conclusions as to the effects of monetary integration. The mere count of reforms and recommendations suggests that countries participating in the D-mark and core-EMS areas have on average implemented a higher number of reforms than other EU countries, providing prima facie evidence in favor of a positive effect of monetary integration on the drive for reform. When reforms are weighted according to their importance for labor-market outcomes, however, as in the account of the follow through of OECD recommendations, the evidence is much less clear, with core-EMS countries showing a weaker reform effort than other EU countries. Finally, although table 4.4 suggests that countries in the D-mark area tend to move away from intermediate levels of coordination-centralization that are generally thought to lead to inferior labor-market outcomes, the evidence is by no means conclusive. Clearly, comprehensive empirical evidence on these issues is difficult to collect and hard to interpret since institutional changes and reforms are multiform, may differ in intensity, and may be implemented and enforced in different ways. In addition, the relationship among integration, competition, and reforms may also be influenced by other factors, such as the initial levels of unemployment, which may significantly affect the political economy of the reform process. Indeed, what is most relevant is the impact that institutional change and regulatory reform may have had on labor-market flexibility and performance. We therefore turn to the analysis of cross-country differences and changes over time in the sensitivity of the macroeconomy to demand and supply shocks, as a proxy for the scope and depth of reforms implemented in EU countries. We look first at nominal flexibility and then turn to evidence concerning real rigidities. 4.2.1 Nominal Flexibility When the cost of gathering information and learning about the state of the economy is significant, the optimal strategy followed by firms involves time-dependent rules or contracts. The length of such con-

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tracts—be they wage or price-setting rules—is likely to depend on the rate of inflation, the frequency of inflation shocks (proxied by the variance of inflation), and the size of aggregate-demand shocks. The optimal contract length, and the ensuing degree of nominal rigidity, is a decreasing function of the rate and the variance of inflation because the cost of maintaining prices and wages fixed in nominal terms (i.e., the cost of maintaining a suboptimal relative price of output or labor) is higher for a given contract length the higher the rate and the variance of inflation.51 On the other hand, larger demand shocks are likely to lead to shorter contract periods and increased nominal flexibility because the larger the size of demand shocks, the greater the incentives for firms to revise prices, due to increasing marginal costs of production, and for unions to renegotiate wages, due to decreasing marginal utility of employment and wages (i.e., the convexity of union indifference curves in the real wage-employment space). Since the loss of monetary independence is likely to affect the rate and the variance of inflation as well as the size of demand shocks, the economywide flexibility of nominal wages and prices is likely to be affected by the adoption of a single currency. As Calmfors (1998) has pointed out, however, the sign of the net change is uncertain since one could expect a currency union to result at the same time in a lower and more stable inflation with larger demand shocks. Indeed the historical experience of EU countries suggests that the abandonment of an independent monetary policy has led to both low average rate and low variance of inflation. Figure 4.1 plots the average rate of inflation against the standard deviation of inflation in a sample of OECD countries during the 1981–1998 period. Clearly, D-mark countries have had lower and more stable inflation than most of the other countries; this would tend to increase the length of contracts, increasing nominal rigidities. The loss of monetary independence, however, could also raise the size of aggregate-demand shocks, because monetary policy can no longer be used to counter country-specific disturbances, tending to reduce contract length and thereby raising nominal flexibility. The empirical literature suggests that the second effect tends to dominate, with the loss of monetary independence often resulting in increased flexibility. Bayoumi and Eichengreen (1996) found that wage changes were more rapid during the period of the gold standard; Anderton and Barrell (1993) found increased wage flexibility after Italy joined the EMS; and Muet (1996) found increased flexibility in France during the same period.

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Standard deviation of inflation

8

Por 6 NZ Ire

Ita

4 Fra Swe Nor Spa Den Can Fin Aus Bel UK Net Aut Ger USA

2 Jap 0 0

2

4

6

8

10

12

Inflation Figure 4.1 Inflation patterns in OECD countries, 1981–1998

An increase in nominal flexibility is likely to amplify movements in wages and prices and lower the effect of demand shocks on real variables, affecting the magnitude of the business cycle. First evidence on the reaction of OECD economies to demand shocks can be gathered by looking at the cyclical variability of unemployment. Economies enjoying a wider flexibility of nominal wages and prices should display a lower cyclicality in unemployment. Figure 4.2 shows the variance of the changes in unemployment, a proxy for its cyclical behavior, during the 1960–1980 and 1981–1998 periods. In countries along the diagonal the cyclicality of unemployment has remained the same in the two periods, while in countries below (above) the diagonal the variance has increased (decreased) in the most recent period. It is interesting to note that, with the exception of Germany (which had an independent monetary policy and suffered from the shock of reunification), countries in the D-mark area succeeded in keeping the cyclicality of unemployment at a relatively lower level during both periods than in most other OECD countries. Another way to check whether monetary integration increased nominal flexibility is to compare the reaction of real output to demand shocks in countries participating in exchange rate stability zones and in

Variability of unemployment over the period 1960–80

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2.1 1.9 1.7 1.5 1.3 1.1 0.9

Bel

0.7 0.5

Por Net

Lux

0.3 0.1 0.1

Den

USA

Jpn 0.3

Ita Fra Aut Swi 0.5

Can

Ger Nor

0.7

UK

Aus

Fin

Spa

Ire

Swe

NZ 0.9

1.1

1.3

1.5

1.7

1.9

2.1

Variability of unemployment over the period 1980–98 Figure 4.2 Variability of unemployment Note: 1. The cyclical variability of unemployment is measured by the standard deviation of yearly changes in actual unemployment rates. Source: OECD.

other OECD countries. Following Ball, Mankiw, and Romer (1988), we use the change in log nominal GDP as a measure of demand shocks and estimate their impact on real GDP to measure the degree of nominal flexibility.52 We estimate the following equation for a sample of nineteen OECD countries (i = 1, . . . , 19) during the 1960–1998 period, where t is a time trend, y is the log of real GDP, and Y the log of nominal GDP: yt = a 0i + a 1i t + a2i DYt + a3i yt-1

(9)

Table 4.5 shows the resulting estimates of the sensitivity of real output to demand shocks (a2), our measure of nominal rigidity, for two subperiods, before and after the creation of the EMS.53 The estimated coefficients should be taken with caution because, due to the small number of degrees of freedom, they are quite sensitive to the period covered and they are often not significant at conventional levels. A few (prudent) considerations, however, can be made. First, countries in the D-mark area appear to be characterized by higher nominal rigidity than elsewhere in the OECD. Second, relative to many other countries, their degree of nominal rigidity appears to be more stable over time.

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Table 4.5 Sensitivity to demand shocks Time periods Country

1960–1980

1981–1998

1960–1998

D-mark area Germany Austria Belgium Netherlands

0.69 0.80 0.72 0.62

0.79 0.83 0.75 0.52

0.77 0.73 0.64 0.55

Core-EMS France

0.28

0.35

0.26

Other OECD Australia Canada Denmark** Finland* Ireland Italy

0.33 0.40 0.99 0.46 0.19 0.19

0.61 0.68 0.48 0.75 0.59 0.06

0.43 0.51 0.69 0.53 0.12 0.21

0.38 0.33 -0.01 0.44 0.23 0.35 -0.04 1.26

0.47 0.79 0.20 0.39 0.86 0.76 0.65 0.84

0.21 0.37 0.24 0.18 0.22 0.39 0.07 0.69

0.46

0.60

0.42

New Zealand Japan* Norway Portugal* Spain Sweden United Kingdom United States Average

Source: Author’s estimates. Notes: * difference between time periods significant at 5 percent level, ** difference significant at 10 percent level.

Therefore, there is no prima facie evidence that membership in a currency area has fundamentally changed the way the D-mark economies adjust to nominal shocks.54 Since the D-mark countries have had lower and more stable inflation, it is possible that this nominal convergence may explain the higher level of nominal rigidity, due to the effect of a stable nominal environment on the features of wage contracts (see above). We checked this conjecture by running a cross-country/time-series regression of the estimated nominal sensitivity coefficients (a2) during the 1960–1980

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and 1981–1998 periods on the corresponding average rates and variances of inflation.55 The results showed that the variance of inflation explains a large amount of the variance of the sensitivity across countries and across the two time periods, with a lower variance associated to higher nominal rigidity. To further explore the channels through which nominal convergence can increase nominal rigidity, we looked at the simple correlations between the estimated sensitivity coefficients and some of the features of wage contracts in OECD countries, such as their length, their synchronization, and the presence of indexation. The correlations had the expected signs, with the degree of nominal sensitivity-rigidity being positively related to contract length (R2 = 0.32) and negatively related to indexation (R2 = -0.55) and synchronization (R2 = -0.20). Only the correlation with indexation, however, was found to be statistically significant. We can conclude that, by lowering the variance of inflation, participation in the D-mark area is likely to have made more attractive contractual arrangements, such as lengthy and unindexed contracts, favoring a relatively high degree of nominal rigidity. In such a scenario, the effect of nominal convergence appears to have prevailed over that of larger demand variability in determining the behavior of unions and firms. We were unable to find hard evidence, however, that participation in the D-mark area actually changed the behavior of agents. As noted above, if anything, the D-mark countries appear to have enjoyed more stability in the sensitivity of real output to nominal shocks than other countries, a result that was also confirmed by the inspection of the recursive estimates of the sensitivity parameters. These conclusions must be taken cautiously, however, since they hinge on our measures of nominal rigidity, which are relatively poorly estimated. 4.2.2 Real Rigidities Cross-country differences in unemployment are widely believed to be grounded in differences in the rates of structural unemployment (OECD 1994b and 1999b). If high European unemployment rates are largely structural, it is particularly relevant to establish whether giving up monetary independence is likely to lead to labor and productmarket reforms and changes in labor-market institutions with a potentially beneficial effect on structural unemployment. On purely theoretical grounds, the question is unsettled. The potential effects of monetary union on labor-market reform and institutions are essentially of two types (Calmfors 1998). First, there may be incentives for policy-

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makers to change legislations and regulations, such as the level and duration of benefits, eligibility criteria, and employment-protection rules. Second, the strategies of unions and employers may change as a result of the modification in the policy environment determined by the loss of monetary independence. As to incentives for labor-market reform, there are several possible arguments leading to either positive or negative conclusions concerning the effects of the EMU. On the positive side, there are three main lines of reasoning. The first has to do with hysteresis effects. To the extent that such effects are significant, it is in the interest of policymakers concerned by unemployment levels to minimize the extent to which nominal shocks tend to turn into real fluctuations. Since countryspecific shocks will tend to be larger when the monetary policy instrument is lost, EMU membership should provide additional incentives to reduce real rigidities through structural policies.56 The second is based on the observation that, once domestic monetary policy cannot be used anymore to buffer country-specific shocks, the cyclical variations in unemployment are likely to be larger, leading to a higher risk of the occurrence of very bad outcomes (Calmfors 1998). Under the assumption that policymakers are risk averse (e.g., because voters are particularly sensitive to bad outcomes), incentives to implement structural reforms will increase: successful reforms will lower the structural unemployment rate, improving the “risk-return” outcome. The third builds upon the assumption that the single currency, by increasing price transparency, multiplies the possibilities for consumers to arbitrage across countries, increasing the competitive pressures placed on firms operating in EMU countries.57 As a result, relative labor costs will be a decisive factor in deciding on the location of firms within the EMU area, and governments will be keener on implementing those structural reforms that reduce labor costs relative to other countries participating in the currency union (Bean 1998). Negative arguments are essentially of two kinds. The first is based on variants of the “inflation bias” argument (Barro and Gordon 1983).58 For a country participating in the EMU, the incentive to implement structural reforms to reduce the inflation bias (which is an increasing function of unemployment) is smaller since, by definition, having abandoned monetary independence there is no more such bias at the national level (Sibert and Sutherland 1997; Calmfors 1998). On the other hand, the possible bias at the EU level is not very significant both because the ECB is likely to be less inflation-prone than the domestic

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central bank and because the ECB determines monetary policy on the basis of EU-wide developments.59 Therefore, to the extent that an inflation bias existed outside the EMU, the single currency would weaken incentives for reforms aimed at reducing structural unemployment. The second negative argument is based on the assumption that there is complementarity between structural and monetary policies (Lindbeck 1996; Calmfors 1998). Successful reforms lead to a fall in equilibrium unemployment but actual unemployment only gradually converges to this new equilibrium. If the beneficial results of labormarket reform can be accelerated by the shrewd use of demand management policies, the loss of monetary independence will make it less attractive for policymakers (whose horizon is limited by their electoral term) to pursue structural policies. Similar arguments can be used to analyze the reaction of unions to monetary unification (Cukierman and Lippi 1999). A centralized labor union that dislikes inflation is likely to restrain real-wage demands to keep unemployment down and hence reduce the incentive to inflate. In a monetary union, this tendency is reduced as the union now has less to fear from a centralized bank both because it is likely to be less inflation prone than the national bank and because it takes into account unemployment in all member countries.60 The EC (1998) argues that this negative effect of EMU on wage restraint by a centralized union is likely to be more significant for large and relatively closed countries, since they will be able to externalize more of the inflation effect while at the same time incurring relatively minor consequences in loss of competitiveness vis-à-vis the other countries. It could also be argued that, by increasing the externalities caused by differential behavior of unions across countries, EMU could change the optimal locus of wage bargaining, from the national to the EU level. For instance, a large union could induce foreign companies to relocate in its country by pursuing a strategy of wage moderation, thereby raising domestic employment at the expense of foreign employment. This could call for some form of cross-border coordination in the wage formation process, at least among countries characterized by centralized bargaining. At the same time, as argued by Gros and Hefeker (1998), there might also be a tendency to coordinate wage-setting across countries on a sectoral basis, to the extent that sector-specific shocks dominate at the EU level. In conclusion, from a purely theoretical point of view, it is unclear whether EMU will induce governments and unions to pursue structural reforms and changes in labor-market institutions that would favor

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the reduction of European structural unemployment. It is possible that a combination of positive and negative incentive mechanisms could be operating, leaving the net effect on unemployment uncertain. Although the issue can hardly be settled empirically, we can try once again to use the experience of those European countries that pegged their currency to the D-mark as a guide to the likely net effects of a monetary union on incentives for structural reform and institutional change. One way of dealing with this issue is to focus on the sensitivity of unemployment to demand or supply shocks and on the degree of persistence of the resulting changes in unemployment as proxies for the degree of real rigidity present in the economy. Real rigidity may be caused by both the lack of real wage flexibility, that is a steep wage setting curve, and the lack of product-market competition, reflected in a steep labor demand curve (see section 2). Taking an agnostic stand on the nature of the shocks affecting unemployment (the productivity slowdown, biased technological change—between capital and labor or skilled and unskilled labor—oil-price increases, high real interest rates, or the behavior of mark-ups, to name a few) we specify the following reduced-form equation for each country in our sample (i = 1 . . . 19): Duit = l i (a i + g i D - uit -1 ) + e it

