Report No. 32068-CO Colombia Labor Market Adjustment, Reform and Productivity What are the Factors that Matter? (In Two Volumes) Volume I: Issues and Policy Brief November 2005 Colombia and Mexico Country Management Unit Poverty Reduction and Economic Management Sector Unit Latin America and the Caribbean Region Document of the World Bank TABLE OF CONTENTS EXECUTIVESUMMARY............................................................................................................... 1 I BACKGROUND PURPOSE . AND ........................................................................................ 9 11. THEKEYOUTCOMES .................................................................................................... 12 111. WHATLIESBEHINDTHESESHIFTS IN THEMAINOUTCOMES? ................................... 19 IV . THELABOR REFORMOF 2002-GAUGING ITSIMPACT ................................................ 31 V. PRODUCTIVITYAND COMPETITIVENESS: AN IMPORTANT LINK................................... 37 VI. FINAL COMMENTSAND MAINPOLICYALTERNATIVES............................................... 42 ACKNOWLEDGEMENTS This report was preparedby a team ledby Mauricio Santamaria (LCSPP). The team included the following Bank staff Magdalena Bendini (LCSPP), Wendy Cunningham (LCSHD), Ana Maria Diaz (LCSPP), Daniel Lederman (LCSCE), Mdnica Pefiuela (LCSPP), Anne Pillay (LCSPP), Laura Ripani (LCSPP, now IADB) and Emanuel Skoufias (LCSPP). Additionally, the following consultants participated in various stages of the project: James Albrecht (Georgetown University, Washington DC), Ver6nica Amarante (Universidad de L a Repdblica, Montevideo, Uruguay), Rodrigo Arim (Universidad de La Repdblica, Montevideo, Uruguay), Juan Carlos Echeverry (Universidad de Los Andes, BogotB), M6nica HernBndez (Universidad de Los Andes, BogotB), Norman Hicks, Leonard0 Garcia (Universidad de Los Andes, BogotB), Alejandro Gaviria (Universidad de Los Andes, BogotB), Orlando Gracia (University of California, San Diego), Jairo Ndfiez (Universidad de Los Andes, BogotB), Maria Fernanda Prada (Universidad de Los Andes, BogotB), Guillermo Rodriguez, Luz Magdalena Salas andFabio SBnchez (Universidad de Los Andes, BogotB). The government of Colombia, mainly through the MPS and DNP, not only provided key feedback all along the implementation of the Project, but actually participated actively in the production of diverse parts of the report. Particularly important was the contribution of the following government officials: JosC Fernando Arias (DNP), Alberto Carrasquilla (MH),Ramiro Guerrero (MPS), JosC Leibovich (DNP), Hugo L6pez (DNP), Alejandro Mateus (DNP), Carlos Medina (DNP, now at the Central Bank), CCsar MerchBn (MPS), Natalia MillBn (DNP) and Norbert0 Rojas (DNP). Also, important feedback was received from members of the Colombian Congress during the workshops inBogotB. The report benefited greatly by comments made by the peer reviewers, William Maloney (LCSCE), David Rosenblatt (LCClC) and Vicente Paqueo (LCSHD). Additionally, valuable comments were received at various stages, including the seminars in BogotB, from Omar Arias (LCSPP), Alberto Chueca (LCClC), Todd Crawford (LCCOP), Ariel Fiszbein (LCSHD), David Gould (LCC1C), Isabel Guerrero (LCCIC), Laura Kullenberg (LCC1C), Gladys L6pez-Acevedo (LCSPP), Ernesto May (LCCPR), Harry Patrinos (LCSHD), Jaime Saavedra (LCSPP), Carlos EduardoVClez (IADB) and SteveWebb (LCSEP). EXECUTIVE SUMMARY Despite the improvements observed since 2000, at the end of 2002 Colombia faced a difficult economic situation stemming from the recession of the late 1990s. Indeed, growth remained elusive, unemployment continued to show remarkable persistence and wage growth was sluggish. All these factors eroded the confidence of households and entrepreneurs to consume and invest, giving way to a vicious circle between low growth, highunemployment and low private consumption and investment. Since the causes of the recession and these ensuing problems were deemed to arise from deeply rootedfactors, the government engagedin a series of structural reforms designed to revitalize the economy. Among these, a reform to the labor code, considered key due to its potential role in generating incentives for formal employment generation, was enacted in December 2002. Its goals were to be achieved by reducing extra- payments for over-time and nocturnal work, bringing down firing costs and introducing more flexibility through changes in other labor regulations. Also, the reform aimed at promoting employment for hard-to-employ groups, in particular through changes to the apprenticeship contract. Finally, an unemployment insurance system was introduced to alleviate the negative effects of highand persistent unemployment. Inthis context, this report carries out arigorous anddetailed evaluation of the 2002 labor reform and, in doing so, it also assesses the performance of the Colombian urban labor market and identifies the main policy challenges faced in this area. The report has three broad goals. First, to provide additional evidence to inform the intense debate taking place in the country around labor market issues, especially the reform. Second, to shed light on the key factors preventing a swift recuperation of the labor market. Third, to offer sensible policy alternatives that complement the step taken with the labor reform and address those key factors. The analyses are carried out for the key labor market outcomes: employment, unemployment, formality and wages, as well as productivity. Through the analysis of these variables the report tries to enhance the understanding of issues such as informality, labor market rigidities, job creation, protection against shocks and private sector performance. B y and large, these determine whether people can find gainful employment, be adequately protected against shocks and whether firms are profitable so that, on the one hand, investment and technology adoption take place and, on the other, employment and wages grow, which are the truly important concerns for policy makers. The report illustrates key problems faced by Colombia: slow growth reflecting poor productivity performance, high and persistent unemployment and labor market rigidities that help in keeping unemployment high and productivity low. However, the 2002 labor reform shows positive results in some areas, while the impact on others was uncertain or moderate. Thus, the country today has three broad challenges. First, makingthe labor market as efficient as possible; second, increasing productivity growth as a precondition for stronger economic performance, and third, providing effective and inclusive services of social protection for the most vulnerable. These are the channels that will ultimately enable the increase of formal employment and favor wage growth. Inwhat follows, keyfindingsrelatedto the evolution of the mainoutcomes are summarized: 0 The Colombian urban labor market seems to have "stabilized" at a higher level of unemployment recently. Despite the fact that there has been a downward trend in unemployment since 2001, the current level continues to be higher than that observed before the late 1990s' recession. 1 Adult women, teenagers of both genders and the unskilled are the groups of the population that suffer the most during contractions of aggregate economic activity and, despite their lower share of the population, are the ones that cause the largest movements of the overall unemployment rate. The labor market became more segmented in the period 1996-2002. That is, low quality self-employment grew and now seems to be increasingly populatedby individuals that would prefer to be ina salariedjob but cannot find one. Wages, which are related to productivity, show sluggish growth. Indeed, they increased by 9% between 1984 and 2004 (Le. less than 0.5% on average per year). However, this growth was completely due to skill upgrades of the labor force (education increased) and not to effective growth of remunerations within education levels. In this sense, wages for the least and intermediate skilled fell between 10 and 25% over the period. Wage growth was impressive during the period 1991-96, which also coincided with highproductivity growth. All outcomes tend to be worse for the least and intermediate skilled, especially the latter. Productivity growth in Colombia has been sluggish (negative in the 1990s), both for labor and total factor productivity (TFP), especially as compared to other countries. The labor market is increasingly female and commerce and service oriented. The evolution of unemployment and segmentation has been largely determined by increasingly binding minimum wages (particularly since 1998), high non-wage costs (since 1995), and rigid wages that help in preventing a swift return to low unemployment rates. If the minimumwage hadbeenkept constant at 1995 levels, unemployment for men and women would have been 7 and 4 percentage points lower in 2002, respectively, halving its actual level for men. The high minimum wage has its largest negative impact among those groups which supposedly were to be protected: the young and the least skilled. Additionally, the increased participation of women and other groups in the labor market intensified the pressure on unemployment. Indeed, if female participation had remained at 1993-95 levels, unemployment in 1999-01 (20.2%) would have been cut in half. Non-wage costs, combined with the reduction o f labor demand brought about by the recession, appear to have exacerbated the move of workers towards low quality self-employment, that is, to have contributed to increased segmentation. Inthis scenario of increasing number and importance of rigidities, the labor market became less flexible to adjust to macroeconomic fluctuations in recent years. Thus, when economic growth declines, an increasing part of the adjustment i s made by growing unemployment or lower salaried employment. Poor performance of productivity growth at the aggregate level, on the other hand, i s related to a slow and unbalanced pace o f educational accumulation (particularly at the university and technical levels), high and binding firing costs, increasing participation of the state in the economy and the intensificationof the armed conflict. A higher level o f exposure to international markets has impacted productivity growth positively. At the sectoral level (within manufacturing), the most important determinants o f productivity growth are the level and evolution of non-wage costs (negative) and the degree of technological adoption (positive). Importantly, poor performance of productivity growth i s highly correlated with sluggish growth of salaried employment and wages. 2 Regarding the 2002 labor reform, the key findings of the report suggest that it: substantially increased the employment of young workers throughinternshipsthat can lead to formal employment opportunities. This happened mainly because of the reforms introduced to the apprenticeship contract; reduced the level o f informality, especially among the least skilled. The measures that contributed to this result were the extension of the diurnal shift and the apprenticeship contract; hada positive effect on wages, also more markedamong the least skilled; increased overall employment, although moderately, suggested by the low positive response of employers to the question of whether the reform was a major determinant to increase employment. The impact on employment appears to be related also to the longer diurnal shift and the apprenticeship contract, plus the reduction of firing costs. However, the moderate size o f the impact is related to the fact that the costs reductions brought about by these measures were not particularly large (see Table 1, below); ;educed underemployment for insufficient hours due, especially, to the increased diurnal shift; however, no evidence of a positive impact on actual hours worked was found; and the provisions that waive payroll taxes seem to have had little or no impact. The creation of the system of unemployment assistance was a major innovation of the reform. However, most of the beneficiaries are unemployed who come from the formal sector (the least vulnerable). Yet, most of the unemployment comes from the informal sector. Table 1:Main ChangesIntroducedby the LaborReform, Comparison-withLAC Countries I I DismissalCosts I DiurnalShift I AC' I Dremium for i (monthly wages) work on holidays Argentina 3.0 100% Brazil 12.9 100% Chile 3.4 Ecuador 13.7 100% Mexico 3.2 6 a m - 8 p m 4 100% Peru 13.6 6am-10pm yes 100% Uruguay 2.2 6 a m - 6 p m yes 150% Venezuela 6.9 5 a m - 7 p m yes 150% Colombia Before 13.4 6 am - 6 pm 200% Colombia After 10.1 6am-10 m 175% Average Before 8.0 125% ices at salaries contractual reltionship mdcountry labor code! However, it i s important to interpret these results with caution. In effect, trying to evaluate and isolate the impact of a policy change of the magnitude of a labor reform, which affects large portions of the labor market indiverse ways, i s an extremely difficult task, and even more so when the trends of aggregate economic activity shifted at the same time as it was introduced. In this sense, methodological and data constraints were encountered when trying to separate the effects of the reform on the main outcomes from other factors that may influence them. The fact that less than two years have passed since the reform does not help either (the reform went into full effect in April 2003). Thus, the reader i s referred to Volume I1o f this Report for a very detailed description o f the methodological choices and the data used for the evaluation, and presents their caveats and critiques objectively. 