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Labor Market Responses to a Change inEconomic System

Robert J. Flanagan

The economic transitions in Eastern Europe have produced a contraction in theaggregate labor supply and the beginnings of a reallocation of labor from investmentgoods and beavy industry to consumer goods and services. The expansion of the pri-vate sector has reversed-if not eliminated-many of the labor market distortionscreated undsr central planning. Thus the first years of economic transition recordedincreasing returns to human capital. There is some evidence that growlth in the pri-vate sector has led to more rational wage structures. Labor unions and minimunwage legislation have done little to inhibit labor market adjusments. Rather, labormarket programs and incomes policies-with their emphasis on passive measures andwage subsides-have retarded the adjustment of wage structures and the restruur-ing of labor in state enterprises. But, the article observes, changing to active laborpolicies would probably not reverse the decline in employment. Unemployment inthe transition economies is largely a matter of insufficient demand, and labor mar-ket policy is unlikely to have mucb impact until the mismatch between vocationaltraining systems and modem production methods is solved.

T rhe collapse of central planning systems has been dosely tied to a collapse oftotal factor productivity. In the early postwar decades labor force participa-otwn rates and capital resources increased in socialist countries, and their eco-

nomic growth rates compared favorably with those of capitalist countries. But withthe exhaustion of possibilities for extensive growth, these economies needed to usetheir resources more efficiently to achieve intensive growth, and failing this, theireconomic growth faltered. In command economies the increases in toral factor pro-ductivity growth needed to overcome slowing labor force and capital growth werenot forthcoming. This sluggish total factor productivity growth, moreover, con-firmed market-oriented economists' warning that central planning processes wouldproduce both allocative and X-inefficiency.

Robert Flanagan is Konosuke Matsushita Professor of International Labor Economics and Policy Analysis,Graduate School of Business, at Stanford Universiq. The author wishes to thank John Earle for com-ments on carlier drafts

Proceedings of the World Bank Annual Conference on Development Econonics 1994@199S The International Bank for Reconstruction and Development / ThE woRID BANK 405

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406 Labor Market Responses to a Change in Economic System

Today, however, the experience of economies in transition has turned this eco-nomic prediction on its head. Despite the strong presumption among Westemeconomists that transition from central planning to more market-oriented economieswill eliminate the inefficiencies associated with central planning and produce highergrowth, there is no clear vision of the processes through which this fundamental eco-nomic goal might be achieved. Gains in efficiency, moreover, might be offset initiallyby drastic declines in labor force participation.

Macroeconomic stabilization has largely dominated the labor market researchagenda during the early stages of Eastern Europe's transition. The importance ofmacroeconomic stability notwithstanding, there is a real danger that policiesadopted for short-run purposes will conflict with fundamental long-run objecives.The damage such conflicts can do, moreover, is potentially greater for transitionthan for operating market economies.

This artide focuses on the extent to which labor market policies, institutions, andbehavior at the microeconomic level facilitate or impede economic restructuring. Anyeffort to tell a general story risks glossing over important differences among countries.It is equally risky to generalize from the experience of one country about develop-ments throughout a region. One must decde which variations really matter, or elsethere will be no story to telL The standard warning about data quality and availabilityalso applies-particularly with regard to the private sector. Until better raw material isavailable, many issues of labor market adjustment easily explored in OECD countriesmust remain largely conjectural when speaking of former command economies.

Aggregate Labor Market Adjustments

The early phases of economic transition in Eastern Europe brought sharp declinesin state sector output and real wages to virtually all the countries of the region.

Table 1. Cbange in Labor Force Status of Working Age Popukltion, 1989-92(percent distribution)

Bzdgaria Czech Republic Hungar

1989 1992 Differene 1989 1992 Difference 1989 1992 Difference

MenEmployment 88.3 69.0 -19.3 81.2 753 -5.7 8S.5 70.9 -14.6Unemployment 0.0 95 9.5 0.0 1.8 1.8 0.4 10.4 10.0Inactive 11.7 215 9.8 18.8 22.7 3.9 14.1 18.7 4.6

Women

Employment 85.1 62.1 -23.0 75.2 65.3 -9.9 78.1 64.3 -13.8Unemployment 0.0 11.8 11.8 0.0 2.6 2.6 0.4 7.9 73Inactive 14.9 26.1 11.2 24.8 32.1 7.3 21.6 27.8 6.2

Noat Figures are annual averages, except for the Czech Republic, where d=a are for the end of the year, and theSlovak Republic, where employnunt dam are for the end of the year.