(10)

where u is the rate of unemployment, and D is a vector of dummy variables, one for each of the years from 1961 to 1998. The time dummies capture global shocks in each period, while the coefficient g measures the sensitivity of the unemployment rates to these shocks (i.e., the degree of real rigidity). We make no assumption about the nature of these shocks and estimate them directly from the unemployment series itself. The coefficient a measures cross-country differences in average unemployment while l measures the persistence of changes in unemployment over time. The data were pooled and the equation was estimated by nonlinear least squares. Figure 4.3 plots the estimated global shocks and their 95 percent confidence intervals. There are three main episodes of adverse shocks, either in the form of a negative demand or a supply shock. These are the mid–1970s (oil price shock), the early 1980s (interest rate and oil price shock), and the early 1990s (high interest rates among other things). We are not primarily interested in the nature of these shocks but we wish to find out whether the reaction of unemployment in different countries can be explained by their labor and product-market characteristics. As mentioned above, the value of the sensitivity coeffi-

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25

Percentage

20 15 10 5 0 –5 60

65

70

75

80 Year

85

90

95

Figure 4.3 Shocks to unemployment

cient may reflect rigidities in both the labor and the product market. Labor-market reform (e.g., changes in labor-market institutions, welfare programs, and/or legislation on employment protection) then may affect the sensitivity of unemployment to shocks by making the wage curve flatter, that is by decreasing the degree of real-wage rigidity. On the other hand, product-market reform may act to partially offset the sensitivity to negative supply shocks by making labor demand more elastic and shifting it outwards (see section 2). To cast light on the determinants of real rigidity, we follow Nickell and Layard (1998) and regress the estimated values of unemployment sensitivity (g) and persistence (l) on indicators of labor-market institutions (union coordination, union density), labor-market regulations (unemployment-benefit replacement ratio, duration of benefits, employment protection legislation) and product-market regulation (the summary indicator presented in section 3).61 To check for the possible effects of monetary integration on real rigidity, over and above those originating from existing institutions and regulations, we follow the same approach as in the previous analysis of nominal flexibility and also include a dummy for core EMS countries. The dummy may account for differences in the policy approaches and/or the attitudes of employers and unions that are not captured by our institutional and regulatory indicators. It may also account for the effects of increased price transparency on competitive pressures faced by entrepreneurs.

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The results of the cross-country regressions (table 4.6) suggest that labor-market institutions and regulations have significant effects on both unemployment sensitivity and persistence, confirming earlier findings by Layard et al. (1991), Scarpetta (1996), and Nickell and Layard (1998). As expected, generous unemployment benefits and lack of bargaining coordination increase sensitivity, while restrictive EPL translate into a higher degree of persistence. Interestingly, restrictive product-market regulations also have a significant impact on sensitivity, reflecting their negative impact on product-market competition and, hence, on labor demand elasticity. This confirms, in a dynamic framework, the results of the previous section. On the whole, core EMS countries tend to have a regulatory environment that is not favorable to flexibility (generous benefit systems, strong employment protection, high union coverage); however, their wage formation process tends to be centralized and coordinated, implying a low level of real-wage rigidity. It is noteworthy that our regression results associate membership in the core EMS with a lower sensitivity of unemployment to shocks. Although we are not in a position to gauge the net effects of participating in a hard currency area, the results suggest that monetary integration brings about Table 4.6 Determinants of real rigidity Unemployment parameter Sensitivity to shocks (g )

Persistence of shocks (l)

Institutional and regulatory indicators

Estimate

t-ratio

Estimate

t-ratio

Constant Replacement rate Benefit duration Union density Union coordination Employment protection legation Product market regulation Core-EMS dummy

-8.80 0.11 1.30 0.002 -2.09 -0.04 2.53 -1.81

-2.2 1.9 2.7 0.1 -1.6 0.1 1.9 -2.4

0.62 — 0.03 0.001 — 0.06 — —

5.2 — 1.7 1.1 — 3.2 — —

Observations R2

19 0.67

19 0.55

Source: Author’s estimates.

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changes in policies and behaviors that enhance the real flexibility of the economy. We further explored the possible consequences of monetary integration for policies and institutions affecting real flexibility by checking the stability of the unemployment equation over time and by relating changes in unemployment to a summary measure of the reform effort made by OECD governments. The stability analysis suggested that structural breaks in the sensitivity and persistence of unemployment can be detected at the time of the creation of the hard currency area in some countries (Germany, the Netherlands and, albeit at higher significance levels, Austria) but not in others (Belgium and France).62 Finally, using the estimates of the determinants of unemployment sensitivity (table 4.6), we constructed a summary indicator of changes in labor-market institutions and policies and tried to relate it to observed differences in average unemployment rates before and after 1980.63 Although the indicator of reform effort appeared to be negatively related to the change in average unemployment rates in the Netherlands and, to a lesser extent, Belgium, the relationship did not hold for the other core EMS countries. Overall, the cross-country correlation between our indicator and changes in unemployment was very weak. Notes 1. The opinions expressed in this book are those of the authors and do not engage the organizations to which they are affiliated. We thank Olivier Blanchard, Tito Boeri, Alan Krueger, and André Sapir, and two anonymous referees for their useful comments. We also thank Olivier Boyland for statistical support and Roberta Marcaletti for editorial assistance. 2. The introduction was drafted by Giuseppe Nicoletti, section one by Robert C.G. Haffner, and section two by Stephen Nickell. Section three was written jointly by Giuseppe Nicoletti and Stefano Scarpetta, and section four by Robert C.G. Haffner, Giuseppe Nicoletti, and Gylfi Zoega. 3. A similar hypotesis has been recently formulated by Krueger and Pischke (1998). 4. Efforts to do so include Molle (1997). 5. For instance, recent OECD (1997) estimates of the expected impact of regulatory reform in five sectors of the European economy (telecommunications, electricity, airlines, road transport, and distribution) point to expected gains ranging from 3 percent of GDP in Sweden to 6 percent of GDP in Spain. 6. For example, technological change in mobile communication, accompanied by regulatory reforms, has immensely changed the sources of competitive advantage in this market, the formerly dominant players now contested by the entry of new, low-cost providers of mobile communication.

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7. Haffner and van Bergeijk (1998). 8. Different sectors may be affected by integration to different degrees, depending on a number of structural, behavioral, and policy factors that will tend to differ across sectors and countries. 9. The similarity index between countries j and k is: n

Similarity index jk = 100 - Â w i i =1

p ji - p ki * 100 p ji + p ki

where pji and pki are the average prices of product category i in countries j and k respectively and wi is the weight assigned to product i in the calculations. The similarity index between m countries is. Similarity index m =

1 m   similarity jk 2 j =1 k π j

Other measures sometimes used to perform bilateral comparisons of price structures, such as the correlation coefficient, are unsuitable here as they depend on the choice of the numeraire (e.g., the U.S. price level). A change in numeraire influences both the level of the correlations and the relative ranking of the countries in price similarity. 10. We have also calculated price similarity indices weighting the various product categories by their respective OECD-average expenditure shares. For all products, the degree of price similarity is slightly lower for the expenditure weighted results, indicating that price similarity is lower for those products for which expenditures are relatively high. 11. Information on NTBs in the late 1980s and early 1990s was gathered by EC (1997a) drawing on a questionnaire among 11,000 European enterprises and a horizontal study of technical barriers in six industries. The information was used to classify all industrial sectors into three groups according to the overall impact of NTBs. Among the 113 traded goods sectors, 18 belong to a high NTB industry (e.g., those where the public sector is a major purchaser) and 35 to a medium NTB industry (e.g., due to differences in standards or administrative and technical controls). 12. The results for non-EU countries should be interpreted with caution as the NTBclassification was derived for EU sectors only. 13. The general form of the estimated equation is: simt - simt-k = a0 + a1simt-k + a2trade + a3share + a4EU + a5dummy where the dependent variable is the change in the (weighted or unweighted) price similarity of the price structures of two countries (3 £ k £ 11), simt-k is the degree of price similarity between the two countries at the start of the period, trade is a measure of the bilateral trade intensity, share is a measure of the bilateral correlation between expenditure shares, EU is a dummy that has the value one if both countries are part of the EU and zero otherwise, dummy is a dummy variable measuring the effect of the kind of product (consumer goods, energy, services, construction, and equipment goods), the level of NTBs (high, medium, or low) and the tradability of the product (tradable versus nontradables) and a0 is a constant. 14. This can be attributed to the Balassa-Samuelson effect of lagging productivity growth in services; countries with a higher living standard (which generally coincides with a higher share of the service sector) tend to have a relatively high aggregate price level.

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15. In the last section of this book, we investigate whether EU-countries participating in a stable exchange rate area have displayed a significantly different pattern of price convergence compared to other EU countries. 16. We use the logarithm of this variable since it displays a considerable variance, ranging from almost zero (e.g., between Australia and Greece) to 7.1 percent for the trade between Belgium and the Netherlands. Data on aggregate bilateral trade flows refer to 1990 and 1994. 17. Luxembourg is excluded in the regressions due to lack of trade data. 18. Using the logarithm of the initial similarity level produces the same qualitative results. 19. EC (1999b) report that price disparities (as measured by the coefficient of variation) are about 40 percent higher in the EU than in the United States. 20. In these measures, markups are defined as margins over total production costs. 21. In Gersbach (1998), however, a model is presented where more intensive productmarket competition widens the wage differential between skilled and unskilled workers. 22. This would also occur if the impact of unemployment on wage inflation is nonlinear (the “Phillips curve”). For example, if changes in inflation are driven by the difference between the log of unemployment and the log of the natural rate, the average level of unemployment will be larger the greater the variance of unemployment, even if the log of unemployment is on average equal to the log of the natural rate. Indeed, if (log u–log u*) is normally distributed with mean zero and variance s2, then the expected value of u is: E(u) = exp(log u* + 1/2s 2). Turner (1995) presents estimates suggesting that, for three of the G7 countries, the inflationary effects of a positive output gap (output being above trend) are much bigger than the disinflationary effects of a corresponding negative output gap. 23. For instance, industry concentration may be a misleading measure of market power since industry-level Herfindhal indices have little meaning in markets open to foreign competition. Similarly, relating wage premia to markups is generally inappropriate because the two are determined together. 24. The indicators used in this section are the sole responsibility of the authors and do not engage the OECD or its member countries. They report the situation in OECD countries in 1997 or 1998, depending on the country and the indicator, and are based on the information available and country submissions as of June 1999. Nicoletti et al. (1999) revised and extended the indicators based on more recent data and provided a detailed description of the database and the methodology followed in their construction. 25. The average score of the United States along this axis of regulatory intervention depends on the relatively high number of administrative procedures and services involved in business start-ups. Our indicators do not include financial market regulations (such as those affecting the provision of venture capital) and land-use regulations, which are likely to be relevant for business start-ups and labor-market performance. 26. The correlation coefficient is 0.5 and is significant at the 5 percent level. 27. The reaction of employment to changes in EPL is likely to be larger where the initial regulatory stance was more restrictive. In addition small changes in EPL on temporary work may have large effects when EPL on regular contracts remains relatively

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restrictive. An example is Spain, where the legislation on temporary work contracts was eased in the late 1980s (from a virtually complete ban), while protection of regular employees remained restrictive. 28. The correlation coefficient is 0.75 and is significant at the 1 percent level. 29. A lax EPL regulation, however, may make workers’ resistance to regulatory reform stronger insofar as insiders would be less protected in the event of redundancies. 30. See OECD (1999b); Coe and Snower (1997); and Elmeskov et al. (1998) for a discussion of policy interactions. 31. For the purposes of this section the industry aggregate includes manufacturing, electricity, gas, and water, and construction; the service aggregate includes retail, wholesale and hotels, transport and communication, banking, insurance and business services, and private personal services. 32. Employment in the government and business sectors are not independent over the long-run to the extent that increases in government employment may crowd-out employment in the business sector either directly or through the increase in taxation required to finance it. Even in the short-run, employment in the two sectors may closely interact if governments try to compensate for employment losses in the business sector by inflating public employment. Some cross-country evidence supporting this kind of short-run interaction between the two employment rates is provided by Saint-Paul (1998). 33. It is important to note that in this table (as well as in table 3.3) not all indicators of product-market regulations are assumed to exert an independent influence on employment. Indeed, many of these indicators are strongly correlated and should be interpreted as representing different aspects of the same phenomenon. 34. The gap variable is defined as the proportional difference between actual and trend output, where the latter is estimated by applying the Hodrick-Prescott filter to GDP. To minimize possible problems in estimating trend output at the two extremes of the series (1983 and 1995), we have used longer time-series from 1970 to 1998. Moreover, the assumption of an identical parameter for the gap variable across all cross-sectional units does not affect significantly the estimated coefficients for the other explanatory variables. An alternative equation with country-specific coefficients for this variable produced similar results. Results remained unchanged also in another specification where the gap variable was instrumented with its lagged value to account for potential endogeneity problems induced by the simultaneous determination of employment and output along the business cycle. 35. Details on the construction of the institutional and policy variables can be found in Scarpetta (1996). Time varying indicators of the degree of centralization and coordination in wage bargaining are reported in Elmeskov et al. (1998). The methodology used to construct the time-varying EPL indicator is described in Nicoletti and Scarpetta (2000). 36. A diagnostic analysis based on the studentized residuals and the leverage values suggest that several observations significantly increase the standard error of the regression or affect the estimated coefficients. These observations have been removed from the sample: 1995 for Finland and Japan; 1994 for Ireland; 1987 and 1994 for Norway; 1987 for New Zealand; 1991 for Portugal; 1985 for Spain; and 1984 for the United States. See Scarpetta (1996) for details on the tests used to identify outliers in the data set. 37. There are several sources of potential bias that may explain why the coefficient of the public employment rate is less than unity. For instance, the use of public employ-

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ment as a countercyclical policy measure will have the tendency to cause a spurious negative correlation between the dependent variable and the public employment rate; errors in measuring employment or specification errors in the equation will also tend to bias the coefficient of public employment downward. 38. In the tables the reference group includes countries with a low index of centralization-coordination. Therefore, the estimated coefficients on the other two groups refer to the performance of these systems relative to decentralized-uncoordinated bargaining systems. A positive coefficient implies, other things being equal, a positive effect on the employment rate of the bargaining system with respect to the decentralized system, and vice versa. 39. Among others see: for the United States, Krueger and Summers (1988); Katz and Summers (1989); for Japan, Tachibanaki and Ohta (1992); for Germany, Bellman and Möller (1993); for Canada, Gera and Grenier (1994); for Sweden, and a comparison with the United States, Edin and Zetterberg (1989); for Austria and Norway, Barth and Zweimüller (1992); for Switzerland, Ferro-Luzzi (1994); Katz and Summers also estimated rents going to capital owners in the United States and found that they are very small. 40. The extensive research on the effects of deregulation on sectoral employment and pay developments in the United States suggests that the relationship between restrictive regulations and wage premia is particularly strong in service industries (for an overview, see Peoples 1998). It was impossible to look at these industries, however, in the context of this book; international comparisons of service-sector productivity and wages are problematic and few cross-country details on regulation and market structure in service industries were available at the time of writing. 41. Throughout this section, we used the 1993 data on purchasing power parity (PPP) compiled jointly by the OECD and Eurostat to approximate product prices for manufacturing and services industries. To this end, a mapping was established from 202 basic expenditure headings (in which the collection of 2,000 expenditure prices of individual goods is aggregated) to the classification of industries of the international sectoral database (ISDB). 42. Microstudies often employ detailed data on job tenure, fine occupational and education breakdowns, data on geographical location, and so forth. Work-place characteristics include working hour schedules and data on other working conditions 43. This result is confirmed by Katz and Summers (1989) for the United States and Tachibanaki and Ohta (1992) for Japan, while the link between innovations and wages is confirmed at the firm level in the United Kingdom (Van Reenen 1994). 44. “Excess burdens” are defined as the difference between the indicators of administrative burdens on the creation of corporations and sole-proprietor firms. These indicators summarize several kinds of administrative requirements to be fulfilled to create the two kinds of firms: number of procedures (e.g., registration, licence, etc.) necessary before and after the establishment of the firm; number of levels of government to be contacted; minimum capital requirements; direct administrative costs, etc.). 45. Value-added mix indices were constructed that are specific to each of the three sectoral aggregates. Relative sectoral productivities were assumed to be those of the OECD average. 46. See Grubb and Wells (1993); OECD (1994b).