3 Policy Recommendations Given the three broad objectives identified above, namely, makingthe labor market more efficient, increasing productivity growth and providing a more inclusive and effective system o f social protection, the following are the five key areas for policy attention proposed here. The current debate about the labor reform should focus on the necessary improvements and not on the convenience or inconvenience of the reform as a whole. Additionally, this debate should be more inclusive, bringingin, for example, the unemployed, the self-employed and those that do not belong to organized groups. Indeed, given that the reform had positive effects on some outcomes but mixed in other areas, it would be inappropriate to center the debate on whether the reform should be reversed or not. Rather, the issue should be dealt with using a results management approach in which tailored adjustments are introduced if needed. In this context, the reform should be viewed only as an initial step towards a more inclusive, efficient and productive labor market. However, there are still areas that call for action, some within labor regulations per se, and others related to broader labor or social protection "institutions". Many of them are discussed below. Minimumwage growth needs to be constrained. This report and other studies provide evidence that the current pace of minimum wage growth cannot be maintained without productivity expansion that makes it sustainable in the long run. The objective o f providing a minimum standard of living should be viewed in a broader fashion, by realizing that excessive increases of the minimumwage jeopardize directly the standard o f living of those who become unemployed or informal, who, according to the findings of the Report, are concentrated on the least and intermediate skilled and the young (i.e. the most vulnerable). Therefore, the minimum wage must be set at a level that balances income goals with the market responses to the instrument, which i s clearly not the case right now in Colombia. It suffices to note that the country has the second highest minimum to average wage ratio in the LAC region. A minimum wage that i s set this high actually increases poverty and income inequality, so social justice guidelines should be implemented in a way that the different effects of the instrument are taken into account. Until now, these guidelines have been interpreted only considering the supposed increase of labor incomes for low earning workers brought about by generous adjustments o f the minimum wage. However, the other half of the story has been missing: those workers are precisely the ones who become unemployed or informal because o f the unsustainable growth of minimumwages. Therefore, and taking into account that in 1998 a substantial "overshoot" took place (the minimum wage grew by more than 8 percentage points in real terms), from now on minimum wage setting should be based on productivity increases and conservative estimates of future inflation, recognizing explicitly the costs in terms o f unemployment and informality. That is, the final goal should be to bringback the real minimumwage to pre-crisis levels in the near future, ensuring that it maintains a close link with the evolution o f productivity. While recognizing that this is a very sensitive issue, some actions may be taken in the short runto confront it, starting with wide dissemination efforts of the negative impacts o f unwarranted increases o f the minimumwage on the employment opportunities of the most vulnerable and, therefore, on the welfare of those workers and their families. 4 This last point i s crucial. Untilnow, but particularly inthe last six years, minimumwage setting in Colombia has favored the interests of only a portion of the labor force that i s very well represented by the unions and exerts substantial influence on the decisions related to the minimum wage. Unemployed and informal workers, on the other hand and despite being the most affected, have had little or no voice in these decisions, partly because they do not have objective evidence on the impact of the minimumwage on their welfare, and partly becausethey lack organization to be able to effectively participate in the decision instances or voice their concerns to the relevant authorities (e.g. constitutional court). Finally, since the pressure from increased female and teenage participation on the labor market i s likely to continue, especially in future downturns of the cycle, a particularly efficient policy would be to establish lower minimum wages for the young. This would help in overcoming the obstacles they face to access the labor market, which become more bindingdue to the relative higher sensitivity to participate, as a responseto movements of the cycle, observed among these workers. This policy has been used in other countries and, inthe case of Colombia, the effectiveness of the apprenticeship contract provides support for its adoption. Wage taxes cannot be increased further and, in the longer run, they should be reduced. The Colombian payroll i s already heavily burdened with taxes. The prospects for reducing wage taxes, however, are not particularly positive given the tight fiscal situation, and the expectation of future needs for pension financing. Two alternatives could be analyzed. First, reduce directly some components of non-wage benefits by, for example, allowing individual negotiation of contracts and reducing the minimum legal mandates. Second, de-linking social security and protection from the labor market. The parafiscales, which amount to almost 1% of GDP, should be reviewed carefully to gauge if the services provided are valued by the society that much. Also, careful evaluation of the programs financed by them is neededto make difficult decisions about their permanence. An ample debate on the convenience of the parafiscales, including the government, Congress and civil society, i s long overdue. Note that the evidence provided by the report indicates that taking actions related to non-wage costs i s also important for the evolution of productivity growth andto foster innovation. Given these considerations, at this point it i s fundamental to highlight the following: the results presented in the report related to minimum wages and non-wage costs clearly point out the fact that the Colombian labor market moved to a more inflexible stance since 1998. This is key because it means that, increasingly, the labor market adjusts to the cycle through quantities (i.e. generating unemployment) rather than wages. Inthis context, urban unemployment appears to have stabilized at a higher level inthe latest years, showing remarkable resilience to fall. Thus, if no actions are taken to tackle the issues of minimum wages and non-wage costs, the country will inevitably be faced with costly, and possibly inefficient, alternatives to deal with this situation. One of them is, for example, the introduction of a more inclusive system of unemployment protection, revamped to extend coverage to the informal sector. This, however, will be complex given the present tight fiscal situation and the institutional difficulty of designing and administering such a system (see below). As always, the macroeconomic environment is extremely important, not only in terms of growth and employment creation, but also through the effect of public spending and the volatility of the exchange rate on the evolution of employment, segmentation and 5 productivity. Thus, strengthening macroeconomic stability and containing public spending becomes even more essential. In this respect, the C E M produced by the Bank highlights the importance of acting on items such as transfers to sub-national governments, pensions and the many inefficiencies of the tax system. More broadly, the goal i s not only to maintain a stable macro environment, but also to reduce the government burden on the development of the private sector (including taxes and regulations), which has become a real constraint for higher productivity growth. In this context, issues of regulation, financial sector development and the efficiency of the judiciary, also analyzed inthe CEM, should be confronted as soon as possible. Developing a more effective, coordinated and inclusive system of social protection, which provides protection to the self-employed and informal workers, who inthe current system are almost completely unprotected. Including them, however, i s not an easy task, given the already high burden of non wage costs. Also, providing social protection to self-employed and informal workers constitutes a challenge from the fiscal point of view because, in the end, somebody pays for the services they have access to, even if they are of low quality. Key policy questions, which call for difficult trade-offs, are: 0 how to reshuffle spending among the wide variety and dispersion of programs existing today, action which calls for a clear identification of priorities and bottlenecks. It would also entail a redirection and reshuffling of resources among the current programs; 0 should some sort of assistance to the unemployed from the informal sector (at least the poorest) be provided? This group, besides including the majority of the unemployed, comprises the most vulnerable workers. However, they do not have any sort of protection against unemployment, while formal workers have the Cesuntiu and, in some cases, additional severance payments. This i s an issue that still requires more thought and, in any case, it would entail a more even distribution of the funding destined now to the unemployment protection system, plus a redirection of resources used in other programs (e.g. SENA and CCFs). It may be also necessary to differentiate unemployment insurance from unemployment assistance. Insurance, by definition, i s a system where people pay in, pool risk, and withdraw ifthey are negatively affected by the shock. The distinction i s important because benefits to workers who have not contributed may be lower than those obtained by workers that contributed, allowing higher coverage among informal workers. 0 how to de-link social protection and insurance from the labor market. This would serve two purposes: removing from the labor market one of the major constraints for formal employment creation, and helping in the simplification of the tax system. Without doubt, this is an issue that, inany event, will surface soon taking into account the fact that labor markets are not structured as they were when the social protection systems were originally conceived, meaning that the de-linking i s crucial so that services can be provided to those who are not formal. This question, however, needs to address other important issues, such as the following: (i) should the de-linking only cover some services within the general umbrella o f social protection? And (ii) can social protection and insurance services be unbundled to favor choice by the worker according to family needs? 