Flanagan 407

Declines in state sector employment ranged from about 33 percent in Hungary toabout 20 percent in Bulgaria, the Czech and Slovak Republics, and Poland(Blanchard, Commander, and Coricelli 1993). In Romania employment in stateenterprises dropped by about 23 percent, but that figure was closer to 40 percentwhen employment in cooperatives was included (Earle and Oprescu 1993).

These large net declines in employment reflect the private sector's failure to expandits activity at a pace that absorbed the labor shed from the state sector. The differentpatterns of net employment change shown in table 1 reflect how much offsettingemployment growth the private sector was able to generate. Among countries withintermediate declines in the state sector, the Czech Republic had the strongest privatesector development and Bulgaria, Hungary, and the Slovak Republic the weakest.

The allocation of net employment declines between unemployment (appearingfor the first time since the onset of central planning) and departure from the laborforce is determined in part by differences in incentives for market and nonmarketactivity, influenced in part by labor market policy. Poliqc effects aside, however, thereal wage declines in Eastern Europe should produce both substitution and incomeeffects on aggregate labor supply. The substitution effect is visible in withdrawalsfrom the labor force in response to deteriorating market rewards. The income effectis visible in the increased partcipation of individuals attempting to maintain familyincome as other family members lose their jobs. In virtually all OECD economiesthe substitution effect dominates, and labor supply elasticities are highest forwomen and for both sexes at the extremes of the age distribution (OECD 1983).

Absent unusually large income effects on the labor supply in Eastern Europeancountries, one would have expected the aggregate labor supply to -contract duringthe early phases of economic transition. Labor force participation rates did indeeddecline in four of the countries surveyed. Consistent with Western experience, netwithdrawals from the labor force were higher for women than for men in these four

Poland Romania Sbvak Republic

1989 1992 Diff6ec 1989 1992 Difference 1989 1992 Differenca

Men

Employment 82.6 71.9 -10.7 87.S 81.0 -6.5 87.1 72.8 -14.3Unemployment 0.0 9.4 9.4 0.0 S.3 5.3 0.0 8.8 8.8inactivc 17.4 18.7 1.3 12. 13.6 1.1 12.9 18.5 5.6

WomenEmployment 68.6 58.3 -10.3 80.7 80.9 0.2 78.9 58.8 -20.1Unemployment 0.0 10.6 10.6 0.0 9.3 9.3 0.0 9.7 9.7Inactive 31.4 31.1 -0.3 19.3 9.8 -9.5 21.1 31.5 10.4

Sou;e.- Commission of thd European Communidies, 1993, p. 15. For Hungur, Poland, and the Czech and SlovakRepublics the data are based on establishmen surveys and adminisative recors, cepr the 1992 data for Hungaryare from a labor force survey. Bulgaian and Romanian da are from adminittive records (induding labor office reg-istions for unemployment) and estmates of privat employmenL

408 Labor Market Responses to a Cbange in Economic System

countries. But in Poland labor force participation was close to a wash (with someincrease for women), and in Romania it actually increased, mainly because of thelarge influx of women into the labor force. The labor force response of women inthese countries is contrary to postwar experience in most market economies andrecent experience in other Eastern European countries. It is, however, reminiscentof the old "additional worker effect" said to have influenced female labor force par-ticipation during the Great Depression. Relatively strong income effects are plausi-ble in Eastern European labor markets, even in the absence of labor market policyinfluences, given low asset levels and the rapid elimination of monetary overhang byearly transition price shocks.

The allocation of net employment dedines between unemployment and nonpar-ticipation was not uniform throughout the region. The comparative importance ofincreased nonparticipation stands out in the Czech Republic and-to a lesserextent-in Bulgaria and the Slovak Republic, while in Hungary, Poland, andRomania increased unemployment was more important. While policy-inducedincentives appear to have affected each country's experience, the history is too shortto establish the connection rigorously. Overall, unemployment insurance systems intransition economies are less generous than those in OECD countries (Scarpetta,Boeri, and Reutersward 1993).1 The Czech and Slovak Republics, although their eli-gibility requirements and replacement ratios are in the middle of the range, offer thebriefest duration of benefits and (along with Bulgaria) impose the lowest maximumbenefit payments, thereby discouraging long periods of joblessness. Preliminary evi-dence indicates that the generosity of the unemployment insurance schemes affectsthe allocation of net employment reductions between unemployment and laborforce withdrawal in predictable ways.