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47. See Mundell (1961). 48. Note that the employment-population ratio, however, is still fairly low due to low labor-force participation rates. Around 13 percent of the population is now counted as disabled, although this is mainly the result of policy errors in the 1970s. 49. Public pensions are included to account for the role of early retirement in providing income support to the unemployed. 50. In the context of the OECD Jobs Strategy, country-specific recommendations were formulated covering labor-market policies and education policies as well as policies affecting the business environment. Progress made in implementing these recommendations is discussed in OECD (1999b). In the table, the follow-through rate refers to reforms in the labor market only. 51. By contrast, in menu-cost models the effect of higher inflation on the frequency of price adjustment is indeterminate as—within the class of Ss rules—the size of the band of inaction is affected. 52. The implicit assumption is that the aggregate demand curve is unit elastic, making the product of prices (GDP deflator) and real output independent of supply shocks. 53. The EMS was created in 1979 with eight participating countries: Germany, France, the Netherlands, Belgium, Italy, Denmark, Ireland, and Luxemburg. At the end of 1979, however, there was a reajustment of the parities. 54. Recursive estimates of equation (g) also suggest that the evidence of changes in nominal flexibility in the EMS zone is weak. 55. We estimated the following equation using the thirty-eight observations: a 2i = b0 + b1p + b2sp + b3DY + dEMU The coefficient of sp had a negative sign and a t-statistic of -3.7. The coefficients of the other variables were insignificant. The EMU dummy was included to check whether participation in the hard-currency area would have effects on nominal flexibility independent of those implied by nominal convergence. 56. The popular belief that the loss of the exchange-rate instrument would imply that there is no alternative but to implement structural policies is implicitly based on a similar argument. In fact, unless hysteresis effects are significant, exchange-rate depreciations are no substitute for structural policies since they can only smooth out cyclical unemployment with no effect on its structural component (Calmfors 1998). 57. The evidence on price convergence in the D-mark area presented in this section suggests, however, that the effect of price transparency on competitive pressures cannot be taken for granted. 58. Inflation bias occurs when the incentive to inflate is larger at higher rates of structural unemployment (because voters and policymakers do not differentiate between a high cyclical and a high structural unemployment). Therefore, the pressure to undertake fundamental labor-market reforms is higher in countries that have a discretionary monetary policy since this is likely to reduce the temptation to inflate. 59. In the EMU, high structural unemployment in one country imposes a negative externality in the form of an inflation bias on other countries, and a low level of structural unemployment in any one country imposes a positive externality on other countries in

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the monetary union because of a reduced inflation bias. The externality arises because of the centralized nature of monetary policy and the decentralized nature of labor-market policy. 60. This is again an externality problem. A large union in any one member country imposes a negative externality on other countries by demanding higher real wages resulting in higher domestic unemployment. The externality is felt in higher rates of inflation in the other countries. Similarly, there is an external benefit to wage moderation by a large, national union. 61. Data on labor-market institutions and regulations was drawn from Nickell and Layard (1998). 62. Structural stability was investigated by estimating the following linearized version of equation (10) (using the estimated global shocks as hard data), which also includes a domestic inflation shock to assess the level of nominal-price rigidity (see Layard et al. 1991 and Phelps 1994): Duit = f1i + f 2i uit-1 + f3iD + f4i Dp + eit where f2 measures the persistence of unemployment, f3 the sensitivity to global shocks, and f4 the sensitivity to nominal shocks. Among core-EMS countries, Chow tests of a break in 1980 were significant at 5 percent levels for Germany and the Netherlands and at 15 percent levels for Austria. 63. The indicator was defined as: reform = -( 0.08*D( repl. ratio) + 0.98*D( ben. duration) + 0.02*D( union dens.) - 1.45*D( union coord.)) 2.53). Product-market regulation could not be included because it is only observed for one period.

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Comments Olivier Blanchard

This is an extremely informative book on a difficult issue. It has two main strengths. It is intellectually honest; it is not a pamphlet about the evils of economic rigidities, but a balanced review of the theoretical arguments, together with a careful examination of the empirical evidence. It shows the power of OECD resources at work: the new set of indexes for goods market distortions represents a gigantic amount of work. It is not something that an individual researcher could have constructed alone. It proves useful here, and will prove useful to other researchers in the future. For both reasons, this book may well become a standard reference on what we know about product-market rigidities and labor-market performance. The study suggests that, while product-market liberalization is desirable on many grounds, one should not expect miracles in the labor market. One wishes for a stronger bottom line, but I suspect the authors have reached the right conclusion and for a simple reason: if the goal is to improve labor-market performance, then the first set of institutions one should look at is labor market, not product-market, institutions. For example, were we to fully eliminate state-provided unemployment insurance—something I do not condone—I am confident that the equilibrium rate of unemployment would substantially decrease in Europe. No product-market reform is likely to have, even remotely, effects of this magnitude. This is not to say that product-market reforms or financial market reforms do not matter. They matter enormously, but they surely matter much more for output and productivity than for unemployment. Most of the focus of this book is on the steady-state effects of productmarket regulations on the labor market. This is obviously the right first step. I think the dynamic effects, however, the effects on the path of employment and unemployment of product-market liberalization, are

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likely to be very important and that we have a number of clues as to what might happen. 1 Product-Market Restrictions: Causes and Effects A few years ago, I participated in a McKinsey study of differences in productivity across France, Germany, Japan, and the United States, by sector (McKinsey 1997). It gave me a much better idea of how productmarket restrictions affect an industry, and, by implication, a much better idea of what the effects of product-market liberalization may be. The first part of this book involves using detailed industry information together with PPP adjustment for prices to do productivity comparisons across the four countries. Figure C.1 gives a summary of the results. On average, for the six sectors the study focused on, labor productivity in both France and Germany was equal to 80 percent of labor productivity in the United States. In the automobile industry, labor productivity in France was only 55 percent of best practice (in West Germany France

Indexed to best practice benchmark = 100* Output Automotive (vs. Japan)

= 85 45

Retail banking Retail

¥

Employment**

70 55

125 80 100

70 80

70 70

Housing construction Telecom

Labor productivity

85

45 50

40 40 70 60

90 80 85 100 100*** 100***

70*** 65***

Computer software

55*** 55***

Weighted average

70 60 100

90*** 70*** 80 80 100

85 60 70 65 60 75 85 75 100

* US, if not mentioned otherwise ** Total hours worked per working age population *** Estimates Source: McKinsey

Figure C.1 Summary of the economic performance analysis at the industry case level, 1994/95

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this case, Japan rather than the United States), and labor productivity in Germany only 70 percent of best practice. The second part of this book involves trying to identify the sources of these productivity differences for each sector. Figure C.2 gives a summary of the conclusions for the automobile industry. The conceptual approach followed by McKinsey proceeds in three steps: look first at external factors, from macroeconomic policy, to product, labor, and financial-market regulations; then look at the impact of these external factors on industry dynamics, from the degree of competition to exposure to best practice; and finally, go to the organization of production and the implications for productivity. In the case of the automobile industry, the conclusions were very clear. Much of the lag behind best practice was due to a lack of competition, due in particular to protection from foreign (especially Japanese) competition. This lack of competition had two main effects on industry performance: 1. Higher rents, in the form of higher markups (irrelevant for productivity, but very relevant when we think about product-market reform). Important

1

Secondary Country comparison G vs.J External factors

• Fiscal and macroeconomic environments • Product market – Competition/concentration rules – Trade/FDI barriers – Product regulations – Other industries/up- and downstream • Labor market – Labor rules/unionism – Relative labor cost • Capital market – Corporate govemance/government ownership – Relative cost of capital/inermediation

Industry dynamics/ nature of competition

• Competition with best practice • Domestic competitive intensity

Production process

F vs.J

F vs.G

Less product/service innovation

• Mix of products/services and marketing • Production factors – Capital intensity/technology – Scale – Labor skill and motivation • Operations – Organization of functions and tasks – Design for manufacturing – Suppliers and supplier relationship Productivity performance (best practice = 100)

Less efficient processes

70

55

80

1 Explaining > 10 percentage points of the overall productivity differences 2 Explaining 3–10 percentage points of the overall productivity differences 3 Explaining 0–3 percentage points of the overall productivity differences 4 Financial pressure (resulting from product regulations) offsetting lack of pressure from owners (In France) Sourese : MMcKinsey

Figure C.2 Causality for productivity differences—automotive

2

Undifferentiating3

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2. Lower productivity, coming from a lack of exposure to best practice. This was the main source of differences between what had happened to the U.S. industry and what had happened in Europe. Faced with increased competition, the U.S. automobile industry had gone through crisis and resurrection, but the European industry had not. The study identified three specific shortcomings of the European automobile industry: (1) a poor organization of tasks, that is too many workers; (2) a poor design and use of economies of scale; and (3) inefficient relations with suppliers. What are the implications here? Were France and Germany to allow for more competition in the automobile market, the effects, the book suggestes, would be twofold. First, as emphasized by Nicoletti et al., there would be a large decrease in rents. Second, there would be a potentially large effect on productivity and output. Let me now generalize from the automobile industry to the economy as a whole and ask the question: If deregulation led to lower rents and higher productivity, what would be the dynamic effects on unemployment? 2 Deregulation, Productivity, and Unemployment Let us start with productivity. If deregulation were to lead to a productivity boom—or more accurately, to higher productivity growth for some time—what would be the likely effects on unemployment? The answer from both theory and empirical evidence is fairly clear. In the long run, the higher level of productivity should have roughly no effect on the unemployment rate. This is probably one of the best established facts in macroeconomics: the steady increase in productivity over time has not led either to a steady increase or decrease in the unemployment rate (it has been associated with a steady decrease in the number of hours worked, but there is little in common between the determinants of unemployment and the determinants of the laborleisure choice). Because of this long-run neutrality proposition, the study by Nicoletti et al. does not focus on the implications of productivity gains on unemployment, and in the long run, this is clearly right. The empirical evidence also suggests, however, that the long run may be very long in this case, and the dynamics are important. If it takes some time for higher productivity growth to be reflected in an increase in wage demands, equilibrium unemployment will be lower

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for some time. The evidence suggests that, higher productivity growth leads to lower unemployment for some time: Looking at unemployment and TFP growth across time suggests that high TFP growth after WWII was associated with low unemployment, while lower TFP growth from the mid-1970s was associated with an increase in unemployment. The proximate cause appears to be that, as TFP growth decreased, real wage growth took some time to adjust to this new reality, leading to an increase in labor costs and to higher unemployment. (This statement is based on the empirical work in Blanchard 1998.) •

Looking across European countries, one can read the Irish miracle as an example of what higher TFP growth can accomplish. Since the mid-1980s, largely under the influence of FDI, TFP growth has been high in Ireland. As real-wage growth has lagged behind, labor costs have dropped and unemployment has steadily decreased. The Irish experience is largely idiosyncratic: labor mobility between Ireland and England has limited wage growth in Ireland to be roughly the same as in the United Kingdom where TFP growth was lower. This effect would not be present in an economy without such labor mobility, but it is still relevant. To the extent that product-market deregulation leads to higher productivity growth for some time, it is likely to lead to lower unemployment for some time as well. This is good news. •

3 Deregulation, Rents, and Unemployment Let us ask the same question about rents as we did for productivity. If deregulation were to lead to a reduction in rents, what would be the likely effects on unemployment? The answer is much less clear than in the case of productivity. It depends on what happened to the rents, on who captures them, firms or workers. If firms kept the rents, then their elimination is likely to do some good, both in the short and the long run. This is the case the book mainly focuses on when it looks at the effect of a decrease in the markup brought forth by higher competitive pressure. A decrease in the markup in effect increases the real wage paid by firms (by reducing the price of goods relative to the nominal wage). This is likely to lead to a decrease in unemployment, at least for some time.