0 given the heterogeneous nature of self-employment in Colombia, in which segmentation has risen, the design of social insurance mechanisms gains special relevance. Attempts to expand coverage of benefits to the self-employed without any cost or link to other dimensions of salaried employment may simply shift the labor market towards that occupation even more. Thus, the design of any social protection system in the future has 6 to have a comprehensive view that takes into account the incentive effects throughout the entire labor market; 0 an important component of this system would be a well-designed training program for the unemployed that takes advantage of the existing network of training institutions, and uses flexible arrangements that favor choice. Thus, the reform of SENA, currently underway, should be given priority within the government; 0 an issue that also requires attention i s whether the CCFs should continue playing such an important role in the social protection system of the country, especially if a more coordinated one, which addresses the needs of most vulnerable, i s indeed the final goal posedby the government; 0 what to do with the program "Familias en Acci6n" in the near future, in terms of long term financing and administrative placement. Additional policy options include: Designing more specific interventions to facilitate access to the labor market by women and the young. Given the findings of their difficult access to the labor market and their sensitivity to the cycle, this action would ensure an efficient use of the resources and a greater impact on outcomes. These interventions can be designed both to contain participation and promote formal employment. Examples include targeted active labor market policies to facilitate the flow of information, for which the Mexican experience can be valuable; training programs for the young within a more decentralized and competitive system in which the supply of programs matches market needs more closely; and support for job search, also targeted. Note, though, that the best way to enhance the possibilities of these groups (especially the young) of finding good qualityjobs would be to align the minimumwage to market realities. The program that fosters access to undergraduate studies to poor and middle income students, currently underway, is an important component of this strategy (both on the participation and employment sides), which also will have longer term effects, both on employment and productivity. This program should be given continued support. This i s especially important because (i) of the labor market outcomes (employment and wages) most have deteriorated the most for high school graduates; and (ii) one of the main determinants of poor productivity performance was the unbalanced enrollment and completionrates observed for tertiary schooling. More thought should be given to the apprenticeship contract (AC) in order to slightly adjust the instrument. It may be usefulto analyze the issue of the compulsory quota of apprentices more thoroughly to answer questions such as: do firms get additional information about potential workers and thus decrease the expected cost of hiring new workers? Do the apprentices have a higher likelihood of getting a job, and thus i s this a kind of job-training, which should be subsidized by SENA?Could the cost of "buying-out" of the apprenticeships be adjusted? Are firms taking advantage of other cost-saving regulations which could lower their overall tax bill?A review of these issues could better help the Government determine how and to what extent to revise the apprenticeship quotas. Regarding the 2002 labor reform and related to the first recommendation, things that couldbe subject to some refinementinclude the following: 7 0 flexibilize hiring regulations. Schemes like the contract by the hour, the reduction of the threshold to apply the salario integral, or an extension of the probation period constitute sound alternatives; 0 extra costs related to Sunday or holiday work are still the highest inthe LAC region; 0 extend the "regular shift" to sectors other that commerce and services; and 0 given the poor results obtained with the exemption of Parafiscales and the slow start of the PADE program, it i s recommended that the government carries out a rigorous analysis o f why the entrepreneurs are not using these subsidies. I s it a problem o f information or rather that the amount o f the subsidy i s still to low? Could there be other problems? Completely revising public labor market regulations, especially those related to remunerations. The impact of the public-private wage premium appears detrimental for the poorer segments of the population due to the rigidity that i s transmitted to the overall wage structure. Wages of public employees should be more closely linked to market wages and employee performance, more so when taking into account the significant discrepancies found within the public sector in high skilled jobs (executive vs. legislative and judiciary). This, however, needs to be part of a broader civil service reform. The issue of protection to the agricultural sector again surfaced in this report. It seems to be time to seriously address it, beyond political considerations, and weigh its benefits and costs, especially those related to productivity growth. Finally, the evidence suggests an agenda for labor reform beyond the usual focus on rigidities: eliminating the inefficiencies inthe provision of medical benefits, pensions or biases in promotion systems not based on merit will reduce the incentive to informality and increase the supply to the formal sector. More fundamentally, informal employment infirms of relatively low technology and capital intensity can only be attractive if the overall level o f productivity in the formal sector i s low, as i s the case in Colombia. To the extent that regulations hinder investment in physical or human capital, or prevent the efficient organization of firms, they perpetuate low levels of productivity and, thus, segmentation, low wages and informality. This i s o f particular importance when realizing that the Colombian labor market shifted away from manufacturing and towards commerce and services, sectors characterized by higher informality and self- employment due to their nature. 8 LABOR MARKETADJUSTMENT, REFORMAND PRODUCTIVITY INCOLOMBIA: What are the Factors that Matter? I.BACKGROUNDANDPURPOSE As many countries in the developing world, Colombia went through a period of transformation since 1990. After years of a largely stable economic environment, characterized by isolation from world markets and moderate intervention by the State in the economy, the country engaged in a series of structural reforms. These included opening to international competition and foreign investment, liberalization of the capital market, two labor reforms (1990 and 2002), a reform of the social security system and opening of public utilities to private competition. There was also an increase in tax revenues as a share of GDP and an even sharper rise in government spending. In addition, a new Constitution, issued in 1991, brought with it decentralization of social services and an independent Central Bank, as well as mandates to increase social spending and make increasing transfers to sub-national governments since 1993. These reforms sought to increase growth by providing an environment amenable to private investment and innovation, increasing the efficiency of resource allocation and by facilitating human capital accumulation. Initially, these goals were fulfilled as the growth rate averaged more than 5% during 1992-95.However, problems began to arise from the mid 1990s. The volatility of the business cycle increased, making it shorter but more profound. Further, external shocks in the 1990s (Russian, Asian and Tequila crises) impacted the economy adversely, and with the expansion of government spending and the ensuingfiscal deficit, private investment fell sharply and the financial sector became fragile. Increasing levels of violence further inhibitedprivate investment. As a result, the economy began to show signs of recession in 1996and low economic growth lasted until 2002. Indeed, 1999 was the worst year since the 1930s as growth plummeted to -4.3% and only averaged 1% per annum during this seven year period. There i s some evidence of recovery in 2003 and 2004, however, as growth has been around 4% inboth years. These events all impacted severely on the functioning of the labor market. Structural reforms required an industrial and occupational restructuring of the labor force that affected wages and the composition of employment. Labor and social security reforms affected the cost of labor and the terms of employment. Yet, the functioning of the labor market remains a key determinant of sustained future growth and of the welfare of the population. In2002, a reform to the labor code was introduced to increase the ability of the labor market to provide "good jobs" to the population and to begin to reconfigure the social protection system. The effects of this reformhave been the subject of an intense debate, as many argue that they were badly needed for the labor market to be more effective in providing a decent living for a larger share of the population. Yet, others argue that it was simply an instrument to favor employers by increasing their profits. Taking into accountthese considerations, the mainobjectives of this report are to: analyze the structural changes that occurred inthe labor market; 0 evaluaterecent labor market interventions as rigorously as possible; 0 analyze the mainfactors that hinder formal employment creation. That is, investigate why adjustment of the labor market has been so painfulsince the recession; 9 0 examine the path of productivity growth, both labor and overall; and 0 based on the above, suggest policy options that raise labor market efficiency, provide better alternatives of social protection for the most vulnerable and help accelerate growth. This report, conducted jointly by researchers in various countries, the Government and the World Bank, aims to address these questions not by focusing on labor market functioning, but on its outcomes. After all, the really important questions are not whether the labor market is overly informal or excessively rigid. What i s central are labor market outcomes, such as adequate employment growth so that people can find gainful employment, acceptable worker productivity levels that are fairly compensated, and reasonable protection against shocks for workers and their families. This shift in focus, however, complicates the work. While one can study labor market functioning without paying too much attention to non-labor factors (e.g. payroll taxes), such approach i s impossible when the subject of study i s outcomes. Employment growth depends on macroeconomic factors at least as much as on labor regulations; productivity levels depend as much on investments in physical and human capital, as they do on labor market interventions; and protection against shocks depends as much on factors such as safety nets as it does on labor regulations. But this added complexity i s necessary for a better understanding of the labor market. To simplify matters, the focus i s on the most relevant relationships, between labor market institutions, its functioning, and outcomes. The report i s structured accordingly. The rest of the report i s divided into four sections. Section 11looks at the evolution o f the main outcomes over the past 20-odd years, which are taken to be employment (and its composition), unemployment, wages and the occupational distribution o f workers. Most o f the key outcomes point to a deterioration of labor market functioning. This i s followed by an analysis (Section 111)o f the causes of this deterioration, focusing mainly on high unemployment and increased segmentation. Section IV studies the effects of changes in labor regulations (2002) on the main outcomes. Section V looks at trends in productivity and competitiveness, which i s treated separately due to its conceptual complexity and somewhat different determinants. However, an explicit link i s made between labor regulations and productivity outcomes. Finally, Section VI presents some concluding comments and policy alternatives, emphasizing five that are considered top priority. This Volume summarizes the main findings and seeks to offer a simpler view of the labor market, its outcomes, what influenced their behavior and what can be done to improve the functioning of the labor market. The second volume contains detailed technical analyses, which constitute the basis of what i s contained inVolume I. 10 Box 1.1: this Report's Main Innovations: this report adds a series of novel features (and methodologies) to the existing understanding of labor markets inColombia, and is produced at an opportune moment in light of the intense debate taking place in the country with regards to the 2002 labor reform, presently under heavy scrutiny. The main innovations of the report are the following: I t is the result of a truly collaborative effort between the Bank and the Government. The key objectives from the Government side are to evaluate the labor reform of 2002, to understand the reasons for chronic high unemployment, and to look at issues of competitiveness in view of the free trade negotiations with the US. Thus, the subjects included were discussed extensively with the government (and Congress and Academics) from the very beginning and constant interaction has been the norm all along the implementation of the Project. In this context, for example, workshops were held in Bogota in 2004 to discuss the main findings and to sharpen the messages.Additionally, some of the analyses were carried out directly by the government using their own resources. Finally, intense interaction existed also with some members o f Congress and with other Bank teams working in Colombia to ensure consistency in the messagesand feasibility of the proposals. - Characterizes the Colombian labor market, and describes its evolution in the last decades. I t addresses the most relevant aspects of the public debate in Colombia today. Within this general context, it traces in a detailed way the links between outcomes (employment, wages, informality and productivity) to the factors that affect them and that are generally perceived as being key (non-wage costs, minimum wages, participation, public sector issues --analyzed in a rigorous way for the first time here- and public interventions). The goal is to arrive at policy options to improve outcomes. - Identifies the links and the channels through which "exogenous" factors affect outcomes. We use rigorous methodologies that allow confidence in the results. Also, and importantly, to identify the links, determinants are analyzed in a compact framework, which controls for the seemingly greater difficulty of the urban labor market to adjust to shocks, generating a higher level of unemployment recently. - Analyzes self-employment and informality in detail, vis-l-vis salaried employment. This analysis i s novel in the country and proved very useful in understanding key characteristics o f the labor market, especially on issues related to segmentation and previously unidentified channels through which determinants affect outcomes. This is complemented with a thorough study of how employment behaves along the business cycle for different sub-groups o f the population. - Provides the first clues of the impact of the 2002 labor reform on labor market outcomes. This i s one o f the main innovations introduced by the report since it is bound to importantly influence the debate in the country. Theses analyses were carried out in the most rigorous way possible and using many alternative sources of information. Furthermore, the different analyses supported by this task have already had a profound impact on the debate within the country and have created sound discussion among many actors, including government, academics, congress and unions. - Incorporates productivity into the labor market analysis. This is both to understand the role it has played in the recent evolution of the labor market and investigate the link between productivity related outcomes and labor market regulations. - Examines the implications of labor market functioning for the most vulnerable. The report explicitly addresses this issue, approximating the most vulnerable population by the least skilled in terms of education and age. In particular, it examines how, in most o f the cases, Colombia's poor are the most disadvantaged by labor regulations, supposedly designed to help them, resulting in their (partial) exclusion from the labor market in terms of employment, formality and wages. 