Unemployment

Unemployment is influenced by labor market policies and institutions.North-American-style unemployment consists of relatively high inflows to and highoutflows from joblessness, with most spells of unemployment being comparativelybrief A scenario in which workers released from state enterprises queued for jobsfor a brief period before moving into private sector jobs would produce such anunemployment pattern. In contrast, however, European-style joblessness is markedby low exit rates from unemployment-either because employers are reluctant tohire or workers are reluctant to accept jobs-and long durations of unemployment.Long unemployment itself, moreover, reduces the odds of getting a job.

There is now considerable evidence that Eastern European countries have devel-oped super European-style unemployment (Blanchard, Commander, and Coricelli1993; Boeri 1993). Inflow rates are lower than in most Western European coun-tries-in part reflecting the widespread use of early retirement incentives. But as theimportance of this adjustment necessarily declines, future inflow rates shouldincrease. While the majority of the newly unemployed in formerly commandeconomies are workers released from state enterprises, there are also important

Ftanagan 409

inflows from outside the labor force (particularly among inexperienced workerswho have completed their schooling and cannot find a job) and from the private sec-tor. Outflow rates have been even lower than in Western Europe, and many spellsof unemployment do not end with a job. While the low outflow rates reflect generaldemand problems indicated by extremely low ratios of job vacancies to unemploy-ment, there also appear to be important structural influences.

In addition to the influence of unemployment compensation arrangements on thewillingness to accept jobs, at least two structural policies can make employers intransition economies reluctant to hire. The former Czechoslovakia, Hungary, andPoland all have regulations governing collective dismissals that require consultationwith employee representatives, advance notce of dismissals, and severance payranging from one to six months (Scarpetta, Boeri, and Reutersward 1993). Whilethese costs may slow flows into unemployment, they also make employers reluctantto hire and thereby slow the movernent from unemployment to employment.Incomes policies that limit growth of the wage bill also discourage hiring. Sincethese regulations apply only to state enterprises, howeve&, their damage to restruc-turing may be slight.

Labor Market Programs

When unemployment is on the rise, a common recommendation is for greaterspending on labor market programs. Eastem Europe is no exception, and theabsence of rudimentary job-matching and safety-net institutions at the beginning ofthe economic transition added urgency to the recommendations. Some advocates oflabor market programs suggest that such programs will substantially reduce unem-ployment in transition economies. Experience in the West, however, suggests thatthat is likely to be true only under special circumstances. The key questions, then,are whether current policies are likely to facilitate restructuring and whether labormarket programs in general can reduce unemployment.

By fiscal 1992-93 most transition economics had higher unemployment ratesthan most OECD countries yet spent less (as a percentage of GDP) on labor marketpolicies that might improve the skill levels and the matching prospects of the unem-ployed. Moreover, public expenditure on labor market policy has concentrated onsuch passive measures as unemployment compensation and early retirement, mea-sures that may, in fact, extend joblessness and facilitate withdrawal from the laborforce. Active measures, on the other hand, contribute directly to employment or theefficiency of future labor inputs (OECD 1993a).

Acive labor market policies in transition economies have not focused on skilldevelopment. Expenditure is disproportionately weighted toward wage subsidiesand public employment by comparison with such spending in Western economies.Although most wage subsidy expenditures in European countries do not go to statefirms that should be shedding labor (OECD 1993a), much of the expenditureappears to support employees who would have been hired anyway. A case can bemade for targeting wage subsidies to support new entrants into the labor force (to

410 LrOMaTrket Responses to a Change in Economic System

provide work experience and on-the-job training) and those unemployed a longtime (to prevent skill depreciation), but for reasons developed below, the case is notsecure. Overall, however, current labor market policies throughout Eastern Europedo not appear to facilitate either restructuring or unemployment reduction.

Nor would changing the mix of labor market policies be likely to alter substan-tially the region's unemployment experience. One difficulty is that active policiescannot solve the problem of insufficient demand. Training and related measures donot create vacancies but only help to fill them, and in Eastern European labor mar-kets the difficulty is not in filling vacancies but rather in their general absence. Withlimited demand, active labor market policies can change the order of workers in thejob-seeking queue but not the length of the queue itself. Analysis of the effects ofactive labor market policies, moreover, rarely considers the extent to which thegains of targeted groups are obtained by displacing nontargeted groups (OECD1993a). Policy measures, therefore, can seek to attain only such lirmited social gainsas can be realized from changing the order in the unemployment queue.