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It may be that the rents were captured, however, by the workers. Such capture can take many forms: higher wages in sectors with higher monopoly power, or similar wages, but various degrees of excess employment—labor hoarding. There is plenty of evidence that both forms are present in practice. If this is the case, then the effects of product-market liberalization on unemployment may be quite different. Take for example the case of labor hoarding. Suppose that productmarket deregulation leads to higher competitive pressure, which in turn forces firms to eliminate labor hoarding. In the short run, the elimination of labor hoarding means higher layoffs and so an increase in unemployment. Other things being equal, the reduction in labor hoarding means higher profits. This may in turn lead to more capital accumulation and more employment over time. The bottom line is that the reduction of rents may lead to higher unemployment for some time. This is bad news. Why do I insist on this case? Because I believe it is not a hypothetical case but rather something we have observed for some time in Europe. 4 The Last Fifteen Years: Capital Shares and Unemployment Figures C.3 and C.4 show the evolution of two central macroeconomic variables in France, Germany, and Italy since 1970. The variable plotted in figure C.3, the unemployment rate, is familiar. And so is its evolution, the steady increase in unemployment since 1970. Much less attention has been paid to the variable plotted in figure C.4, namely the capital share in the business sector of the economy. Note the evolution: a drop in the share in the 1970s, but a much larger increase since then. In all three countries, the share stands at a historical high—at least in recorded statistical history. For example, the capital share in France stands in 1999 at more than 10 percentage points above its 1981 level, an enormous swing by historical standards. There are many ways to interpret the evolution of the capital share, but my interpretation of the evolution of the capital share is that the increase in the capital share reflects in large part a decrease in labor hoarding by firms since the early or mid-1980s. Blanchard 1998 presents the full argument, but the intuition behind this interpretation is straightforward. By definition, reducing labor hoarding means decreasing employment at a given wage; this clearly generates unemployment,

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0.44 0.42

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Figure C.3 Capital shares in France, Germany, and Italy

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Figure C.4 Unemployment rates in France, Germany, and Italy

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at least initially. Decreasing employment at a given wage also implies a reduction in the wage bill and thus a reduction in the labor share— equivalently an increase in the capital share. Thus, a decrease in labor hoarding can explain both why unemployment has remained high since 1985 (when a number of other factors should have led to a decline), and why the capital share has increased so much since then as well. This decrease in labor hoarding—if indeed this is the right interpretation of what has happened—may not have been due to productmarket deregulation. It may have come instead from a decline in the bargaining power of unions for any number of reasons, from changes in labor-market institutions, and so forth. It may be a portent, however, of what will happen as a result of product-market regulation, namely more unemployment for some time. Another empirical observation may be relevant here. Since 1985, the unemployment rate in southern Italy has jumped from 12 to 22 percent, while the overall unemployment rate remained roughly constant. While one can think of a number of factors, one major factor appears to be considerable reduction in subsidies to firms in southern Italy (in the process of transition from national subsidies to EU based “structural programs”). This is a clear warning that, as desirable as reductions in subsidies may be, they may well come at the cost of higher unemployment, for quite some time. To summarize: product-market restrictions, and by implication, product-market liberalization have major effects on rents and productivity. Some of the effects of liberalization (higher productivity, lower markups) may lead to lower unemployment for some time; some of these effects (decrease in rents going to workers, decrease in labor hoarding) may instead increase unemployment for some time. What I have done in my comments is to attempt to identify the mechanisms. One could wish to sign the net effect, but this would require having more knowledge than most of us have at this point. References Blanchard, O. 1998. “Revisiting European Unemployment, Capital Accumulation and Factor Prices.” NBER working paper, no. 6566. McKinsey Global Institute. 1997. Removing Barriers to Growth and Employment in France and Germany. McKinsey.

Comments André Sapir

During the past twenty-five years, the EU, the United States, and the world economy in general have undergone important shocks and changes. Most economists appear to agree that, compared with the United States, Europe has displayed little aptitude to respond to the new set of economic circumstances. One of the manifestations of this inadequate response is the unemployment problem afflicting European society, which is generally viewed as a result of sclerotic labor markets. Labor markets are far from being alone in their failure to respond appropriately to changes confronted by Europe. Other markets also suffer from sclerosis. In general, it is probably fair to claim that most product and factor markets in Europe are less responsive to changes than in the United States. This situation translates into a significant difference of per capita GDP (measured in PPP) between the two sides of the Atlantic. During the thirty years after WWII Europe was able to catch up with the United States, but the gap between the two continents has remained nearly constant since the late 1970s and it has even increased during the 1990s. Today, per capita GDP in the United States is 45 percent above the EU15 level, which suggests that structural deficiencies remain important in the EU. The gap in per capita GDP between the EU and the United States relates to problems in both product and labor markets. Deficiencies in product markets probably explain why labor productivity in the United States was, in 1997, 20 percent higher than in the EU15, whereas deficiencies in labor markets are probably responsible for the fact that the U.S. employment rate is about 10 percentage points higher than in the EU. The study by Nicoletti et al. deserves to be commended for enlarging the scope of investigation of Europe’s problem beyond the traditional analysis of labor markets and into the difficult realm of product

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markets. The only market that is not covered by their study is the financial market. As readers will recall, the single market program (SMP) (“Europe 1992”) was designed to improve the functioning of product and financial markets by removing barriers to free circulation inside the EU. It did not address directly, however, the functioning of labor markets. A few years ago, the EC attempted to make an economic evaluation of the SMP.1 We were able to provide a measure of the extent of product-market integration based on price comparisons, but this measure was only partially adequate. Nicoletti et al. use two measures of product-market integration: one based on price comparisons as in the EC work and the other based on product-market regulation. Price comparisons are useful, but they need to be supplemented by studies about the behavior of prices such as those by Engel and Rogers.2 One such study was undertaken recently by Natalie Chen, who adopts a two-stage research strategy.3 In the first stage, Chen uses monthly observations for domestic output price indices for NACE three-digit sectors. Chen tests mean reversion toward PPP by sector for five countries (Belgium, France, Italy, the Netherlands, and Spain) relative to Germany. Her findings indicate that prices behave differently across countries (mean reversion generally occurs for Belgium, France, and the Netherlands, but not for Italy and Spain) and across sectors. In the second stage, she estimates probit equations for the probability of mean reversion based on the results of stage one. Chen’s findings indicate that this probability is influenced by country variables (exchange rate volatility and distance) and sectoral variables (nontariff barriers, product differentiation, and market concentration). The main contribution of the study by Nicoletti et al. lies in the construction and analysis of an indicator of product-market regulation. This opens an extremely fruitful line of research. Precisely because of its importance, I want to underline two major problems that I see with this indicator. First of all, the indicator of product-market regulation focuses almost entirely on the country dimension, excluding the sectoral dimension. This is regrettable because, contrary to labor markets where the country dimension clearly dominates, product markets exhibit a very strong sectoral dimension. The other problem with the indicator lies in its focus on government regulation, whereas barriers to competition in product markets can also arise from the behavior of firms, which again relates to the sectoral industrial organization.

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Leaving aside these considerations, I want to turn to the indicator itself as a measure of product-market regulation. How should we go about testing whether the indicator provides a reliable measure of the extent of product-market regulation? In the case of labor-market regulation, the reliability of the indicator previously constructed by the OECD could easily be verified with the help of a simple indicator of labor-market performance, such as the employment or unemployment rate. By analogy, an appropriate indicator of product-market performance could be labor productivity for OECD countries with similar factor endowments. Using labor productivity as a check, the indicator of product-market regulation devised by Nicoletti et al. appears to perform well when comparing the United States with the average for the EU. The results are far from satisfactory, however, for intra-EU comparisons. Here are two examples. Italy ranks near the top and the United Kingdom ranks at the bottom on the product-market regulation scale, whereas the former outperforms the latter in labor productivity. The same holds true for Belgium, which ranks second in regulation, and the Netherlands, which ranks near the bottom of the scale. Despite a certain degree of skepticism about the indicator itself, I not only accept but share the key assumption of the study, namely that product-market competition interacts with labor-market regulation to affect employment performance. The authors offer a great deal of (weak) econometric evidence in support of their assumption, however, they are commendably forthright about the shortcomings of their results. The authors also seek to evaluate the likely impact of economic and monetary union (EMU) on product-market competition and labormarket regulation. The study rightly argues that in theory EMU could either increase or decrease labor-market regulation, hence, the question is essentially an empirical one. To provide empirical evidence on the link between EMU and labormarket regulation, the authors attempt to draw lessons from the European monetary system (EMS). Unfortunately, the EMS is a poor proxy for EMU. The latter consists of two channels in the context of the issues raised in the study: a macroeconomic channel operating through the strong expectation of price stability, and a microeconomic channel operating through increased competition in financial and product markets. Both channels are relevant, but the authors choose to concentrate on the macroeconomic one, which is probably the least powerful

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of the two channels as far as the potential impact on labor-market regulation is concerned. Greater competition in financial and product markets induced by EMU is likely to translate into greater competition and lower regulation in labor markets, at least initially, a tendency that labor would want resist. Since the labor market is essentially a political market mediated by governments, the issue of the effect of EMU on labormarket regulation boils down to the reaction of governments to the expected pressure. Governments in all EMU member countries are deeply committed to the success of EMU. Most have come to realize that the smooth functioning of monetary union requires the implementation of structural reforms designed to improve the functioning of all EU markets, including labor markets. This awareness has led to the so-called Cardiff process, whereby the European Council (EC) asked for closer monitoring on and coordination of structural reforms.4 The system of peer pressure established by the Cardiff process has already borne fruits. Indeed, the 1999 broad guidelines of the economic policies of the member states and the EC adopted by the council on recommendation by the commission include, for the first time, country- and marketspecific suggestions for structural reforms. Lastly, I want to address the issue as to whether increased competition in product and factor markets and lower regulation of labor markets at national levels may lead to renewed efforts toward social regulation at the EC level. Throughout the history of European integration, there has been a debate about the relationship between liberalization and social protection. On the one hand, optimists have claimed that liberalization “naturally” leads to harmonization through convergence of economic conditions. On the other, pessimists have asserted that harmonization is required prior to or in conjunction with liberalization so as to avoid social dumping or a race to the bottom in social protection. As long as European economic integration generated rapidly increasing incomes and low unemployment, optimists were vindicated. With the slowdown in income growth and rising unemployment since the late 1970s, however, pessimists have become louder in Europe.5 This suggests that the prospect for EMU to promote EU social regulation will depend upon the effect of EMU on income and employment.

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Notes 1. European Commission, “Economic Evaluation of the Internal Market,” European Economy, Reports and Studies 4, 1996. 2. See, for instance, C. Engel and J. Rogers, “How Wide is the Border,” American Economic Review 68, 1996. 3. N. Chen, “The Behavior of Relative Prices in the European Union: A Sectoral Analysis,” ECARE, Université Libre de Bruxelles, mimeo, 1999. 4. See “Economic and Structural Reform in the EU (Cardiff II),” A report by the European Commission, 1999. 5. See A. Sapir, “The Harmonization of Social Policies: Lessons from European Integration,” in J. Bhagwati and R. Hudec (eds.), Fair Trade and Harmonization, Cambridge: MIT Press, 1996.

Conclusions: Is There a Role for Supranational Institutions? Tito Boeri

The two studies presented in this book shed light on the complex institutional transformations taking place in Europe and on their likely effects on the labor market. They also provide important background material for policy, and in some areas formulate explicit policy recommendations. In the first part, desirable features of social policies in a united Europe are identified and supported by sound theoretical arguments. In the second part, the benefits deriving from a furthering of product and labor market liberalization are pointed out in a carefully documented and balanced way. A key issue raised concerns who should lead Europe from here to there, which level of government should be in charge of the institutional transformations going on, and who should direct regulatory changes to reach the long-term objectives set by the authors. The main issue is to which extent national authorities and/or EU-level decisionmaking should be governing this process. An apparent tension exists between the two studies in this respect, which is important to point out, as it may otherwise mislead the reader. The research by Giuseppe Bertola, Juan Jimeno, Ramon Marimon, and Christopher Pissarides (Bertola et al. henceforth) suggests that important results can be achieved without necessarily strengthening EU institutions. The policy prescriptions developed in the first part of this book are indeed all compatible with EU institutions, which lack politically accountable executive power at the central level and are subject to strong unanimity requirements in central decisions. In principle, even without reforming European institutions, it is possible to implement the first proposal made by Bertola et al., namely to harmonize programs of social assistance of last resort. Clearly, such programs should entail limited international redistribution, as large cross-country transfers would require strong EU institutions in charge

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of running income-of-last-resort schemes. The other prescriptions of Bertola et al. involve some EU-level policy coordination, which can be achieved possibly without stronger supranational authorities. In the field of social insurance, in particular, it is recommended that mandatory minimum contribution rates be coordinated at the EU level, leaving to national entities the task of designing such schemes. The EU should make sure, however, that social-insurance schemes can be financed in a sustainable way by contributions to preserve appropriate labor-mobility incentives. All other social-policy interventions, according to Bertola et al., should be left to local decision-makers and fully financed at the local level to accommodate the wide heterogeneity of preferences and economic means within the EU. The Luxembourg process is criticized in this study insofar as it aims at imposing specific models on necessarily country-specific labor-market policy strategies and reform trajectories. The second study, by Nicoletti, Haffner, Nickell, Scarpetta, and Zoega, does not address explicitly the issue of supranational authorities. A key message of this study, however, is that while the benefits from liberalizing product and labor markets can be substantial, there is no guarantee that EMU and, more broadly, the furthering of the European economic integration process, will deliver environments with less product-market restrictions and, above all, less employment protection. Nicoletti et al. argue and show, based on the rich body of empirical evidence they assembled, that restrictive product- and labormarket regulations are closely interlinked. Environments more prone to restrict competition in the product markets also tend to offer more protection to labor-market insiders and vice versa. Nicoletti et al. suggest that regulatory reforms should go hand-in-hand in product and labor markets. Simultaneity in regulatory reforms of product and labor markets can win resistance to change and makes it more likely that liberalization exerts positive effects on employment. As regulatory reforms lead to better outcomes, the authors conclude, there is a potential role to be played by the European institutions, both in coordinating national reforms and in setting the framework for Europe-wide policy actions. Although the EC has a mandate and executive powers in the area of product-market regulations—and the EC has indeed played a key role, according to their study, in dismantling regulations that were unfriendly to competition—it has no powers in the field of labor-market regulations. Hence, from these facts and arguments one may be tempted to draw the conclusion that supranational authorities

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prerogatives should be strengthened on labor-market regulation front, at least to match those prevailing in the field of product-market reforms. In the first part of the book, we have a study on social policy— making a strong case in defense of relatively large, albeit more efficient than in the current European landscape, social welfare systems—that does not advocate stronger supranational powers. In the second part of the book, we have a study illustrating the benefits deriving from more competitive markets, which provides arguments for stronger EU institutions. How can this contrast be? It is because the two studies put the debate on a new footing. We are at least one step ahead of the traditional dichotomy between, on the hand, advocates of social protection and, on the other hand, apprentice liberals. There is also no distinction between optimists and pessimists of European integration, the historical divide recalled by André Sapir in his comments. There is no room for ideological statements in this book, as acknowledged by all the discussants. This is an important achievement in its own right, as all too often caricature prevails over reasoning when these highly sensitive topics are addressed, even when scientists, rather than politicians, are at work. The tensions between the two parts of this book are also much less marked than it may appear at first sight. The stronger supranational prerogatives in the field of labor-market policy that should match the EC powers on product-market regulations are much more in the spirit of negative integration than in the logic of positive integration. Supranational powers are needed to dismantle existing protections rather than to introduce brand new EU-wide regulations. If the Luxembourg process was only an exercise in which the EC simply pushes through reforms of employment protection legislation and restrictions to regional and cross-country labor mobility, I believe that Bertola et al. would be much less critical of this exercise. They would also be more sympathetic with the spirit of the EC employment guidelines if these were confined, in their “positive” interference with national policies for employment, to circulating information on best practices, making full use of the policy experiments going on in Europe, and persuading governments to follow some policies that proved successful elsewhere. In the first part of this book it is clearly stated that full advantage should be taken of wide experimentation, ensuring the availability of information as to the character and effectiveness of social policies. The issue is that the Luxembourg process currently goes much beyond this; for