11 11.The Key Outcomes This section analyzes the evolution of employment and its composition, unemployment, hours worked, occupation-- formal salaried worker (FS), informal salaried (IS), and Self- employed (SE)--, productivity and wages. These are the outcomes that, by and large, determine the welfare of workers and the profits of firms, which are the issues that concern policy makers. Box 2.1: National HouseholdSurvey (ENH):the report relies on the Encuesta Nacional (continua from 2001) de Hogares (ENH) for urban areas. This survey i s collected by the National Administrative Department of Statistics (DANE)since 1976.It compiles changes inemployment indicators, as well as socio-demographic data (gender, age, marital status, migration and education) for the entire population. I t was carried out quarterly until 2000 and continuously since 2001. Nevertheless, the periodicity used here is quarterly by aggregating the monthly data provided by DANE. Also, the questions used to measure employment and unemployment changed and thus, all the exercises adjust the series for this methodological change. The survey collects the information on 13 metropolitan areas. For consistency, the report uses data for the seven main cities, which are loosely called "Urban Colombia": Barranquilla, Bogoth, Bucaramanga, Cali, Manizales, Medellin and Pasto. Employmenthasbecomemorefemale, hasshiftedtowardsservices and commerceand self- employmentgainedimportance.. . Since 1984, there have been important structural shifts in the composition of employment. The share of employment in manufacturing declined from 25% to less than 20%. Wholesale and retail trade increased from 23 to 30% and services from 30 to almost 34%. Another major change occurred in the financial sector, where employment was reduced by half (although it was never more than 8% o f the total labor force). Figure2.1: Shares of Employment by Occupation(Indices), 1980-2004 - 1.2 0.4 --self employedw orkers 0.2I .- .-..,salariedworkers -public workers Source: ENH- DANE, Author calculations A more important shift, however, is the growth of self-employment observed since 1994 (Figure 2.1). It increasedby about 20% over the period, reaching a peak in2001.Private salaried employment, on the other hand, fell by approximately 10% with the decline starting simultaneously. Thus, both roughly coincide with two important events: the introduction of the reform o f the social security system (Ley 100 de 1993) and the worst period o f the recession. Public employment also lost share in total employment, reflecting policies directed at reducing public employment as a means o f containing the deficit and increasing the efficiency of the public sector. The decline was of the order of 50% and consistent all along. The working population also became older and more educated. For instance, workers with higher education (university) rose from 13 to 29%, while those with high school went from 39 to 44%. 12 Participation increased markedly due to the behavior of women. In a related fashion, unemployment grew and remained high, while hours worked declined.. . One the most important changes that occurred in this period was the increased participation of women in the labor market. While male participation rates remained virtually unchanged (around 72%), female participation grew from 44% in 1984 to almost 60% in 2004 (Figure 2.2). Female participation growth acceleratedinthe period 1996-2001, which coincides with the recession. This last fact may imply that many women begantojoin the labor market as a responseto declining householdincomes. As a result of the increaseinfemale participation, their employment rate rose from 32 to 46%. Male employment declined to stabilize at around 62%, down from 70% in the mid 1990s. Thus, it would seem that the labor market has been able to provide jobs to partially accommodate the ever increasing number of women entering the labor force, maybe at the expense of men (Figure 2.3). Figure 2.2: ParticipationRatesby Gender, 1983-2004 women .-P m P 40% Source: ENH-DANE,Author Calculations Figures2.3: EmploymentRatesby Gender, 1983-2004 men women 70% v aeE60% -E 8 50% 0 E 40% 30% Source: ENH-DANE,Author Calculations Unemployment continued to be a chronic problem all during this period, despite growth in output. During 1983-95 unemployment averaged around 10-11%. The lowest point occurred in 1985 (7%), but then it grew continuously with the slowdown of the economy. A peak of 20% was reachedin 2000, and though unemployment has declined after 2001, it remains higher when compared to the initial period, despite renewed economic growth in 2003-04,. Part of the reason for the rise in unemployment can be traced to the increase of the participation rate (from 50 to 65%), which was partially reflected ina combination of risingemployment rates, declininghours worked (especially among women), and rising unemployment (see Figure 2.4). In terms of 13 unemployment rates by education, all levels display a similar behavior following the general trends. However, the intermediate groups (high school or incomplete university) consistently show the highest rates, while the lowest belong to the most educated. Unemployment rates for women have always been higher than those of men. The ratio of male to female unemployment fell between 1984 and 1995, at which point it rose to almost double by 2004, which i s important because it indicates that the labor market has been able to provide jobs for the increasing participationof women inthe labor market. Figure2.4: Trends inUnemployment, Employment,ParticipationandHours Unemp l o pent Rate Employment Rate 25% 7 57% 20% - 54% ae 15% - 51% 10% - 48% 5% - 45% 0% 42% Labor Force Participation Rate Hours Worked 70% 50 60% 50% 49 ae 40% E 40 30% I" 3 47 20% 10% 46 0% ' 45 ' I Source: ENH-DANE, Author calculations The accommodation of more women in the labor force occurred at the same time that their hours worked declined, reflecting the fact that many of the new jobs created were of lower quality (e.g. part time). In fact, the general decline in hours worked (Figure 2.4) i s almost entirely accounted for by changes in the hours of women (Figure 2.5). While men experienced no change in hours all during the period, women endured a sharp drop that started around 1995 and became steeper inthe recession.Weekly hours for women fell from 46 to 42 over the period. Figure2.5: Weekly Hours Workedby Gender, 1983-2004 men women 52 I I I Source: ENH- DANE, Authors' calculations 14 Wages have only increasedfor salaried workers with high education... Both men and women's wages followed a similar evolution: no change until 1993, impressive growth during the remainder of the 1990s, sharp decline during the recession and a timid recuperation starting in 2001 (Figure 2.6). As a result, sluggish growth (around 0.5% per year) was observed over the entire period. Women's wages grew more than men's during the expansion (40 vs. 30%) and the decline during the recessionwas similar for both (around 20%). Women's wages, unadjusted for experience and education, remainabout 30% lower than men's. There are important differences between salaried workers and the self-employed, however. Wages of private salaried workers increased markedly during the expansion but did not fall as much during the recession, reflecting more inflexibility of wages in this occupation. However, wages of the self-employed fell continuously since 1996 until 2002, indicating greater ability in this occupation to adjust to changing economic conditions. The increase in wages observed for the entire period, however, i s due to the increased education of the labor force and not to increases inremunerations for each education level. Figure 2.6: Real Wages by Gender, 1984-2004 men women 30000 28000 26000 -gE24000 22000 20000 18000 16000 140002 Source: ENH-DANE. Authors' Calculations Finally, wages of all educational groups moved with the economic cycle. Since the early 1990s, however, wages of college educatedworkers increasefaster during booms and fall slowly in recessions. As a consequence, earnings gaps and wage inequality across groups increased. Figure2.7, which shows the evolutionof wages of salaried workers by education level, confirms this assertion. Infact, wages of college workers were the only ones that increased (by 3%). All the other groups experienced falls in their wages, the largest being observed among the intermediately educated (especially completed secondary), for which wages fell by 23%. Figures 2.7: Wages of Private Salaried Workers by Education,1983-2004 I%p,1 2 0 1 1 5 1 i o 1 05 0 85 0 eo 0 75 S P ~ i 9 S B ~ ~ ~ S ~ 0 70 Source:ENH- DANE.Author's Calculations 15 Self-employment is on the rise and, importantly, the labor market seems to have become increasingly segmented.. . The discussion about salaried employment, self-employment and informality i s important to the extent that this split causes a loss of welfare for the workers and/or negatively affects the development prospects of the country (e.g. productivity i s negatively affected). That is, if the split is forced by some external factor and workers are, for example, self-employed as the only choice available to them (and one that entails lower wages and less protection), or firms choose to work in informality to avoid regulations and remain small and unproductive, there could be an improvement by removing the constraints that cause this segmentation. In a labor market without rigidities, salaried employment and self-employment, and relative wages between the two, should move in the same direction over time. The self- employment sector, in this case, i s viewed as consisting largely of small entrepreneurs who choose that occupation as a rational decision, possibly because of misalignment of social security benefits and contributions, high costs of registration or for personal reasons (the desire to be one's own boss, not having to comply with schedules, etc). In the reverse case, when relative sector sizes and wages move in opposite directions, the labor market faces constraints that ration out some workers from salaried employment, even though they would prefer to be there. In this case, self-employment i s seen as an undesirable outcome. This distinction i s important because the policy implications for the design o f social security and insurance systems may vary substantially. Additionally, it sheds light on the appropriateness of labor market related regulations, notably non-wage costs and minimum wages. Figure 2.8 plots relative sector sizes (salariedself) and relative wages for the period 1984-2004. Figure 2.8: Evolution of Relative Sector Sizes and Wages (salariedself), 1983-2004 T 1.6 2.3 1.5 2.1 1.4 1.21.3P 1.1 1.5 1 1.3 0.9 Source: ENH-DANE, Author Calculations After 1995 and until2001/02 the series move inopposite directions, indicating that at that time some factor(s) turned the labor market into a more segmented one. It was precisely then that the reform to the social security system went into effect (Ley 100 de 1993). This reform substantially raised payroll contributions to finance health and pensions, and thus increased the cost of being a salaried worker. The decline of salaried employment continued