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example, it defines thresholds to be reached by active labor-market policy intakes in all countries of the EU no matter what their labormarket conditions and characteristics of the unemployment pool look like. One of the key reasons why it is risky to rely on supranational powers in this field is that institutional features are very closely interconnected. The linkages between product- and labor-market restrictions, documented by Nicoletti et al., are matched by the country clusters and institutional trade-offs (e.g., less unemployment insurance more employment protection) characterized in the first part. They are also described in Olivier Blanchard’s insightful remarks. These institutional linkages imply that reforms need to be comprehensive to be successful. Comprehensive reforms, however, should necessarily work on country-specific institutional clusters. The fact that the policy recommendations developed in this book do not challenge the broad character of EU institutions means that they can be implemented rather quickly. We may have different views as to whether in the long run the EU will and should have an elected executive providing democratic consensus to more ambitious EU social policies. It would be dangerous, however, to postpone the reforms of social policy in the EU to a necessarily long-run institutional rebuilding process. Policy review exercises carried out at the EU-level, for example, in the context of the Cardiff process, as well as multilateral surveillance by international organizations on the implementation of structural reforms can appreciate institutional differences across EU countries and be respectful of national specificity. As acknowledged by three senior economists, however, with longstanding experience in this field, who intervened at the Genoa conference—David Coe (IMF), John Martin (OECD), and Georg Fischer (EC)—peer reviews and multilateral surveillance exercises can do little to bind governments to push through reforms. The pressure of national lobbies defending productand labor-market restrictions is much stronger than the persuasion profusely dispensed in the context of these policy review processes. These may have some impact on national policies only when they are used for screening purposes, for instance, in the context of negotiations with countries that want to join the EU. In this case, the desire to please the EC may be sufficiently strong to stimulate candidate countries to take the steps that are advocated in these multilateral surveillance exercises. It is much more difficult for policy reviews to have some impact on

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national policies for the countries that are already members. This does not mean, however, that it is not worth trying. The problem with having EU-level decision-making under majority rule in charge of the structural reforms discussed in this book is in the pressures to harmonize institutions. Social Europe is so heterogeneous—and social policies so strongly interlinked with redistributional policies—that majority voting may result in some countries being always in the minority. The problem lies not in the fact of having someone from the outside pushing national governments to act. Quite the opposite is true: as stressed by Gøsta Esping-Andersen in his stimulating comments, external pressures have played and can play a very important role in legitimizing reforms undertaken by governments facing powerful lobbies that oppose reforms. If external pressures for reform cannot be too strong, there is no alternative other than trying to identify ways to reduce the opposition of internal pressure groups. There ought to be reasons why small EU members have often been most successful in undertaking fundamental reforms of employment and social protection without meeting strong political opposition. There must be some explanation for unions and employers associations resisting reforms more in some countries than in others. These issues were not discussed in this book, which is focused on long-term outcomes rather on politically feasible reform trajectories. Further work carried out by the Fondazione Rodolfo Debenedetti will try to address these important dimensions of labor-market and social-policy reform in Europe.

Appendix: Taking Stock of Social Policy Reforms in Europe Fondazione Rodolfo Debenedetti

Figure A.1 Reforms of Employment Protection Legislation (EPL) in Europe (1986–1997)

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Table A.1 Reforms of Employment Protection Legislation (EPL) in Europe (1986–1997) Austria

1993: The employment security law is introduced, written justifications to the labor office and compulsory contributions to older-worker retraining programs may be required in the event of the lay-off of workers over 50 years old. The employment contract adjustment law came into force. It stipulates that when a company is taken over, the existing employment contracts have to be taken over too. This does not apply if the sale is the result of bankruptcy proceedings. 1996: To promote the recruitment of older workers and to prevent layoffs a “plus/minus” system was introduced on 1 April 1996. It specifies that employers have to pay only half of the employer’s unemployment benefit contribution if they take on an employee over 50 years of age. If they take on someone over 55, this contribution is waived entirely. If an employer lays off an employee of over age 50 who has been working for the company for ten years or more, on the other hand, he/she has to pay a special unemployment contribution until the employee in question reaches the age of 55 (for women) or 60 (for men).

Belgium

1994: Notice periods for high-income white-collars made subject to negotiation (permanent workers). A new type of contract came into force (“emploi-tremplin”), it is possible for a specific category of workers (aged less then 30 years and with less than six months of experience) to interrupt the employment relation on the basis of a shorter notice period (one month in case of dismissal or one week in case of voluntary separation).

Denmark

1990: Temporary work agencies (TWA) were deregulated. 1994: Notice period extended. A new law (AFLM 1/6/’94, no.414) extends the notice period in very large establishments making half the workforce redundant.

Finland

1996: Employers’ notice period is shortened. For workers with tenure of less than one year the notice period is halved; it is reduced from two months to one month.

France

1986: Administrative authorization for individual dismissal for economic reasons is abolished. Administrative authorization was previously required only for collective dismissals of more than nine employees. From July 1986 to 31 December 1986 (3/7/1986 nr.86–797). The list limiting the circumstances in which the use of fixed-term contract is allowed is abolished. The use of “intermittent” work contract (containing provisions for temporary interruptions), is authorised. Ordinance 11/8/’86. 1986: The employers must state the ground of the individual dismissals in writing. Law 30/12/1986 no. 86–1320. 1989: Individual dismissals for reasons not related to the person, (but depending from modification of the employment contract as a result of economic difficulties), must be notified in a letter including the grounds of the dismissals. Statuary requirements that collective redundancies are accompanied by “social plans” (early retirement schemes, retraining contract). Law 2/8/1989, nr.¢89–549.

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Table A.1 (continued) 1990: The list limiting the circumstances in which the use of fixed-term contracts and temporary staff is permissible is restored. (law 12/7/’90 nr.¢90). 1992: The law (29/7/92) established that all separations (i.e., resignations or the refusal of a radical modification of the employment contract) due to economic reasons are subject to the regulation concerning dismissals for economic reason. 1993: Statutory requirements are introduced concerning the contents of social plans (if there is no social plan or the measures proposed are inadequate, the redundancies will be considered null). Law 27/1/1993 nr.¢93–12. In 1995 the cour de cassation will interpret the 1993 legislation restrictively. Germany

1993: Notice period for blue-collar workers extended and aligned with those of white-collar workers. 1994: TWA and private employment services are allowed. 1996: The employment threshold at which EPLs applies, is increased from five to ten employees (on a full basis) per firm. A law comes into force liberalizing employment conditions. Legal conditions covering dismissals are relaxed. 1997: Exemption from general dismissal law widened; social criteria for dismissals relaxed.

Greece

1990: A new law replaces compulsory arbitration of labor disputes related to dismissals with special boards responsible for the creation of a group of independent mediators and arbitrators. Three independent professors sit on the board in addition to three employers’ and three union representative as well as one ministry of Labour official and a chairman elected by the rest. 1991: Liberalisation of collective agreement.

Ireland

1991: A law increases job security for part-timers, ensuring, at the same time, that they qualify for a wide range of benefits. 1993: Amendment to the unfair dismissal act introduces compulsory reinstatement of an employee unfairly dismissed. 1994: Employment (information) act came into effect. This act requires an employer to provide employees with a written statement of the contract conditions, including the length of the notice period required in case of dismissals.

Italy

1987: Fixed term contracts can be used more widely, if allowed by sectoral collective agreements. Increased the age limit of apprenticeship, among artisans, to 29 years of age. Reorganization of employment offices. Law 28/2/1987 nr.¢56. 1989: The employment threshold guarantees in cases of dismissal on disciplinary ground extended to small firms (with less than sixteen employees).

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Table A.1 (continued) 1990: Compulsory reinstatement and/or compensation in case of unfair dismissal is extended, to employers of noncommercial organizations employing more than fifteen employees in the same production unit and those employees in enterprises with more than sixty employees in total. Law 11/5/1990. 1991: A law regulates collective redundancies, establishing standards related to notice and consultation. Law 23/7/1991 nr.¢223. Reinstatement for the lack of dismissal communication in written form. 1997: In case of violation of fixed-term contracts legal discipline, a new act limited the drastic sanction (conversion of fixed-term contract into an open-ended one) only to serious cases. TWAs were legalized. The law has stated that the training contract can be extended, from two to years in the south of Italy in case of a change into a permanent contract. The law has established that the term of apprenticeship contract can vary in all sectors. Luxembourg

1993: Legislation concerning collective dismissals tightened. 1994: The government presents a new package of measures to preserve employment, including a reorganization of the Public Employment Service. 1997: Measures to encourage recruiting more people on fixed-term contracts. Reform of the public employment service (PES). The emphasis is on improving communication among the PES, enterprises, and job seekers. The obligation for employers to notify all vacancies to the PES.

Netherlands

1989: Dismissals that result from bankruptcy of companies no longer need authorization by the public employment office (PES). 1991: The official employment service was overhauled by the provision of employment act. This entailed a number of steps to decentralize the service and involve employer organizations and trade unions both in its operation on policy formation. The ban on private recruitment agencies for permanent employment was lifted; they are now allowed to operate alongside the official service. They need a license from the Ministry of Labor to operate. 1994: Implementation of the EU directive on proof of an employment contract (91/533/ec art 653 civil code). This requires employers to provide every employee with the basic terms on the conditions of their employment in writing no later than one month after their employment commences. (See Ireland, 1994—harmonization of national law to EU directives). 1995: The government decides to ease dismissal procedures. According to the new rules, an employer can dismiss an employee at the same time or even before asking permission from the director of the Public Employment Office.

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Table A.1 (continued) Portugal

1989: Several restrictions on layoffs’ legislation are phased out. The length of the decision process was reduced and administrative redtape revoked. At the same time, legislation governing dismissals was deeply changed; individual dismissals due to failure to adapt were reintroduced; the list of circumstances that can be considered cause for individual dismissal due to economic reasons are broadened. 1989: Part-time employees have the same contractual rights as fulltime employees. They have the same basic employment rights such as the right to claim for unfair dismissal. Art. 648 civil code. 1991: Firing restrictions eased. Through a wider range of admissible lay-offs. 1996: The government, the employers’ associations (AIP), and the trade unions sign a strategic social pact. Wider use of atypical work term contracts is allowed. In the public sector, fixed term contracts can, under special circumstances, be extended two more times beyond normal requirements before being automatically transformed into a permanent contract. Incentives for using temporary employment agencies, stronger sanctions against firms employing children or false independent workers.

Spain

1994: Individual dismissals eased: zero days of notice required when length of service is below fifteen days for blue-collar workers or below one month for white-collar workers. Thereafter (only for objective dismissal) one month when length of service is below one year, two months when length of service is between one and two years, and three months for two or more years’ service. Collective redundancies: the firms can initiate a collective dismissal if the dismissal affects to 10 or 30 percent of workers, depending on the size of the firms. The legally acceptable causes for collective dismissals have been expanded to include production and organizational causes. Law 19/5/1994 nr.¢11. 1994: TWA legalized, increased restrictions on fixed-term contracts. 1997: The reform has extended the causes that may give rise to an individual dismissal. It includes the possibility of staff adjustments with a view to overcoming problems related to a lack of competitiveness. Decree 17/5/1997 nr.¢8. 1997: Payment for unfair dismissal is reduced to thirty-three days per year of seniority for new permanent contracts of employment (aimed at young and disadvantaged workers), with a maximum of twentyfour months wages. Decree 17/5/1997 nr.¢8. 1992: The government wage guarantee in the case of employers’ bankruptcy is lowered.

Sweden

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Table A.1 (continued) 1996: Local union may freely agree on recruitment and dismissal provisions, economic sanctions in case of breach of the rules are to be adapted to the enterprise’s ability to pay. Refocusing of the activities of employment offices. From administering ALMPs toward their traditional role of improving the matching between unemployed and vacancies. Formulation of individual plans reflecting the job-seekers qualifications. A reassessment of balance between EPL and the enterprise adaptability attempts to bring out an agreement between social partners on further changes in this framework. United Kingdom

1993 Trial period extended from one to two years.

Figure A.2 Reforms of nonemployment benefits in Europe (1986–1997)

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Table A.2 Reforms of Nonemployment Benefits in Europe (1986–1997) Austria

1989: An amendment to the Unemployment Law approved; entry conditions for youth and long-term unemployed are improved. 1993: The definition of “suitable job-offer” is tightened. • Early retirement for employees over age 55 is introduced. 1995: Weeks of work necessary to requalify for Unemployment Insurance in the case of repeated spells of unemployment are reduced from twenty-six to twenty weeks. • The special preretirement benefit (Sonderunterstützung), higher than the normal Unemployment Benefit and available from the age of 54 for women and from the age of 59 for men is abolished. • Entitlement for Unemployment Benefits and special help for longterm unemployed is restricted. • Unemployment benefits for those on high incomes cut and the minimum age for support of older unemployed in a few special sectors is raised. 1996: Incentives for early retirement in the public sector are phased out. • The qualifying period for Unemployment Benefits is increased from twenty-six to twenty-eight months and the earnings history for the calculation of benefits is increased from six to twelve months. • A “bonus-malus” system is introduced to encourage employment of older workers and to discourage their dismissal. • Number of months of contributions necessary for early retirement is increased from 420 to 450 and early retirement for older workers on account of long-term unemployment is phased out. 1997: The unemployed made eligible for continued receipt of Unemployment Benefits even if they accept temporary employment. • For early retirees the earnings base from which pension entitlements are computed is increased by three years to the eighteen “best years” of a person’s work history, to be phased in between 2003 and 2020. • The eligibility conditions for early retirement on account of reduced capability to work are sharpened by extending the required contribution period within the previous 180 months from 36 months to 72 months and requiring a spell of reduced capability to work of at least twenty weeks to qualify for the pension. To be enforced from 1998 onward.

Belgium

1986: Certain categories of the unemployed are excluded from benefits because of a new method of calculation of Unemployment Benefits. 1988: The Unemployment Benefits replacement rate is lowered markedly with the December tax reform. 1990: An agreement between the employers’ federation and trade unions is stipulated; Unemployment Benefits for people between 50 and 55 years of age are increased. 1992: A fiscal package on Unemployment Insurance is approved: • Temporary unemployment schemes and part-time unemployment are made less financially attractive.

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Table A.2 (continued) • The number of daily unemployment benefit payments that can be combined with part-time employment is limited to a maximum of 13 per month; the maximum wage at which it is possible to cumulate benefits and wages is reduced. • Monitoring of the availability of unemployed to take up “suitable job offers” is increased. • Minimum age for early retirement is increased from 55 to 56. 1993: The “global plan” is approved in November; eligibility for Unemployment Benefits is tightened and linked more closely to work by, inter alia, extending the period during which school-leavers are not entitled to Unemployment Benefits. 1996: Conditions under which older unemployed are exempted from job search are eased. • Stronger incentives for people interrupting unemployment are introduced (interruption de chômage). • Rules governing the exclusion from the unemployment schemes on grounds of abnormally long periods of unemployment are tightened. Denmark

1987: Unemployment Benefits and retirement payments are significantly increased. • Rules diminishing Unemployment Benefits after a certain period of unemployment are abolished. 1991: Budgetary outlays for Unemployment Benefits are reduced. • Compensation for the first twenty-five hours of unemployment is abolished. 1991: Eligibility conditions and rules on refusing suitable job offers are tightened. 1994: A comprehensive Labor Market Reform is approved by the Parliament. • The maximum duration of unemployment insurance benefits is limited to seven years. • The Unemployment Benefits period is split in two (four plus three years) with full-time activation through job offers, training, and education compulsory in the second period. • The possibility of renewing entitlements to Unemployment Benefits by participation in active programs is abolished. • Policy implementation is decentralized to regional labor market authorities. 1996: Another Labor Market Reform is approved. • Eligibility criteria for access to Unemployment Benefits are tightened (fifty-two instead of twenty-six weeks necessary to qualify). • The minimum age for access to Unemployment Benefits is raised from 17 to 19 years of age. • The maximum duration of Unemployment Benefits is lowered to five years.

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Table A.2 (continued) Finland

1993: The government’s employment commitment imposed by the Employment Act of 1988 is removed. • The benefit period in the basic flat-rate of Unemployment Assistance scheme is limited. • Unemployment assistance eligibility requirements and duration brought in line with those of the Unemployment Insurance earningsrelated supplementary benefit. 1995: The Employment Program is approved in September. • Unemployment Insurance recipients required to work for at least ten months to requalify for benefits. • The benefit level at which Unemployment Insurance participants requalify is linked to the compensation received during the ten-month period rather than to the pre-unemployment earnings before unemployment. • The automatic extension of Unemployment Insurance benefits for those over 55 years old is reduced from five years to three. 1997: The period of prior employment for entitlement to the earningsrelated unemployment benefit is extended from six to ten months, and the basis for earnings-related daily allowances to be calculated from the date when the employment requirement is fulfilled; new allowances will be at least 80 percent of the previous allowances. • Incentives for earning additional income while benefiting from unemployment insurance are improved. • The period of unemployment benefit for the long-term unemployed over 53 years of age is shortened by two years. • People between 20 and 24 years old with no vocational training are no longer entitled to labor market support if, without any acceptable reason, they refuse a suitable job offer or a slot in a training course. • Unemployed persons are allowed to make short, occasional trips abroad without loosing the right to daily unemployment benefit if there is advance notice of the trip and they can be immediately contacted during the trip and are able to accept work offered within a few weeks. • Long-term unemployed persons who have been active in the labor market in paid employment or as entrepreneurs for at least twelve years and registered as unemployed job seekers with the employment office for at least twelve of the preceding twenty-four months have the right to daily unemployment benefits or to Labor Market Support benefits during a period of voluntary training aimed at promoting professional skills for a period not to exceed two years. • The possibility to be reintegrated into unemployment compensation rolls after having been on subsidized employment is tightened. • Reduction in benefit level for renewal of unemployment insurance is adopted. • New benefit rules are implemented to discourage entry into early retirement.

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Table A.2 (continued) • The “education guarantee,” a special in-school benefit at a level equal to the Unemployment Assistance scheme that was previously available only to unemployed workers out of work for at least six of the previous eighteen months, is “opened-up” to all unemployed workers. France

1992: A downward sliding scale for benefit payments (allocation unique dégressive) is agreed upon. 1993: Benefits cut by reducing their duration, which now varies according to the age and the length of prior affiliation to the unemployment insurance system.

Germany

1990: Eastern Germany Unemployment Insurance merged with the western German Labor Office. • The two previous GDR social security institutions—the social security insurance for employees and the state social insurance system—are collapsed into one organization “the Social Insurance of the GDR”. • Early retirement schemes for employees over 57 years old are introduced. 1991: Early retirement schemes are extended to employees over 55 years old. 1994: Most of the payments of benefits under unemployment insurance and labor-market policy are reduced by 3 percentage points. 1995: Several changes to unemployment insurance are implemented to halt the trend towards early retirement through the use of generous unemployment insurance provisions for older workers. • The duration of UI in case of unjustified dismissals is limited to twenty-four months. • The duration of unemployment (UI) benefits is linked to the amount of redundancy payments. 1996: A gradual withdrawal of early retirement provisions is agreed upon. 1997: Redundancy payments (abfindungen) now generally credited against unemployment insurance benefits up to a fixed limit. • The minimum age for receiving unemployment benefits for more than a year is raised by three years. • Abolition of the possibility of refusing job offers on the grounds that they do not correspond to the vocational qualification of the unemployed; offers must be accepted during the first three months of unemployment if the wage offer is within 20 percent of the previous wage and this discount rate is 30 percent in the following three months; from the seventh month job offers must be accepted if the net income is greater than unemployment benefits. • Tighter controls of the eligibility criteria are introduced. • Abolition of the possibility of renewal of the right to Unemployment Insurance through participation to training courses. • The age of early retirement for women and for the unemployed with a long contribution record are raised, effective in the year 2000.

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Table A.2 (continued) Greece

1990: The duration of unemployment benefits is raised from seven to twelve months. • The system of employment incentives and unemployment benefits consolidated (a system of multiple-use voucher is introduced to allow the unemployed to choose to apply the money value of the voucher to either training, a wage subsidy, or unemployment benefits). • Early retirement schemes are introduced for older unemployed workers. 1996: Unemployment Benefits set at a flat rate of Dr 2,710 per day plus 10 percent for each family member (reduction in generosity on account of increasing financial deficits of the agency responsible for distributing unemployment benefits).

Ireland

1987: The earnings-related component of the Unemployment Benefits is reduced to 12 percent for new applicants. • Earnings-related benefits are halved. 1988: Social insurance is extended to farmers and the self-employed. 1991: Social insurance coverage is extended to part-time workers. 1994: The earnings-related supplement to unemployment benefits, which was payable for one year, is phased out. • Unemployment benefits are made taxable. • Unemployment benefits for the long-term unemployed are raised by more than the rate of inflation, but less than in the previous years. • Unemployment assistance is sharply increased to equalize the payments under the two systems. 1995: Unemployment benefits replacement rates are reduced while cutting taxes on the low paid and providing full indexation of benefits to prices. 1996: The rise of unemployment benefits kept below the increase in average earnings. • The universal child benefit is increased by 7 percent while the child dependant allowance paid to unemployed parents is left unchanged, thus making employment relatively more attractive. • Long-term unemployed who start working are allowed to retain the dependent allowance for three months and their free medical card for three years instead of two.

Italy

1988: The daily Ordinary Unemployment Benefit is raised to 8 percent of the average wage. 1991: The Wage Supplementation Fund (cassa integrazione guadagni, CIG), for workers put on short-time or zero-time work is reformed. • Time-limits put on the duration of the benefits. • Special Wage Supplementation Fund (cassa integrazione guadagni straordinaria, CIGS), is replaced by a generous “mobility allowance” paid to employees laid off in the context of “mass layoffs.” • Ordinary Wage Supplementation Fund (cassa integrazione guadagni ordinaria, CIGO) subjects to a ceiling after six months.

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Table A.2 (continued) 1993: New entitlements to early retirement are frozen. • The “ordinary” unemployment benefit replacement rates are raised to 30 percent of previous earnings. 1994: A plan to cushion the effects of rising unemployment is approved. • The unemployment allowance is increased. • Benefits paid by the Wage Supplementation Fund are extended to small and medium-sized enterprises. • The coverage of Special Unemployment Benefits is extended to construction workers with at least three years of job seniority on solidarity contracts and mobility lists. • Early retirement benefits are extended to workers in the steel industry, to workers in large enterprises, and for employees of Alitalia. • Income support provided by the Wage Supplementation Fund (cassa integrazione guadagni) is extended to include banks, trade, and public utilities. Netherlands

1987: The two key parts of the previous Unemployment Benefits scheme (WW, unemployment insurance and WWW, unemployment assistance) are combined and eligibility requirements are tightened. • The maximum duration of benefits is more closely linked to the age and length of the contribution period. • The revision of the Social Security System Act is enacted to reduce the incentive to obtain a disability pension rather than an unemployment benefit. • Criteria governing access to disability pensions are tightened. • Claimants who are less than 80 percent disabled will receive a prorated disability pension supplemented by an unemployment related component declining over time. • The total benefit will decline over time as the unemployment related portion of the benefit falls, with a maximum benefit period of five years. • Eligibility requirements for unemployment benefits are tightened: workers are obliged to accept an appropriate job even outside their geographical region. 1990: The minimum wage and social benefits are again linked to wage growth after the nominal freeze decided in 1983. 1991: The obligation of the PES to inform the institutions in charge of unemployment benefits of insufficient job search efforts by benefit claimants introduced with the new PES Law of January; sanctions for refusing a suitable job offer increased: refusal now entails a complete and permanent loss of unemployment benefits. • A new Social Insurance Organization Act is approved: the implementation of social security laws concerning unemployment, sickness, and disability schemes is now entrusted to a tripartite national public body to assure a better balance between administrative costs and the quality of implementation and to make the implementation effectively independent of the social partners.

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Table A.2 (continued) 1991: Social security benefits and the minimum wage are raised by 1.27 percent. • Social security benefits and the minimum wage are increased by 1.7 percent. 1992: The link between the minimum wage and social benefits is no longer automatic: the government is no longer obliged to respect the full linkage if the dependency level (the ratio of full-time equivalent beneficiaries to full-time employed persons) exceeds a reference level. 1995: The indexation of the legal minimum wage and social security benefit to the contractual wage is restored for 1996. 1996: Local authorities are given more responsibility in the implementation of income-support legislation with the General Social Assistance Act, which stresses also the Activation obligation (anyone who receives income support, except for single parents with children under five years of age, must in principle be available for work). • Eligibility to Unemployment Benefits after voluntary quits is removed. • Penalties for violating the rules on unemployment benefits are made mandatory and are no longer applied discretionally by the administration. Portugal

1987: First-time job-seekers are entitled to compensation subject to certain conditions. 1988: Unemployment benefits regulations are revised: minimum qualifying contribution period is reduced and age henceforth taken into account in determining the period of receipt. 1994: A fundamental reform of the social security scheme for selfemployed workers came into effect; the contribution rate is scheduled to reach parity with the overall rate for dependent employment by 1999.

Spain

1992: A decree to redress fiscal slippage approved by the government: the minimum contribution period for eligibility is raised from six to twelve months. • The duration is reduced by about one third. • Lump-sum Unemployment Insurance schemes offering lump-sum payments are phased out. • The system of minimum unemployment assistance allowances is reformed: it now provides those who have worked for at least three months but are not eligible to unemployment insurance with 75 percent of the minimum wage. • The amount is reduced by over 10 percent. • The unemployed are no longer allowed to take up the unemployment insurance payment in a single installment to start a new business as a self-employed worker. 1993: Unemployment benefits amounts are lowered. 1994: Unemployment benefits become subject both to income taxes and social security contributions, even if the tax regime is more generous than for wage income.

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Table A.2 (continued) 1995: The special unemployment subsidy for temporary farm workers in Andalucia and Extremadura, the empleo rural, is reformed in February. • Eligibility requirements are lowered (the minimum days worked in a year to qualify for benefits reduced from sixty to forty). • Entitlements are increased for youths and older workers (entitlements of unmarried youths under 20 years old raised from one and one-half days of benefit per day of contribution to two and onequarter days, while those of youths between age 20 and 25 receive three days benefit). Sweden

1986: Training participation is considered equivalent to work for benefit eligibility purposes. 1987: An unemployed person approaching benefits exhaustion is given the right to receive a job offer of a duration that would renew his entitlements. 1993: The Unemployment Insurance replacement rate is reduced from 90 to 80 percent. • A five-day waiting period is introduced in the unemployment insurance. • The unemployed are entitled to a slot in a training course that could be used for requalification. • Compensation in the relief work scheme is reduced by 10 percent. • Rules for early retirement are tightened. • The public employment service monopoly of formal job brokerages is abolished. 1994: Membership of unemployment insurance funds made mandatory. • The possibility of acquiring indefinite benefit periods through participation in labor-market measures is abandoned. • The youth practice labor-market scheme is phased out. 1995: The replacement rate is reduced from 80 to 75 percent. • Sanctions for not complying with the job availability criteria for unemployment benefits are tightened. 1996: Replacement rates in social security schemes are lowered from 80 to 75 percent. • The Employment Bill is put forward by the government. • Length of spells on unemployment insurance to be limited (an upper limit of three years is introduced). • The replacement rate to be increased to 80 percent. • The qualifying period to be increased from five to nine months. 1997: The Employment Bill repealed before it entered into force and the revised proposal forwarded in March: • The qualifying period is increased from five to six months (it had been proposed nine months). • The proposal for an upper limit of the duration is dropped. • The underlying structure of the unemployment benefit is changed; the benefit now consists of an earnings-related part and a flat-rate component.

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Table A.2 (continued) • The maximum Unemployment Insurance (earning-related component) benefit raised. • The possibility of requalifying for benefits through participation subsidized jobs is no longer available. United Kingdom

1987: Further limitations are placed on unemployment benefit claims. 1988: Unemployment Benefit replacement rates are reduced by increasing waiting periods for eligibility. The earnings-related supplement to the basic unemployment allowance is abolished. • Entitlement to benefit is calculated on net rather than gross earnings. 1989: Unemployment Insurance replacement rates are reduced, especially for short-term unemployed by lengthening minimum waiting period for eligibility. • Rules on refusing a job offer are tightened. 1996: Unemployment Benefit is replaced by the Job-Seekers’ Allowance. • The duration of the Job-Seekers Allowance is halved (from twelve to six months). • The replacement rate of the Job-Seeker Allowance is lowered. • The Income-Support scheme is replaced by the means-tested component of the JSA as a safety net with a marginal withdrawal rate of 100 percent.

Figure A.3 Reforms of pension systems in Europe (1986–1997)

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Table A.3 Reforms of Pension Systems in Europe (1986–1997) Austria

1988: The rate of compulsory social security contributions to public pension to be increased by 0.5 of a percentage point to 9.5 percent as of 1 January 1989. 1989: The rate of compulsory contribution to the public-sector pension fund is raised by 0.25 of a percentage point to 9.75 percent. 1990: The law regulating private pension funds and enterprise pension systems is enacted: • Pensions to be increased 5 percent as of 1 January 1991. • Minimum pensions for singles to be raised to Sch 6,000 (Sch 8,000 for couples). 1993: An amendment to the general social security law came into effect: • Pensions entitlements will require at least twenty-five years of contributions into the system with four years’ credit given for time off for raising children. • The basis for calculation of benefits will be the fifteen highestearning years. • A job can be held while drawing on a normal old-age pension, although with earnings above Sch 7,000 per month the pension is reduced. 1995: Compulsory social security contributions to public pension for civil servants are raised by 1.5 points. 1997: The pension reform is approved: • Over the entire contribution period, pension rights are accumulated at a uniform rate of 2 percent of the calculation base for each year of insurance. For each year of early retirement the above mentioned percentage is reduced by 2 percentage points up to a maximum of 15 percent or 10 percentage points. The law will take effect in 2000. • The criteria for taking a part-time pension have been relaxed about the required reduction of hours of work. • Pension claims brought from raising children are increased. The law will be enhanced as of January 2000. • Individuals nursing family members who give up employment can still be covered by the pension insurance under related favorable conditions. • A new form of part-time pension is introduced, requiring a shorter contribution period. • The degree of self-financing—as opposed to financing out of the government budget—in the pension insurance for self-employed and for farmers is increased by Sch 250 million annually. Valid from 1998 onwards. • The pension base for civil servants is changed from the last salary to the same base as the general pension system. Phased in between 2003 and 2020.