during the recession (1996-Ol), but the ratio o f wages did not decline in that period, demonstrating the inflexibility of salaried wages (since the majority of salaried workers are in the formal sector), Additional statistical analysis (see Volume 11)leads to three very important conclusions: 16 0 the Colombian labor market has become more segmented since 1995/6, which coincides with the full enforcement of the social security reform enacted at the end of 1993; 0 the recession may have also played a role in this shift, by restricting labor demand, particularly amongthe most skilled; 0 those with the lowest skills were the most affected by this move towards more segmentation, in that they appear to have been rationed out of salaried employment in a larger proportion than other groups. Thus, the move towards an increasingly segmented labor market appears to be a function of the amount of payroll taxes (which affects both the decision to become self-employed and the demand for salaried employment) and the state of the economy. The minimum wage is also suspect due to its impressive growth after 1998. These determinants will be formally studied in the next section. Informal salaried employment and self-employment: Figure 2.9 shows the evolution of salaried informal employment for the five skill groups generally used in this report (primary, secondary incomplete, secondary, tertiary incomplete and college), and for the whole sample of workers'. Figure2.9: InformalSalariedEmploymentby SkillLevel, 1984-2004 0.2 --- - 0 16 L \ Source: ENH-DANE The graphclearly shows some important facts: 0 informality i s higher for the lowest skill levels; 0 in most of the groups there is an important decline in informality since 2003, which appears to be especially large for the least skilled groups; and 0 the period 1994-2000was characterized by a substantial increase ininformalemployment inthe three lower groups. In terms of wages, average wages of the self-employed were significantly higher than those of informal salaried workers until 1999. After 1999, the differences disappeared, suggesting that self-employment became more of a residual activity in a more segmented labor market. This conclusion was confirmed by an exercise that compared the characteristics of the 1The analysisof IS employmentcan only be carriedout in 11quarters (thesecond quarter of 1984, 88, 92, 94, 96,98 and 00-04). 17 workers who are either self-employed or informal salaried at two points in time: 1994 and 2004 (see detail in Volume 11). The messages from this exercise can be summarized as follows. First and very importantly, in 1994 workers in self-employment conformed to a pattern in which people move to this occupation when they have accumulated work experience and capital to start a business. Ineffect, the young were the least likely to be self-employed while those between 30 and 49 years o f age displayed the highest likelihood. However, in2004 there were no differences among the various age groups. IS workers, on the other hand, were concentrated among the young. The second message is related to education. Inparticular, while in 1994 the most likely to be found in SE were the unskilled (primary and secondary incomplete) and the most skilled (college), by 2004 the situation changed to one in which a negative relationship between education and self-employment was observed. That is, in2004 the most likely to be found in SE were the least skilled, whereas the least likely were the most educated, pattern identical to that found in the IS occupation. These facts clearly point to a shift of SE, which turned it into an occupation very similar to IS employment. That is, the move towards increased self-employment seems to be dominated by low qualityjobs inthis occupation. MainMessages The main messages from this chapter can be concisely stated as follows: The Colombian urban labor market seems to have "stabilized" at a higher level of unemployment and labor participation has increased markedly. Hours worked declined inthe last ten years. 0 The labor market is increasinglyfemale and commerce and service oriented.While in1984four out of tenwomen were inthe labor force, today this figure is six. 0 In terms of occupations, the compositionof the urban labor market became more self-employedoriented.The important things about this move are that these new self- employment jobs appear to be o f low quality; and that the labor market shifted toward a higher level of segmentation in the period 1995-2002. That is, self-employment now seems to be increasingly populatedby individuals that would prefer to be ina salariedjob but cannot find one. 0 The labor market has a stable share of informal salaried employment, despite an important increase during the 1990s. Indeed, the share of informal salaried workers remained stable at around 35%, after reaching a peak of 40% in 1998. 0 Wages, which are related to productivity,show sluggish growth if the entire period i s analyzed. Indeed, they increased by some 9% between 1984 and 2004 (i.e. less than 0.5% per year). However, wage growth was impressive during the expansive period 1991-98, which also coincided with a period o f highproductivity growth. 0 All outcomes tend to be worse for the least and intermediateskilled, especially the latter,when compared to the rest of workers. 18 111.What LiesBehindThese Shiftsinthe MainOutcomes? The purpose of this chapter i s to investigate the determinants o f the trends observed inthe main outcomes, discussed above. Special emphasis will be placed on the persistence of high unemployment in the last few years and on the increased degree of segmentation. The chapter will analyze why labor market adjustment has been so slow after the late 1990s recession, once economic growth resumed. The analysis i s presented interms of misalignments caused by labor demand and labor supply factors that were introduced over the 1990s. For instance, labor demand has been affected by minimum wages and other rigidities, as well as by labor and non- labor costs, particularly those introducedby the reform to the social security system that affected firm and individual decisions. On the other hand, labor supply suffered structural changes in recent years, mainly due to an increase infemale labor participation. Thus, this chapter addresses the following questions: (i)what i s the impact of the business cycle on employment, its composition and wages? (ii) did the minimum wage affect unemployment and occupational how choice? (iii) what are the mechanisms through which Ley 100 influenced the labor market and what was its impact? (iv) have wage rigidities changed over the 1990s? (v) how did the increasing labor participation put pressure on unemployment? and (vi) what impact did public wage policies have on the functioning o f the entire labor market? 1.EmploymentandUnemployment The Labor Market is increasinglymore proneto adjust by quantities(unemployment)than by prices(wages) ... Output fluctuations can affect unemployment in two ways. First, GDP contractions (expansions) reduce (increase) the demand for labor. Second, reductions in wages can induce labor supply to increase as people who were not participating decide to join to compensate for lower household income. In Colombia, evidence suggests that the relationship between unemployment and output became asymmetric, as unemployment seems to increase more during downturns than it shrinks during upturns. Thus, unemployment tends to persist even once economic growth resumes. Figure 3.1 confirms that, as expected, GDP growth has a larger than proportional effect on unemployment2, i.e. a reduction of one percentage point in economic growth increases unemployment by about two points since 1998. The most important detail, however, i s that unemployment has become more sensitive to changes in output since the last recession, shown by the increasingly positive relationship betweenthe two variables (inabsolute value). When this relationship was studied for the usual skill groups, it became apparent that GDP movements have greater effects on less educated workers. For the earlier years, unemployment o f highly educated workers seemed to not be sensitive to the economic cycle, but after the recession, their unemployment rate became very sensitive. Also, since for all groups cyclical variations inoutput affect the unemployment rate more since 1998, the adjustment has relied increasingly on quantities. The coefficients are higher than one in absolute value 19 Figure3.1: Unemployment and GDP Growth(Okun's equations) Coefficients and confidence intervals 0.00 -0.50 -1.oo B -1.50 -2.50 -2'oo -3.00 -3.50 -4.00 ____I---- r r r r r r r r r r r r r r r r l - Source: Author Calculations Note: the graph shows IO-year moving windows. Dotted lines are 5% confidence intervals O f course, the other side of the coin i s given by the relationship between wages and the cycle, which i s shown inFigure 3.2. It i s clear that the impact of GDP movements on wages was larger in the mid 1990s, indicating a fairly direct adjustment of wages in response to output changes. Towards the end of the period, however, the sensitivity of wages to changes in aggregate output declines to about half o f its previous value, coinciding with the implementation of the social security reform and the increase of the minimumwage. Figure 3.2: Wages and GDPgrowth(Okun's equations) -1 0 -1 1 # 9 W2 f w !@ J $ k L @E . x $ 8 8 k 8 8 $ @5 , # 8 4 Source: Authors Calculations. Note: the graphshows 10-year moving windows (up to 3/96 coefficients are not significant). Thus, despite the increase in the volatility of output, it seems to be a fact that the labor market adjusts now more through quantities rather than wages. Factors such as the minimum wage, non-wage costs and public wages appear to have introduced more rigidity to wages, at least in the salaried sector. This situation is in sharp contrast with what happens, for instance, in Mexico where, despite larger volatility, unemployment remains low and less variable. The Colombian case seems much closer to the Argentinean one and to others in LAC that have moved toward a more inflexible stance (Saavedra, 2001). 20 Box 3.1: Output Shocks and Labor Market Adjustment, a comparison between Argentina, Colombia, and Mexico: after inflation stabilization programs were implemented in L A C during the 1990s, labor markets became more prone to adjust to real shocks through employment rather than wages. This was certainly the case inArgentina, where the hard-peg-based Convertibility Plan, which relied on the exchange rate as a major policy instrument and an anchor for inflation expectations, was implemented in 1991. During that period, adjustments to the real exchange rate could only occur through deflation of nominal wages and prices, because the nominal exchange rate could not be adjusted and inflation could not be used to reduce wages. When the country's recession moved into an escalating crisis, nominal wages did not fall, and the labor market adjusted through increasing unemployment. Between 1998 and 2001, unemployment jumped from 13% to 18%, peaking at 22% in 2002. This sharp increase in unemployment hit the formal sector hard.Ineffect, it accounted for almost 90% of the jobs lost at the height of the crisis. With a resumption o f inflation inthe post-convertibility period, real wages increasingly absorbed the adjustment, helping to ease the impact o f the crisis on employment, as evidenced by the fact that, despite an 11% output contraction in 2002, employment only fell only 1.1%. Real and nominal wages for formal sector employees, which were the most stable between 1995 and 2001, suffered a dramatic contraction in 2002. Informal workers' wages were more flexible throughout the period, though this was not sufficient to restore full employment. Real labor costs in the private sector also fell, and by mid 2002 they were 30% lower than at the peak of the crisis. All o f this indicates that, while during the earlier phase of the crisis the labor market adjusted mainly through unemployment, once the devaluation took place, wages costs became the main adjustment mechanism, triggering a deceleration of unemployment growth. Mexico poses a different case, as a distinctive characteristic of its labor market was the wage response to changes in economic activity, which helped to cushion their effect on employment. The country's swift recovery from the large slump of 1995 was attributed to Mexico's flexible wages, which absorbed most of the adjustment. Mexico's unemployment rate during the 1990s was surprisingly low, especially when compared to those observed in other Latin American countries, including Colombia and Argentina. Despite constant increases in labor participation, Mexico's unemployment rate never reached a two-digit figure and, with the exception o f the Tequila crisis, it was never above 5%. This resulted from the stagnation of remunerations, with 2003 wages around pre-1995 levels. Recent evidence suggests that the ability of Mexican labor markets to adjust to shocks through wages may have been declining since the late 1990s,in line with the rest of the continent. Colombia's adjustment to the crisis of the late 1990s seems very similar to that of Argentina. The high level of inflexibility of the Colombian labor market, combined with increasing labor force participation lead to a jump in unemployment that reached 20% in 2000. The formal and informal sectors adjusted to the contraction in output in very different ways, though. Due to wage rigidities caused by a binding minimum wage and high non-wage costs, the formal sector had to resort to cutting jobs on an enormous scale. The self-employed, on the other hand, did not register such large increases in unemployment, but actually increased their job share, absorbing a third of previously wage-earning workers. They did face, however considerable reductions in earnings of up to 20 %, in clear contrast with salaried workers. Some additional adjustment in wages was obtained through reductions in the gender gap and higher female participation. As in the case of Argentina, the devaluation of the peso prompted a deceleration of unemployment growth. The evolution of unemployment and wages in dollars, below, suggests that after the devaluation, wages absorbed a larger share of the adjustment, preventing unemployment from further increases. I 025 7 400 -- 100 -- 50 000 7 0 19831 1985111 19881 1990111 19931 1995111 19981 2000111 20031 Source:ENH- DANE-Banco de LaRepliblica 21 Women of all ages, teenagers and the unskilled are the groups that suffer the most during contractions of aggregate economic activity.. . Despite the strong influence of the cycle on the labor market, it is not clear how this impact i s distributed on the population, information which i s essential for the design of appropriate policies. A simple methodology allows the disentangling of the response o f various groups to the cycle. It reveals that cyclical changes in aggregate economic activity are associated with dramatic changes in the gender composition of employment. Lower aggregate demand i s associated with a decline in the proportion of males employed in most age categories and an increase in the proportion of women. The most important source of this change i s the increased participation of women as a consequence o f reduced household income. Importantly, the sensitivity o f labor participation for women i s usually greater than the change in employment, suggesting that the entry of women contributes to the increase in the overall rate o f unemployment. An examination of the response of males reveals a different picture. Participation of adult males displays a very small sensitivity to cyclical fluctuations. The labor participation o f young teenagers (12-19), on the other hand, appears to be highly sensitive. A decrease in aggregate demand of one percentage point leads to a 4.3 point increase in the labor participation of 12-15 males and of 1.5 for those 16-19 years old. Also, the proportion of the teenage boy population employed appears to increase only for the 12-15 group, but the increase is smaller than the growth o f participation, meaning that many of them go to increase unemployment. For the 16-19 group, almost all the increase inparticipation goes to unemployment. The overall results (see Volume 11)indicate that young workers (20-24) and adult women are the groups that move the aggregate unemployment rate the most in response to the cycle. Fewer adult men and 16-24 year olds enter employment, while more adult females and younger teenagers enter employment. Thus, in Colombia secondary workers, such as women and teenagers, who are not strongly attached to the labor force, join the labor market when economic conditions deteriorate. Finally, these exercises also revealed striking numbers about the main drivers o f the overall unemployment rate during downturns: teenagers (15-19 year olds) and young adults (20-24 year olds) account for 30% o f the increase o f the unemployment rate when GDP growth declines, while adult women are responsible for more than 20%. Adult men are responsible for only about 17% of the increase. This i s the result of adult females (25-64) accounting for almost 30% of the increase in labor force participation. The youngest group o f teenagers (12-15) i s the group that contributes the most with almost 40%. Box 3.2: Comparison with Other Countries: the labor markets in urban areas of Argentina, Brazil, Mexico and Colombia are very similar to the US. In each o f these countries young workers and teenagers accounted for the largest share of the short-term variation in employment. The response of the youngest group, however, i s strikingin Colombia. As in the United States, teenagers up to 24 years of age are only 25% of the population and yet they comprise almost 40% of the cyclical variation in employment. In contrast, adult men account for a smaller share of the cyclical variation in employment than their share inthe population. The important difference with the US is that in this country women do not appear to be as sensitive to the cycle. Also, Mexico is the country where the least sensitivity of the different groups i s found. The impact of increasing minimumwages since the mid 1990son unemployment appears to be substantial, being particularly pervasive since 1998.. . Mandated minimum wages can cause misalignments in the labor market in numerous ways, increasing unemployment and the share of informal workers. Minimum wages, while nominally only relevant for the formal sector, may also influence wage setting in the informal 22 sector. The minimumwage inColombia declined between 1984 and 1994, and then rose sharply (Figure 3.3). By 2003, it was about 4% higher than in 1984. The country has the second highest minimumto average wage ratio inLatinAmerica, only below Honduras. This ratio declined until 1998, to rise significantly since then, as a result of a real increase of about 8% in the minimum wage in 1998 (Figure 3.4). The present value of the ratio i s in line with its 1984 level, after reaching its lowest in 1997, when it was almost 25% lower. As a result, the proportion of people earning less than the minimum wage increased in recent years, especially among the self- employed (Figure 3.5). This indicates that the minimum wage has become more binding. It i s important to note that this happened at the same time that the economy was undergoing its worst recession inhistory, which probably augmented its negative impact. Figure3.3: MinimumWages, 1984-2003 (real pesos per month, 8 quarter moving average) I: 11100 10900 9 10700 10500 3 10300 .EE 10100 9900 9700 Source: Banco de La Repliblica Figure 3.4: Minimumto Average Wage Ratio 0.60 f--- " - _ . " " . _ _ _ - ~ _ - - - ^ " 25% 1~ -1 ----" * I I 70% - 20% - ,' % <~* '., * , s 15% - 8 40% - 10% - I 5% - -Men -Men . . " l . l "Women Women1 0 % - , , , , ' $ ' I , , , , ' , ~ ' ' I I 8 , 8 1 8 ' 8 8 1 8 I I 23 To isolate the impact of the minimumwage on wages and employment, diverse statistical analyses were undertaken, separately for the whole labor force and for each skill group (see Volume 11).These exercises showed that: growth of the minimumwage causes the entire working population's wage to increase. Its effects are not restricted to the lowest earners, but it acts as kind o f a "lighthouse" throughout the distribution, causing wage increases until the 75%th percentile. This i s surely related to the practice of indexing wage setting to multiples of the minimumwage; women's wages are more sensitive to changes inthe minimumwage than men's; the minimum wage i s negatively related to employment. An increase o f 10% o f the minimumwage causesthe employment rate to fall 3.6% for menand 2% for women; this negative effect on employment is present for all educational levels but the highest one. It is greater for men than for women, for those with primary or intermediate education and for younger workers; this negative impact became especially large since 1998.The response of unemployment to increases of the minimumwage was fairly stable until that year and, from then on, it increased sharply. Simulations - Minimum Wages and the Recession: to assess the effect of the minimum and the cycle on employment, two simulation exercises were carried out. The first assumes that the minimum wage remained at its September 1995 level, while in the second, GDP growth for the recession period i s kept equal to the average growth for the 1990s. Figure 3.6 present the results for men. Ifthe minimum wage had remained at September 1995 levels, the male unemployment rate would have been 6.7 percentage points lower than it actually was in 2003 (unemployment would have been around 8%, instead o f 14.7%). If economic growth in the late 1990s had been equal to the decade's average, men's unemployment would have actually been one point higher, although inthe worst years o f the recession it was about 2 points lower. Figure3.6: Male UnemploymentRate Simulations - 14% 6.7% 140h 12% 12% 10% 8% 6% 6% 4% zrm z n l $ c zm F~ zm m m 4 % z6 ?8 E6 zm zl : ? ? - : ,2, m c mm g g g z ...... Baseline -Constant Minimum Wage Baseline -Constant GDP Source: Salas (2004) The female unemployment rate, on the other hand, would have been 3.9 percentage points lower under a constant minimum wage scenario. Under the sustained growth scenario, female unemployment would have been nearly 2 points lower in 2003. Simulations for the unemployment rate across education levels show that the unemployment rate for unskilled workers (primary level) would have been 2 points lower with a constant minimumwage and 2.5 percent lower with sustained growth. Overall, it would seem that the high unemployment rate of the late 1990s was, to a large extent, a product o f both the rapid and sustained growth o f the minimumwage, as well as the fall of growth rates of GDP. 24 Box 3.3: Minimum Wages Other EvidenceandInternationalComparisons:Cunningham et. al. (World Bank, - 2005) found that the minimum wage appears to have a strong effect on both formal and informal sector workers' salaries. The minimum wage is more binding in the informal than in the formal sector because of lower average wage in the former. The study also shows how the minimum wage can be a tool for poverty and inequality reduction. Although generally the minimum wage is less than the poverty line, it can serve to increase the incomes of the poorest workers. I t also reduces income inequality because the positive impacts shrink to zero in higher earning households. Nevertheless, in countries with relatively high minimum wages, the minimum wage can also lead to non-wage effects, increased unemployment among the poor, and thus greater poverty and an increase in household income inequality. Neumark et. al. (2003) analyzed the effect of minimum wages in Brazil on the distribution o f family incomes, using cross section time series data. The estimations provide no evidence that, in the lower-wage metropolitan areas, where their effects should be apparent, minimum wages lift family incomes at the lower segments. Maloney and Nliiiez (2003) estimated Kernel density plots for 20 Latin American and Caribbean countries to identify the redistributive effect of the minimumwage on formal and informal sector wages. Inaddition, their study provides evidence on who earns the minimum wage and how it compares to the poverty line. As the following figure depicts, Colombia has the second highest minimumto average wage ratio within the Latin America Region, confirming the conclusions about how it became a binding constraint recently. MinimumWage to AverageWage Ratiofor SelectedCountries,2000 I Source: Maloney and Nliiiez (2003) The impact of rising non-wage costs on unemployment was sizable as well, although lower than that of the minimumwage... Rising non-wage costs and unemployment seem to go together, both growing significantly after 1995 (Figure 3.7). These costs cover such items as health insurance, pensions, severance payments, and other mandated benefits and taxes (Box 3.4). During 1990-1994 two important changes to labor related legislation were introduced. The first was the labor reform of 1990 (Ley 50), whose main objective was to make the labor market more flexible by facilitating hiring and firing. The second one was the social security reform (Ley 100 de 1993), which reformed the system of health and pensions. The reform determined the amount and distribution of the payroll contributions between the contributory and subsidized regimes in health. The affiliation to one of these regimes depends on the income o f the worker: those who have the ability to pay are affiliated to the contributory regime, paying through the payroll, while the lower-income population i s enrolled in the subsidized regime. Under the contributory regime, individuals must make payments equaling 12% o f their earnings, split between the employer (2/3) and the worker. The pension system reform introduced a fully funded system with individual accounts. Contributions increased to 13.5% (14.5% for high earners). 25 Figure3.7: TrendsinUnemploymentand Non-WageCosts 0.20 - T 0.55 - _ unemployment non wage costs I:::: 0 . 