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Table A.3 (continued) • Pensions for civil servants to be annually adjusted applying the adjustment factor of the general pension system. • Social security coverage extended to occasional jobs. Belgium

1986: The self-employed and wage earners are no longer allowed to draw their pension before the age of 60, and the pension age is set at 65 for both men and women. 1987: A general reform of old age, invalidity, and survivors’ pensions is approved. • A single insurance scheme covering manual and nonmanual workers, shopkeepers and tradesmen, industrialists, farmers and professionals is introduced. • A 7 percent increase in all private sector pensions is approved. • A five-stage increase in the guaranteed minimum pension is agreed upon. 1990: The government decides to increase employees’ pensions from 1 to 3 percent, according to the retirement date, effective October 1st. This measure will cost BF 1.3 billion in 1990 and BF 5.3 billion for a full year. 1991: Compulsory employer’s and employees’ social security contributions are slightly increased. 1994: A global plan is approved to redress the financial position of the social security system: • A new method of calculating pensions with a longer base period is introduced. Pensions for men and women are harmonized; the pension regime for women will be brought in line with that of men by the year 2009. 1997: Pensionable age for women will be gradually increased and aligned with those of men (65 years of age). The minimum working period for early retirement will be gradually increased to thirty-five years by the year 2005.

Denmark

1987: In the budget for 1988 significant increases in public old-age pension are approved. 1991: Pensions provisions are reduced in the budget for 1992. 1996: Amendments to occupational and individual pension savings are adopted by the parliament to allow, inter alia, pensions rights to be transferred between jobs.

Finland

1989: The minimum age for entitlement to an unemployment pension (early retirement) to be raised gradually from 55 to 60 years of age and other eligibility requirements are tightened. 1991: Private-sector employers’ contribution rates to social security are temporarily reduced by 1 percent. • Public-sector rates are set at 3.4 and 5 percent. 1992: Employers’ national pension contributions are lowered to 2.4 percent in the private sector and to 3.95 percent in the public sector.

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Table A.3 (continued) • Individuals’ national pension insurance contribution rate is increased by 1.5 percentage points to 2.2 and to 3.7 percent of annual taxable income exceeding Mk 80,000. 1993: Several measures are adopted with the aim of bringing the pension rules in the public sector in line with those in the private sector: • The retirement age for public-sector workers is raised from 63 to 65 years of age, the same as in the private sector. • The annual accrual factor for public-sector workers is reduced from 2.2 to 1.5 of the pensionable age. These adjustments initially applied to newly recruited civil servants since 1995 and will affect all civil servants age 55 or below. • A change in the index for the pensionable wage to take account of reductions in purchasing power of active workers with the introduction of employees’ pension contribution applied (previously only the employers paid such contributions). 1994: The minimum age for early disability retirement is raised from 55 to 58 yeas and the accrual factor of workers in the 60 to 65 years age bracket is raised from 1.5 to 2.5 percent (effectively lifting their pension by 1 percent of the pensionable wage for every additional year of work) • A change in the method of computing the pensionable wage of older workers is introduced: earnings after the age of 55 disregarded if they would lead to a reduced pension level. • To encourage part-time employment of older workers, the required minimum retirement age for part-timers is lowered from 60 to 58 years. • Pensionable wage and postretirement benefits are not indexed for inflation in 1994. 1995: A fixed increase of 1.5 percent per year of nominal pensions replaces the automatic indexation mechanism. • Pension benefits cut by 4.5 percent to reflect the fall in earnings of employees caused by the increase in employment pension and unemployment insurance contributions. • A reform of the employment pension scheme for the private sector is agreed upon by the central labor-market organization. The pension rules are revised, with the benefit calculated on the basis of earnings in the last ten years instead of the last four. The new rules will be introduced gradually, starting on 1 January 1996. 1996: The accrual factors for early retired and disabled workers are reduced from 1.5 to 1.2 percent for those age 50 to 60 years and from 1.5 to 0.8 percent for the remaining five years until regular retirement. • The annual adjustment of postretirement benefits of people age 65 and above is based on 80 and 20 percent weights of the CPI and the earnings index, respectively, a measure that tends to reduce the level of pension benefits relative to the overall earnings.

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Table A.3 (continued) • The flat-rate component of the national pensions to be abolished by the end of the decade. France

1991: Introduction of a new tax—the contribution sociale généralisée—at a flat rate of 1 percent on all incomes. • Employee retirement-pension contribution rates cut by 1 point plus a flat FF 42 per month. 1993: A reform of the “régime général” is decided in July: • The amount of pension is related more closely to the basis on which contributions are calculated (the best-paid twenty-five years instead of the ten best-paid). • The period of contribution is increased. • Pension is indexed to prices instead of (net or gross) wages; nevertheless in case of rapid increases of net wages (high productivity growth), some occasional and discretionary reindexation could be introduced (clause de rendez-vous). • Leaving at the age of 60 will still be possible, but to benefit from the full rate pensioners will face minimum-contribution period conditions that will become progressively tighter, from 37.5 to 40 years for people leaving in 2003. • Noncontributory pension rights are transferred to a solidarity fund financed out of taxes to reinforce the insurance character of the system. 1994: An agreement between the social partners on balancing the pension scheme for managerial staff (Association générale des institutions des retraités cadres—AGIRC) is reached: • Pensions are frozen in 1994. • A pensioners’ solidarity contribution is introduced. • A timetable for raising the compulsory rate of employer and employee contributions is set. • Pensions of farmers are raised by 10 percent. 1995: Old-age and disability pensions are raised by 1.2 percent. • Employers’ contributions to the pension scheme for local authority employees are raised by 3.8 percent. 1996: Old-age and disability pensions are raised by 2.1 percent. • An agreement between the social partners is reached concerning the balancing of the complementary pension system (ARRCO and AGIRC) until 2005.

Germany

1987: The contribution rate to the pension insurance funds is lowered from 19.2 to 18.7 percent of eligible income; the contribution to the Federal Labor Office is raised from 4.0 to 4.3 percent. 1991: Social security contributions are increased by 2.5 percentage points. 1992: A reform proposal put forward and agreed upon by the government: • The de facto net-wage adjustment principle for pensions is formally adopted (the average pension is indexed to the average net wage).

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Table A.3 (continued) • The retirement age is gradually increased from 60 years for women and 63 years for men to a uniform retirement age of 65 years (starting in 2001 and completed in 2012 for women and 2006 for men). This implies the abolition of the present flexible retirement-age scheme; early retirement may still be obtained with a reduction in pension levels, while pension benefits for those working after the age of 65 are increased. • For contributions between 1973 and 1992, multiples (used in computing the individual relative contribution position) below 75 percent are multiplied by 1.5 up to the maximum of 75 percent, effectively reducing the redistribution for workers with income position below 50 percent. • Contributions to the pension system during periods where contributors are receiving income-support payments paid by the unemployment insurance fund are to be increased. • Contribution-free years of higher education are reduced. • Pensions for low-income earners are to be upgraded. • Age 65 is set as the pivotal age for benefit computations; for each year of earlier retirement up to five years and under certain conditions, benefits will be reduced by 3.6 percentage points in addition to the effect of few service years. Rewards for later retirement were also introduced: the pension is increased by 6 percent for each year of retirement postponed. • The possibility of partial retirement is introduced: all rules and regulations apply in proportion. • In the new Länder old-age pensions are raised by 11.65 percent and legislation on pensions extended to the new Länder. 1993: Old-age benefits are increased by 3.86 percent in Western Germany and by 14.24 percent in Eastern Germany. 1994: Contributions to pension insurance funds are increased by 1.7 percent. 1995: The contribution rate for the public-pension insurance fund is decreased from 19.2 to 18.6 percent. • In the new Länder old-age benefits are increased by a nominal 2.78 percent. Due to the introduction of the sickness insurance, the effective rise is 2.23 percent. 1996: The pension contribution rate is increased from 18.6 to 19.2 percent. 1997: Contribution rates for the pension insurance are increased from 19.2 to 20.3 percent of the wage base. • The accrual of pension rights that are not based on contributions is restricted. • The pension level for immigrants is reduced. The 1999 pension reform law is passed: • A phased decline in the average replacement rate from 1999 is introduced. • Higher transfers from the federal budget to the pension system are agreed upon.

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Table A.3 (continued) • Eligibility criteria for invalidity pensions are tightened. • Pension claims for contribution free periods of child raising are increased. Greece

1990: A pension reform law is approved: • For the private sector, the minimum contribution period giving right to a minimum pension at age 65 is lengthened from thirteen and a half years to fifteen years and the minimum pension is increased by 1 percent for each additional year of contribution above fifteen years. In addition to the minimum retirement age, the “35 year” rule will be gradually raised from 58 to 60 by 2002, for men only. • For the public sector a minimum contribution period of twentyfive years is introduced, which mainly affects women who could previously retire after fifteen years’ service and at the age of 42 years. • Civil servants recruited after 1990 will have to pay a contribution rate of 5.75 (civil servants recruited before will continue to be exempt from pension contributions and other public-sector employees to pay minimal rates, less than 3 percent on average). • Contribution rates for private-sector employees will be gradually raised by 3 percentage points, two-thirds of which will be met by employers. • The ceiling for calculating contribution rates is raised. • For the public sector a minimum pensionable age is introduced for those hired after end–1982 (age 60 for men and 58 for women) which will be gradually raised to those applied in the private sector. • For all pensioners an overall limit is placed on the total value of all pensions per individual pensioner equivalent to four times the 1991 per capita GDP; for all funds but applying mostly to the broader public sector and professionals, the replacement rate of new retirees will be capped for primary pensions at 80 percent and for supplementary pensions at 20 percent of the applicable salary base. • The criteria for defining occupations as “hazardous” are tightened. • Eligibility to invalidity pensions is tightened; the minimum degree of invalidity required to receive a pension is raised from 35 to 50 percent and checks on past decisions enforced. 1992: A new pension reform law is adopted: • In the public sector the minimum employment period required to retire without an age limit is extended from 32.5 to 35 years; for people who have worked for more than 25 years but less than 35 the minimum age is raised from 60.5 to 65 and a back-loaded pension formula is introduced to provide a greater incentive to retire later.

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Table A.3 (continued) • All civil servants will pay a contribution to the pensions system raising from 3 percent in 1993 to 6.7 in 1995; for all other public employees the rate is 22 percent for employers and 11 percent for employees. • Private-sector employers’ contributions are increased from 12.5 to 13.3 percent; employees’ contributions are raised from 5.8 to 6.7 percent. • For the self-employed, where contributions are based on a set of voluntarily chosen income classes, the lower classes are eliminated and the earnings base for contributions is gradually raised. • Pensions in the private sector are no longer indexed to changes in the blue-collar minimum wage but adjusted in line with civil servant pensions that are adjusted according to the government inflation objective. • The replacement rate for private-sector pensions is lowered from 80 to 70 percent of the previous earnings. • The minimum age to be eligible for non-insured people is lowered from 68 to 65 years and the benefit made more generous. 1996: A new means-tested old-age pension supplement is introduced. Ireland

1990: A law comes into force establishing a pension commission, guarantees on pension rights, a minimum regime of capitalization, diffusion of information, and equal treatment for men and women. The objective of the law is to build a clear framework for the improvement of private pension funds and to simplify the general rules of pension programs. • The Pension Commission, a group of 14 people, is appointed to regulate and control the development of private pension funds and to inform the Minister of Social Affairs about all issues on pension programs. • The new law states that pension rights must be transferred and reevaluated when a job change occurs. A complete information on pension schemes must be assured.

Italy

1988: Compulsory contributions to public pension are raised and pension ceilings for senior executives are raised. 1988: Pension rights are to be calculated on the basis of ten years (instead of five). 1992: New law introduced on pension programs: • Retirement age of 65 for men and 60 for women by the year 2002. • Calculation of old-age pension; earnings-based, reference earnings = whole career with adjustment of past earnings for inflation and 1 percent real growth. Yield coefficient harmonized at 2 percent. • Eligibility for old-age pensions will require at least twenty years of contributions by the year 2000.

282

Appendix

Table A.3 (continued) • Indexation of pensions: based on price inflation with scope for additional indexation to real earnings. • Contribution rate: 26.5 percent for private employees, 15 percent for the self-employed. Seniority pensions: • Eligibility gradually raised to thirty-five years of contributions for all workers. Private pension funds: • Introduced with 15 percent withholding tax on funds deposited. 1993: Freeze on seniority pensions. 1994: Budget law: Seniority pensions: • Cuts to the benefits received by public workers retiring with less than thirty-five years of contributions. 1995: Budget law: • Retirement age of 65 for men and 60 for women by the year 2000. • Indexation of pensions: 1995 indexation delayed until January 1996. • Private pension funds: 15 percent withholding tax suspended. 1995: New law on pension programs. • Retirement age: flexible from 57 to 65 for both men and women. • New formula to calculate old-age pension, “prorata” is introduced: those with less than 18 years of contribution at the time of reform will enter the contribution system; capitalization of contributions based on nominal GDP growth; the coefficient converting cumulative contributions into annual pensions is based on residual life expectancy, plus adjustment to real GDP growth (1.5 percent). • Eligibility to social pensions requires at least five years of contributions, subject to the condition that pension is at least 20 percent higher than old-age assistance; indexation of pensions to price inflation. • Contribution rate: 32 percent for employees; 20 percent for the self-employed. Seniority pensions: • Eligibility is raised to forty years of contributions, or thirty-five years of contributions plus an age of 57. • Private pension funds: earnings ceiling for participation in public system, to favor the creation of private funds; fiscal incentives for contributions paid. Netherlands

1987: Continuation of nominal freeze of social security benefits. 1988: The freeze of social security benefits in nominal terms is continued. 1990: Contributions for the AOW (old age pensions), AWW (widows and orphans pensions), schemes are included in the personal income tax system.