7 8 0.50 0.16 n l 0.45 I 4 0.10 0.40 0.08 I I Box 3.4: Non-Wage Costs in Colombia: non-wage costs in Colombia are composed, first, by contributions to finance health, pensions and professional risks. Additionally, there are (i)"Cesantias" (individual accounts funded by the employer in the amount of one month's wage per year that act as a kind of unemployment insurance); (ii) paid vacations (half a month wages per year); (iii)Parafiscales, which are taxes to fund a variety of social protection services provided by SENA (training), ICBF (family and child welfare) and the "Cajus de Compensacidn Familiar (CCFs)", which provide services for formal workers, ranging from cash subsidies to recreation. They amount to 9%; (iv) mandatory bonuses (4.2% of the payroll); (v) severance payments for unjust dismissals (around 5.2% of the payroll after the 2002 reform). The 1993 social security reform increasedhealth contributions from 7 to 12%, while contributions for pensions grew from 4.5 to 13.5% (14.5%for high earners) and the 2002 pension reform increased them further by 2%. The only componentthat has gone down among these is (v), which decreased from about 12% in 1989 to the 5.2% mentioned.Most of the reduction came about from the 1990 labor reform, which reduced it to 7%. In fact, total non-wagecosts have increasedfrom some 47% of the payroll inthe 1980s to 60% in 2004. If item (v) is not counted, the increase i s from 35 to 55%. These reforms have two potential effects: first, they could make employment more attractive, thus raising participation rates. With no change in labor demand, this would then add to unemployment. Second, by raising labor costs the impact could directly cause additional unemployment. Interms of labor supply, Figure 3.8 shows observed and estimated participation rates for men and women. The estimated male participation i s slightly lower than the observed. The opposite result i s found for women, implying that the reform decreased female participation. & 3.B - 9.6 . :3.23 :3.1- - e - 2 . 6 . 2.6 - 2 . t . 2.2 - 2 7 , . , . . . . . . . . I . . . . . . a a ,. . I . I. . .. I . . I . . I . . I I I I I q . 26 As economic theory predicts, the response of labor demand to the increase in non-wage costs was negative. As a result, employment rates would have beenhigher if the increase in non- wage costs had not occurred (see detail in Volume 11). Thus, if both the supply and demand effects are considered together, it i s found that, on average, the unemployment rate would have been almost one point lower than the one observedbetween 1996 and 2003. Note, however, that these results depend critically on the estimate of the elasticity of labor demand to labor costs. Taking into account that the ones usedhere are in the low range, it is safer to say that the effect on the unemployment rate i s inthe rangeof 1.2 and 1.8 percentagepoints3. Figure 3.9 presents the results of an analysis of how the relationship between unemployment and (total) non-wage costs evolved over time. Three different periods can be identified. Until the mid 1990s, the relation was negative. Between the time of the implementationof Ley 100 and the end of 1998 (gray area) the relationship seems to be neutral. Finally, towards the end of the period, which coincides with the recession, the relationship becomes positive, indicatingthat the increasesin non-wage costs induced by Ley 100, combined with the reduction of labor demand were a key part of the jump inunemployment that followed. Figure3.9: UnemploymentandNonWage Costs 2 .o ~ 1 . 5 .QE 1 .o 0 0.5 I 0.0 '- ; -0.5 -1.0 .g - 1 . 5 -2.0 Source: Author calculations Public sector wages also seem to negatively affect the adjustment of the labor market, probably by introducing additional rigidities to overall wages.. . A salient feature of the Colombianlabor market is the small share of public employment. When compared to both Latin American and developed countries, Colombia's public employment i s clearly among the smallest. For instance, public employment in Colombia was 8.7% in 1999, compared to 10.9% in Chile, 13% inBrazil, and 15.6% inArgentina. However, in Colombia, public employees earn substantially higher wages than private workers and the difference, on average, seems to have widened recently. Table 3.2 presents a comparison of relative wages across employment types, where public employees' high wages clearly stand out. Public wages were 47% higher than private wages in 1991, and rose to a point of being twice as high in 2002. When the comparisons are made among "similar" workers (Le. controlling for personal characteristics) the premium becomes higher4. This wage premium i s highest for low and intermediate skilled workers and was on the rise between 1995 and 2000. Only among the Estimates o f the impact o f non-wage costs on labor demand range from -0.25 to -0.4. Volume I1contains a detailed analysis o f the public-private wage premium, which takes into account not only the characteristics of the workers, but the selection bias introduced by the choice o f sector. 27 highly skilled the premium fell inthe later years. Regardingthis last point, it is important to note that there are also large differences between workers within the public sector, with highly educated workers in the executive branch earning substantially less (about half) than their peers in the legislative or judicial branches. The public sector's disproportionately high wages, which represent a transfer of the Colombian society to a very limited group of workers through taxes, may be introducing rigidities in the aggregate labor market if they act as a "lighthouse", influencing wages and employment inthe private sector. Table 3.7: Relative Wages Across Sectors, 1991-2003(Compared to PrivateSalaried) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Private 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 Public 1.47 1.54 1.66 1.48 1.49 1.64 1.71 1.47 1.87 1.91 2.03 1.92 2.00 Domesticempl. 0.34 0.33 0.34 0.33 0.37 0.37 0.39 0.35 0.40 0.39 0.38 0.35 0.40 Selfemployed 0.86 0.85 1.01 0.97 1.12 0.91 0.90 0.77 0.65 0.76 0.57 0.69 0.61 Entrepreneur 2.27 2.14 4.32 3.18 3.38 2.38 2.13 2.42 1.85 2.08 1.76 1.75 1.60 Source: ECH, Author Calculations How does this impact on the overall labor market? The analysis in Volume I1looks at the effect o f public sector pay policies, allowing for the different characteristics of public and private sector employees, and adjusting for the choice of sector. Ingeneral terms, the results indicate that men are negatively affected by the public-private wage gap, in terms of having a lower overall employment rate than the one that would exist if such a premium were not present. Men older than fifty and adult men (40-49) with primary schooling are more severely affected. Women, however, do not seem to be as impacted by this wage gap. The impressive growth of female participation has severely impacted unemployment.. . Labor force participation in Colombia has grown uninterruptedly since the mid 1980s. Much of this can be explained by the continuous increase of female participation, which, as Figure 3.10 shows, has been rising steadily as a consequence of both short-term and structural influences. Short-term changes relate primarily to the business cycle. Structural shifts, on the other hand, are associated with deep social changes, such as greater and more egalitarian educational access, as well as fertility rate declines. Figure 3.10: Unemploymentand Labor Force Participation by Gender Female 0.80 . 0.75 - 0.70 - f 0.65 - -- 0.15 5 0.60 - 0.55 - ...,.~. *_,..,* ....'...;- 0.10 k =E ...,.... . . .....,. 0.50 - -- 0.05 3 ~ , 0.45 -+.:.'............. , . .--..:../.............'...:*...-LFP Unsrnployment Rate 0.40 ~ 0.00 Source: ENH-DANE 28 There are differences in the determinants for men and women for entering the labor market. For example, unmarriedmen participate less than marriedmen, while unmarried women participate more. Further, the presence of children under seven years has a negative impact on female participation, but a positive impact on men's. Female participation has grown continuously from 1984, experiencing an increase of 16 percentage points. The increase was especially markedduringthe recession.This behavior can be explained by increases ineducation attainment (48%), increases in the proportion of women as heads of household (13%), changes within the family structure (17%) and changes in fertility rates (2%). Women's decisions to participate in the labor market seem to be related also to the business cycle: rising when the economy i s weakening, and falling when the economy i s strengthening. Based on an analysis of the probability of participation (Volume II), it is possible to undertake simulations of the impact of changes in participation on unemployment. They show that changes in labor participation have a considerable effect on unemployment (Figure 3.11). During the recession period (1999- 01) unemployment reached its highest level, 20.2%. However, had the participation rate remained at 93-95 levels, the unemployment rate would have been around 10.2%. Figure3.11: ObservedandEstimatedUnemploymentRate 25 0% 20 0% 15 0% % 10 0% 5 0% n no,. -.-.I , 84-86/87-89 84-86/93-95 93-95/99-01 84-88/99-01 Iestimted0observed Source: Diaz(2004) Importantly, the impact of labor participation on unemployment i s particularly strong for the least and most skilled workers. This result i s related, again, to the behavior of women. Inthe lower education groups female sensitivity to the cycle i s very high (women in these groups joined the labor market in a higher proportiondue to the recession), while in the highest group i s where the largest increase of female participation due to "structural" factors i s found. 2. Segmentation The increased level of segmentation (Le. the move towards low quality self-employment), on the other hand, is associated with the increase of non-wage costs, the recession and, to a lesser extent, with the late 1990s rise of the minimumwage.. . Detailed statistical analyses (Volume 11) about the main determinants of the move of the Colombian labor market to a more segmentedstance clearly providedthe following results: 0 there exists a positive long term relationship between the size of the self-employment sector and non-wage costs that became larger during 1996-2001 and then stabilized at a high level, as Figure 3.12, below, shows. That is, as the regulations introduced by Ley 100enteredinfull force (1996) the size of the self-employment sector grew continuously, with an increasing pace after 1998 when the recession was at it worst. After 2001, the relationship stabilized at ahigh level; the economic cycle played a chief role in increasing segmentation, especially among the most skilled segments of the labor force (incomplete and complete college); 29 Figure3.12: Long-RunRelationshipbetween Self-EmploymentandNon-WageCosts,1984-2004 Source: Author's Calculations the minimumwage was also a determining factor inthis move. Its effect was particularly strong among the intermediate skilled. Additionally, it was apparent that minimumwages became a more bindingconstraint affecting the decision of becoming self-employed since 1998, when its effect increased by more than 30%; 0 firing costs were also found to have a large impact on the degree of segmentation, but only among the skill groups of secondary complete and tertiary incomplete; and 0 the large devaluation of the period 1998-02 contributed to higher segmentation. Therefore, the main messages from this chapter may be summarized as follows: - Increasing participation rates, especially female and young, have had an important impact on unemployment, particularly during the recession. Participation, inturn, has been driven by structural changes and by fluctuations of GDP. - The corollary of this is that women of all ages, teenagers of both genders and the unskilled are the groups that suffer the most during contractions of aggregate economic activity and, despite their lower share of the population, are the groups that cause the larger movements of the overall unemployment rate. - Minimum wages and non-wage costs appeared as key determinants, not only of unemployment, but of self-employment, informality and segmentation. Their effect became particularly pervasive since 1998 for minimum wages and 1995 for non-wage costs. Minimum wages seem to be particularly relevant for the determination of employment, while non-wage costs affect more the split between occupations. - Wages seem to have become less sensitive to the cycle, fact that is also partially explained by the behavior of minimum wages and non-wage costs in the last ten years. However, public wages, which may be acting as a "lighthouse", at least for workers with intermediate or low education, are also affecting overall wages. - Thus, the labor market has become less flexible to adjust to macroeconomic fluctuations inrecent years. That is, when economic growth declines an increasing part of the adjustment i s reached by increasing unemployment. Therefore, the importance of maintaining macroeconomic stability cannot be sufficiently stressed. Also, the effect of the cycle on unemployment has two channels: through a decline in employment generation and also through an increase in labor participation rates, particularly among women and the young. - Poor performance of productivity growth (see chapter V), is highly correlated with sluggishgrowth of salaried employment and wages. 