Appendix

283

Table A.3 (continued) 1991: Social security benefits are raised by 1.27 percent. 1991: The government submits a set of policy proposals relating to retirement pensions to Parliament. It includes a proposal to base pensions on the average wage during the career instead of the last earned wage. Moreover, it contains a proposal to improve pension rights for two-earner couples relative to single-earner couples. 1993: The government eases investment rules for the General Government Pension Fund (ABP), allowing it to invest up to 10 percent of its funds abroad. 1995: The early retirement system will be transformed from a payas-you-go system to a funded system. 1996: The Pension Fund for Civil Servants is privatized. 1997: The budget is presented including an increase in social security contributions. Portugal

1987: Old-age and disability pension provisions are increased from 1 December. General scheme pensions are increased by 1 to 23 percent and noncontributory pensions (farmers) by 14.7 percent. This decision implies additional expenditure of Esc. 34 billion (0.6 percent of GDP). 1988: Pensionable age is lowered from 62 to 60 years. 1989: The government increases retirement and invalidity pensions paid by the social security scheme. 1990: Invalidity pensions and retirement pensions are increased by 17 percent in average. 1991: Retirement provisions are increased by 15 percent on average. 1993: Reforms on pension formula: • The basis to calculate old-age pension will be fifteen (rather than ten) years, and the accrual rate will be reduced from 2.2 to 2 percent. • A gradual rise in the retirement age for women from 62 in 1993 to 65 years by 1999. • An increase in the contribution period required for full pension. • A reduction in the contribution rate paid by employers of 0.75 percentage points, offset by a rise in VAT rates of 1 point, receipts of which are marked for social security.

Spain

1990: Unions and the government agree on an increase in pensions averaging 10 percent and on a full compensation (to civil servants and pensioners) for the overshooting 1989 inflation target. 1993: The minimum legal pensions for 1994 are raised by 3.5 percent and the latter will be revised if actual inflation exceeds 3.5 percent. 1997: In July the Parliament approved legislation introducing several reform to pension system: • Gradual extension of the basis to calculate pensions from the last eight years of contributions to the last fifteen years.

284

Appendix

Table A.3 (continued) • Unification of the different contribution ceilings at the level of the highest one. • Reduction of front-loaded accumulation of pension rights, which provides incentives to retire early by having an accumulation rate that diminishes in relation to the years of contributions. Sweden

1987: Semiretirement pensions are increased from 50 to 65 percent of the loss of earned income. 1992: The pensionable age is raised from 65 to 66 years and public pensions are reduced with effect from January 1993. 1994: The age limit for part-time retirement is raised from 60 to 61 years. The replacement rate is lowered from 65 to 55 percent. 1994: The tax on private pension schemes is increased.

United Kingdom

1987: New tax regime for personal pensions is introduced. Employees will be able to contract-out of the SERPS (State Earnings Related Pension) by joining an individual pension scheme to which the State Department will pay a minimum contribution. 1988: Pensionable age for women is increased to 65 years from 60. 1989: Employers allowed to set up “top-up” pension schemes for their employees, with no limits on benefits but without special tax relief. A (price-indexed) limit is placed on pensions paid from taxapproved schemes, based on earnings of £60,000 a year. Annual contribution limit for a personal pension scheme increased in line with earnings and subject to an overall cash limit (based on the earnings limit). 1995: Pension Act: it provides a raising the state pension age for females from 60 to 65 years, starting in 2010 with those born in April 1950 and completing the transition in 2020 with those born in April 1955. • Introduction of a new private-pension scheme.

Marginal Radical

Marginal Radical

Nonemployment Benefits

Public Pensions

15

6 1

6 0

2 0

22

8 2 6 1

5 0

70

10

0

5 13

0

5 0 4

3 0 5

4 0

0 2

23 5 18

13 6

68

2

2 28

24

0

12

GDP growth >1.5%

198

9

69 9 67

36 8

Total per rows

Source: Fondazione Rodolfo Debenedetti. Note: In the case of Employment Protection Legislations, radical reforms are those modifying the rights of permanent workers, while marginal reforms simply introduce new contractual forms holding a lower degree of employment protection (as the “atypical” contracts), they don’t modify the rights of insiders. In the case of nonemployment benefits, marginal reforms are those adjusting the amount of the subsidy by less than 10 percent, or introducing a limited change in the duration of benefits, while radical reforms are those introducing changes on the whole structure of the system and discrete changes in the generosity of subsidies. In the case of public pensions, marginal reforms are those partially adjusting the system, while radical reforms arise from an intervention in the whole structure of the system and discrete changes in the generosity of provisions or introduction of alternative pension schemes.

Total per columns

Marginal Radical

Employment Protection Legislation

GDP growth 0–1.5%

GDP growth <0%

GDP growth >1.5%

GDP growth <0% GDP growth 0–1.5%

Increasing generosity and regulations

Decreasing generosity and regulations

Table A.4 Reforms of Employment Protection Legislation (EPL), Nonemployment Benefits, and Pension Systems in Europe (1986–1997)

Appendix 285

Index

Active labor market policies, 47 Aging, social protection, 138 Agricultural policy, 105 Anglo-Saxon welfare states, 52 Austria corporatist, 44 employment protection, 24 EPL reforms, 257 nonemployment benefits, 261 pension reforms, 272 social assistance, 35 social protection, 30, 33 Belgium EPL reforms, 257 nonemployment benefits, 263 pension reforms, 273 poverty rate, 41 social assistance, 35 social protection, 30, 32 Business, adaptability, 85 cycles, 228n Canada, wage inequality, 79 Capital shares, unemployment, 242–244 Collective bargaining, 44, 170 centralization, 101, 115n decentralization, 101 Competition cross-border, 149 in labor markets, 167–176 in product markets, 154, 169 Continental Europe, welfare states, 52, 78 Contracts, regular and temporary, 46, 113n, 182 Contributions. See Social security contributions

Convergence, price similarity, 156–164 Corporatist countries, 44, 50 Currency areas. See European Monetary Union Decommodification, 70, 113n Demand shocks, monetary integration, 215, 218 Denmark EPL reforms, 257 nonemployment benefits, 263 pension reforms, 273 poverty rate, 41 social assistance, 35 social protection, 30, 32, 41 Deregulation, 229n, 240, 241 Deutsche-mark area, 5, 204 Disability benefits, 71 ECHP. See European Community Household Panel Economic integration. See also Monetary Integration negative versus positive, 87 and political dynamics, 83–96 and social policy, 89–96 and welfare systems, 80–82 Employment protection. See also Employment protection legislation (EPL) contractual, 13, 182 country scores, 183 employment adaptability, 85 European integration, 152 labor markets, 45 and self-employment, 200 and temporary work, 227n

288

Employment protection legislation (EPL). See Employment Protection EMS. See European Monetary System EMU. See European Monetary Union EPL. See Employment protection legislation Equal opportunity policy, 86 European Central Bank, 101 European Commission, 93, 148 European Community Household Panel (ECHP), 36, 41 European Court of Justice, 25, 90 European Monetary System (EMS), 153, 247 European Monetary Union (EMU). See also Monetary integration collective bargaining, 16 labor markets, 1, 204 product market competition, 17, 153, 204, 248 price convergence, 205–210 price transparency, 16 product markets, 204, 248 European Parliament, 84, 97 European Social Fund, 84 European Union budget agreements, 99 cooperative federalism, 98–101 decision-making, 26, 99 economic integration, 83–96 federalist structure, 26 harmonization of welfare systems, 2, 16, 23, 141 policy coordination, 252 political dynamics, 83–96 poverty and inequality, 37 price convergence, 159, 206 price levels, 165–167 price similarity, 157 single market, 167 social policy, 24, 83, 89 social policy budget, 127 social protection, 30, 40, 141 strategic delegation, 102 supranational institutions, 251 voting rules, 114n European Union Treaty (1998), 84 Exchange rates currency crisis, 206 Deutsche-mark area, 207 stability zones, 205 Export industries, tax incentives, 134

Index

Families allowances, 70 composition, 36, 112n extended, 36 formation, 37 labor markets, 68 single parent, 37 social policy, 40, 42, 68 Federalism, cooperative model, 98–101 Fertility, social protection, 138 Finland Employment protection legislation, 257 nonemployment benefits, 264 pension reforms, 273 social assistance, 35 social protection, 30, 33 Fondazione Rodolfo Debenedetti, 11, 17 Foreign direct investments (FDI), 2 France capital shares, 243 employment protection, 24, 258 nonemployment benefits, 265 pension reforms, 275 poverty rates, 41 social assistance, 35 social protection, 30, 32 social transfers, 41 trade unions, 44 unemployment rates, 243 GDP. See Gross domestic product Germany capital shares, 243 economic policy, 114n employment protection, 24, 258 nonemployment benefits, 95, 265 pension reforms, 275 social assistance, 35 social protection, 30, 32, 81 Gini coefficient, disposable income, 37 Globalization economic effects, 76, 222, 231n, 295 welfare systems, 82, 95 Greece EPL reforms, 258 nonemployment benefits, 266 pension reforms, 277 poverty rates, 41 social assistance, 35 social protection, 32 social transfers, 41 Gross domestic product (GDP)

Index

employment protection, 14 FDI inflows, 155 pension expenditures, 7 social policy, 7, 66 social protection, 30, 53, 134 Grubel-Lloyd index, 157 Herfindhal indexes, 227n Households. See Families Housing, 56 Inflation, monetary integration, 215 Institutions, change and reform, 212 Insurance actuarial fairness, 108 contingent provision, 108–110 fiscal competition, 108 regional effects, 108 Ireland EPL reforms, 259 nonemployment benefits, 266 pension reforms, 278 social assistance, 35 social protection, 24, 32 Italy capital shares, 243 EPL reforms, 243 nonemployment benefits, 267 pension reforms, 278 poverty rate, 65 social assistance, 35 social protection, 33 social transfers, 41 Labor active policies, 25, 47, 73 efficiency costs, 70–75 hoarding, 242, 244 institutions, 110, 175 liberalization, 237 Market competition, 167, 176 reform incentives, 210–214 regulations, 152, 177, 180, 248 Log-rolling, 100 Luxembourg EPL reforms, 259 Luxembourg Agreement (1966), 84 Luxembourg Income Study (LIS), 64 Luxembourg Process, 148 Markups, sector averages, 167 Migration, 81

289

Minimum wage, index mechanisms, 45 Monetary integration demand shocks, 215, 218 historical experience, 215 inflation bias, 220, 230n labor markets, 210–214 legislation, 220 nominal flexibility, 214–219 price similarity, 156–164 product markets, 210–214 real rigidities, 219–225 reform incentives, 210–214 regulation, 220 unemployment variability, 217 Monopoly power, economic performance, 167 Nationalism, social policy, 63 Netherlands EPL reforms, 259 nonemployment benefits, 267 pension reforms, 279 social assistance, 35 social protection, 30, 33 welfare reforms, 72 Nonemployment benefits. See Unemployment benefits Nontariff barriers (NTB) industry-specific, 226n price convergence, 157 price similarity, 159, 164 Nordic countries labor markets, 73 welfare states, 52 NTB. See Nontariff barriers OECD. See Organization for Economic Cooperation and Development Oil shocks, economic effects, 76 Organization for Economic Cooperation and Development (OECD), 6, 8, 36, 158, 180–184, 195, 216 Part-time employment, regulating, 46 Paternalism, social policy, 63 Pensions actuarial reforms, 93 defined-benefit, 93 microsimulation studies, 7 occupation-specific, 92 reforms, 272–281 retirement income, 6

290

Politics economic integration, 83–96 pork-barrel, 100, 115n welfare states, 63–69, 130 Portugal collective bargaining, 44 EPL reforms, 260 pension reforms, 280 poverty rates, 41 social assistance, 35 social protection, 33 unemployment benefits, 268 Poverty combating, 29, 64, 67, 132, 136 rates by country, 38, 65 social transfers, 41, 43 traps, 70 Price competition, 3 convergence, 156, 160, 162, 205–210 setting, 173, 215 similarity, 156, 164, 207, 208, 209, 226n structures, 149, 206 Product markets Cardiff process, 148 competition, 169–172 liberalization, 148, 152, 154, 179, 183, 237 macroeconomic stability, 173 monetary integration, 210–214 price convergence, 205–210 regulation, 3, 148, 152, 180, 246 restrictions, 238–240 Profit margins, 165–167 Purchasing power, product markets, 40, 149 Quasi-market arrangements, 27 Reforms. See Social Policy reforms Rents, deregulation, 241 Self-employment, 46, 174, 200, 202, 203 Single market program (SMP), 246 Social assistance cofinancing, 107 family types, 9 generosity, 8 means-tested, 57, 136 transfers, 50 Social policy centralization, 101–103 coordination, 25, 103, 138

Index

decentralization, 101–103 decision-making, 96–103 design, 94 economic integration, 89–96 economics of, 60–62, 69, 88, 110, 134 effectiveness, 24, 41 enforcement, 55, 60, 94 European Union, 28, 83, 89 federalism, 96 funding, 48, 74 goals, 24, 29, 60, 94, 123 harmonization, 127 local financing, 111 majority decisions, 26 principles, 83–88 reforms, 11–15, 28, 53, 257–261 supranational institutions, 253 taxes and contributions, 4, 48, 92 Social security contributions, 4, 92 Social welfare. See Social policy Solidarity-based transfers, 27 Southern Europe, 52 Spain collective bargaining, 44 employment protection legislation, 260 pension reforms, 280 social assistance, 35 social protection, 32 unemployment benefits, 269 Subsidiarity, 115n, 126 Supranational institutions, 251–255 Sweden EPL, 261 pension reforms, 281 social assistance, 35 social protection, 30, 33 trade unions, 44 unemployment benefits, 269 TANF. See Temporary Assistance for Needy Families Temporary Assistance for Needy Families (TANF), 106, 116n Temporary employment. See Contracts, regular and temporary Training, subsidized, 73 Treaty of Rome, 83, 148 Unemployment equilibrium model, 172 global shocks, 222 Phillips curve, 227n

Index

productivity, 240 proxy outflows, 12, 18n variability, 217 wage inequality, 79, 227n Unemployment benefits assistance principle, 46 coverage rates, 46 generosity index, 46 insurance principles, 60, 71 reforms, 261–270 Unions density, 44 monetary integration, 223 social policy, 44 United Kingdom collective bargaining, 44 Employment Action Plan (1998), 86 EPL, 261 pension reforms, 281 social assistance, 35 social protection, 24, 32 unemployment benefits, 71, 270 wage inequality, 77 United States poverty rate, 64 social protection, 32 wage inequality, 77 welfare systems, 28 Universal benefits, income effects, 70 Wages collective bargaining, 44, 170, 176, 215 competition, 169–172 efficiency models, 171, 186 elasticity, 169 premia, 198 Welfare. See also Social policy; Welfare states magnet effect, 114n new debate, 1 Welfare states Bismarckian model, 44 classification, 50, 104, 124 crisis factors, 75–82 liberal, 50, 78 politics, 63–69 poverty reduction, 67 social-democratic, 50, 78 trends, 49–59 Welfare systems. See Welfare states Welfare to work, 57 Work tests, social protection, 57

291