30 IV. The Labor Reformof 2002-GaugingitsImpact' The 2002 labor reform (Ley 789 de 2002) attempted to formalize employment and increase the pace o f employment generation by removing some of the obstacles reviewed above, which became especially binding during the recession. The reforms included reducing extra- payments for nocturnal and holiday work, bringing down firing costs and introducing flexibilization to non-wage costs. At the same time, measures were included to favor employment and formality of HEGincludingwomen, young workers andthe disabled. The most important of these was the reform of the apprenticeship contract (AC). Finally, a set of social protection measures was included in order to begin to create a more effective social protection system, including the introduction of an unemployment insurance system (see Box 4.1). Box 4.1: The Labor Reform Law 789 of December 27,2002: - Measures to create and formalize employment. The labor reform extended the diurnal shift, defining it as being from 6 am to 10 pm (before it was from 6 am to 6 pm). This measure reduced premia paid for nocturnal work (40% over the regular wage). Likewise, the law allowed flexible working hours for the commerce and service sectors, which might vary between 4 and 10 hours a day without going over 48 hours per week; those working hours can be at any time o f the day and any day of the week. On the other hand, extra-payments for work on Sundays and holidays were slightly reduced. The law reforms the apprenticeship contract (AC) by, first, removing the contractual obligations between employers and apprentices ("deslaboralizacih"), so, in practice severance payments are eliminated. Second, the ACs are exempted from paying parafiscales. Third, the new regulation allowed remunerationlower than the minimumwage: 50% in the learning phase, and 75% in the practical. The law enacted the obligation to contract apprentices in firms that have 15 or more employees, according to the number of workers. Inaddition, firing costs were reduced, in higher proportion to workers with 10 years of tenure or more. Differential severance payments for unjustified separations, according to the wage rank, were established. Finally, the reform allowed refunding ofparafiscales to those firms that carry out on-site training. The previous labor reform (Ley 50 de 1990)had significantly reduced severancepayments and established the salario integral, which allows employers to convert non-wage costs into wages, provided that the worker proves that she i s making pension and health contributions. Social Protection Measures. An unemployment insurance (UI) scheme was established, with resources coming from the redirection of one point of parafiscales, in particular those administrated by the CCFs. The regulation establishes that the subsidies must be focused on both unemployed who were members of the CCFs at any time during the last three years (in a higher share) and the unemployed who have not made contributions (Le. were informal workers). Employment of HEG. Incentives were included to increase employment among vulnerable groups, through the exemption of parafiscales to the firms that employ (i)poor heads of household; (ii)ex-guerrillas under a state program (reinsertudos); (iii) handicapped; (iv) people between 16 and 25 years and older than 50; and (v) ex-convicts. O f course, the A C serves also the purpose of favoring employment o f a particular HEG, the young. Since the reform (2002), some important changes occurred inthe labor market: 0 employment grew importantly, especially in2003, but the growth rate declined in2004; participation rates decreased in2004; as a result, unemployment fell since 2001, but more markedly in2003-2004; 0 salaried employment increased and informality fell, especially in2003-2004; and 0 wages of salaried workers increased (some 22% for women and 13% for men) in 2003- 2004, while those of the self employedremained stable over 2001-2004. The question is to what extent were these changes related to the reform. To answer it, diverse analyses were undertaken usingrecently collected firm andhouseholddata (see box 4.2). This sectionis basedon four studies commissionedespecially for this Report:Amarante andArim (2005a),Diaz and Santamaria(forthcoming), Gaviria (2005)and Ndiiez (2005).Other materials, such as, L6pez (2004) and Ministerio de la Protecci6nSocial(2005) were also used. 31 Box 4.2: Data and Methodology: the evaluation of the labor reform was based on (i) special survey of firms that a ~ included questions that specifically asked about the use of the new regulations by entrepreneurs (labeled FSu from now on); (ii) the analysis of administrative data; and, more importantly (iii)the use of household survey data (ECH) for the period 2001-2004 to isolate the impact of the reform on key labor market outcomes, such as employment, formality, hours worked and wages. Analyses using the ECH were based on "differences in differences (DID)" estimators, which allow the isolation of the effects of certain events based on comparisons o f a "treatment" group (exposed to the event, in this case the reform) with a "control" group (not exposed to the reform). As it is well known, the main criticism of this methodology is precisely the choice of treatment and control groups. For a description o f how they were identified, see Volume 11. The FSu, on the other hand, consisted of 1.021 firms located in Bogota in all sectors, including 25% in manufacturing, 41% in commerce, and 18% in personal services. The share of firms with fewer than 10 workers was 41%. For a detailed description, including the questionnaire, see Gaviria (2005). Of course, trying to evaluate and isolate the impact of a policy change of the magnitude of a labor reform, which affects large portions of the labor market in diverse ways, i s an extremely difficult task, and even more when the trends of aggregate economic activity shifted at the same time as it was introduced (Le. growth picked up in2003, after years of being stagnated). The fact that less than two years have passed since the reform does not help either (the reform went into full effect inApril 2003). However, the law itself (inits Article 46) included a mandate to evaluate its impact two years after its enactment, in order to introduce adjustments to those regulations deemed as ineffective or counter-productive6. In what follows the main results are presented. For clarity and, given that in some areas there are mixed results, the exposition will start with the aspects that seem to leave no doubt, to present at the end those in which there i s mixed evidence. Also, the results related directly to labor market outcomes will be presented first, to then finish with a brief evaluation of the social protection related provision^.^ The impacton employmentof youngworkers seems largeand significant.. . Duringthe pre-reform period (2000-02) the number of apprentices showedpractically no change, as if an equilibrium level, given regulations and market conditions, had been reached (Figure 4.1). After the introduction of the reform, however, the number more than doubled (from 33,000 in2002 to 72,000 in2003) and seemed to remain stable in2004. This increase represents more than 4% o f all the employed betweenthe ages of 18 and 25 years inJune 2004 andthey are almost 6.5% o f those working as private salaried workers, which i s a sizeable share. Figure4.1: Numberof Apprentices Working under AC 80000 7 70000 60000 50000 40000 30000 20000 7 0000 0 2000 2001 2002 2003 2004 Source: MPS (2005) Control and treatmentgroups should be composedof "similar" individuals and be subject to the same shocks, except the event being analyzed. Many alternatives were used for treatment and control due to the conceptualdifficulty of finding similar groups of workers that are or are not affected by the reform.Hence, the results shouldbe interpretedwith this caveat in mind. Volume I1 explains the DID methodology in detail and contains analyses of the choices. A second caveat relates to the FSu. Many of the 'questionsonwill the reformare more of aqualitativenature. As such, the responsesrepresentopinions. No attempt be madeto estimatehow manyjobs were created, because this is an impossibletask, and the results are weak 32 The firm survey showed that 35% of firms increased the use of apprentices in 2003 (compared to 17% in 2002). Larger firms and firms engaged in export were more likely to use apprentices. Econometric analysis (Volume II) that the reformincreased the probability confirms of employment by one percentagepoint for workers aged 14-24years as a direct result of the AC reform, this effect beinglarger for menthan for women within this age range. However, two points should be kept inmindabout this result: it is impossible to know if this result reflects only a responseby the firms to the reduced costs and increasedflexibility to hire apprentices, or if it i s due in part to the obligation imposed by the law, which is especially relevant among large firms; and inrelationto this, some firmmanagersexpressedthat they sometimesperceive the AC as another payrolltax dueto the obligation to hire a pre-determined number of apprentices; Formality seems to have beenpositivelyaffected by the reform... Four specific measures of the reform were expected to reduce informality. The cost reduction brought about by the increase of the diurnal shift, the greater flexibility in setting shift times without causing extra payments, the decline in firing costs, especially for workers with more than ten years of tenure, and the introduction of the AC. Most of evidence in this respect points to a favorable impact of these measures on the level of formality. As initial evidence, not tied yet to the reform, Table 4.2 shows flows between formality and informality in 2001 and 2004. The percentageof workers who left informality and becameformal increased substantially (from 18 to 22%), while the proportion of people who did the opposite movement decreased from 45 to 43%. The percentageof people who switched jobs within the informal sector declined as well, while the flows within formality grew. Table 4.2: Flows Between Formality and Informality (%), 2001and 2004 Current (>) Informal Formal Previousjv> 2001 2004 2001 2004 Informal 82.0 78.4 18.0 21.7 Formal 45.0 42.7 55.0 57.3 Source: Gaviria (2005) Likewise, econometric evidence (Volume 11) shows that, due to the reform, the probability of going from unemployment to employment as a formal salaried worker increased by 5.8%. The results also indicate a sizable effect of the reform inreducing informality inhighly informal sectors, such as commerce and services. This effect i s particularly strong among the least skilled, who experienced a reduction of the probability of being informal of 13-25%. However, no significant results were found when the data were analyzed by firm size. The impact on employment creation appears positive as well, although of moderate size.. . The employment impact of the reform is one of the aspects that has generated the most controversy. It was said above that the pace of employment creation increased since 2003, although it lost momentum in 2004. The timing of this event constitutes an indication that the impact of the reform may have been positive. However, making this link i s not an easy task. Thus, several exercises were conducted to establish if there is actually a causal relationship between the two. Statistical analyses show a positive and significant relationship between the 33 reform and employment creation. The results indicate that, as result of the reform, the likelihood of being employed increased by 0.6 percentage points, while this figure i s 0.8 for the least skilled and 0.3 for those with unfinished tertiary education (no impact was found among the most skilled). The exercise was also performed for age groups and for each gender, showing that the effect of the reform was larger for men than for women and that it was concentrated on young workers (18-29) and on those in the 40-49 years group. It i s important to note that the largest effect i s found for workers between 18-24 years of age (almost 0.8 percentage points o f increase in the probability of being employed), which is consistent with the results found above and highlights, once more, the importance of the A C to reactivate employment among the young. Also, the time people stay inunemployment fell, while employment duration increased as a result of the reform. In particular, there i s a reduction of the likelihood of an individual loosing hisher job of 29% in the services sector, 7% in manufacturing and 23% in financial services. Thus, it is expected that the reform increased employment because the stock of employed workers i s higher after the reform. That is, in terms of Figure 4.2, Fe increased, while Fs declined, increasingthe stock of employment at each point intime. Figure 5.2: Labor Market Flows andthe Expected Outcome of the Reform * I III m Employment I * Before Reform: Fs>Fe Expected: Fs