A second problem is that wage subsidies do not always deliver on their promise.In a full-information world wage subsidies should theoretically provide more jobs, yetthe experience of some Western countries indicates that targeted policies can produceoutcomes quite contrary to expectations. When information is unevenly distrib-uted-as when employers are imperfecdy informed about workers' productivepotential, for instance-workers with superior abilities will need to signal their supe-riority in a credible manner, that is, in a way that less-qualified workers cannot imi-tate. Remaining outside labor market programs could be just such a signaL In theUnited States, for example, employer participation in targeted wage-subsidy pro-grams has been low. There is also evidence that employers prefer to hire unsubsidizedworkers, suggesting that they associate pubLic labor market programs with lower-quality workers. High-quality members of a targeted group have therefore effecivelysignaled their quality by remaining outside wage-subsidy programs-an option thatis not available to low-quality workers, whose poor productivity would subject themto dismissal. Policies providing employers with general wage subsidies may mitigatethis problem, but even when subsidies are paid to employers, targeting would raisethe signaling issue.

In Eastern Europe such ideas are far from theoretical. The private sector hiresalmost exclusively from state firms rather than from among the unemployed(Beleva, Jackman, and Nenova-Amar 1993; Commander and others 1993; Vecernilc1993) and avoids using the new labor offices. While the signaling stigma appears tobe less severe for training and other labor market programs designed to increaseproductivity, some taint may still apply.

In summary, the labor force in Eastern European countries has contracted. Workersunemployed for long periods may become virtually unemployable, also reducing theeffective future labor supply. New cohorts of school-leavers lack employment oppor-tunities, a particularly troublesome characteristic because the newest cohorts, whohave the strongest incentive to make the major human capital investments required bychange, are needed to accomplish major economic restmcturing.

Flanagan 411

At this point unemployment in Eastern Europe is largely a demand problem.The exact nature of the structural problems that labor market policy mightaddress will not become clear until there is a closer balance between job vacanciesand unemployment. Yet the pattern of labor market programs in the region doesnot seem to be facilitating restructuring, and the emphasis on passive measuresmay even retard it.

Sectoral Employment and Wage Adjustments

Following the communist takeovers in Eastern Europe in the late 1940s, centralplanners sought to develop and expand investment goods and heavy industry at theexpense of consumer goods and services. With some exceptions, job matching wasleft to workers and employers, while central planners developed national wagestructures to encourage workers to follow planning preferences. National tariffwages were established for job categories under a national job evaluation that gaveweight both to considerations familiar to Adam Smith, such as the qualificationsrequired and onerousness of work, and to planning objectives, such as the socialimportance of the industry. Before long, industry wage structures throughoutEastern Europe had adapted to the tariff wage structre, with large increases in rel-ative wages in industry and construction and decreases in trade and services (Adam1984). Tariff wage policies reduced both returns to human capital and interregionalwage differentials and weakened the link between managerial performance and pay.

Overall wage levels were kept low to permit high investment levels. Low wagesproduced high quit rates, but the range of labor mobility was severely circumscribedby housing shortages. To counter management efforts to attract and retain workers,furthermore, central planners imposed tax penalties for excessive increases in enter-prise wage bills-an early form of tax-based incomes policy.

Labor unions in centrally planned economies had no bargaining role. Their mainrole was to challenge dismissals. Whether labor's weakness under central planninghelped or hindered efficiency depends on whether "monopoly" or "voice" theoriesof union behavior were more applicable in Eastern Europe. Limitations on labor exitand voice opportunities, however, demonstrably reduced job satisfaction to wellbelow Western levels (Blanchflower and Freeman 1993).

To some degree, all Eastern European labor markets have moved away from theoutcomes influenced by central planners. Since 1989 employment has shifted fromindustry and agriculture toward services. Within the service sector, employment hasgrown especially in trade, health, and education-sectors generally neglected undercentral planning.

Private sector employment has grown in all countries (albeit at very differentrates), but the private sector offers heterogeneous job opportunities that range fromsmall service organizations with one or two employees to large manufacturing oper-ations. In most countries large-scale privatization has proceeded slowly, and stateenterprises remain the main source of employment. The private sector's share oftotal employment is largest in Poland (45 percent) and Hungary (35 percent), both

412 Labor Market Respons to a Change in E&onomic System

of which had significant private economic activity before the late 1980s, butthroughout the rest of Eastern Europe it remains at less than 20 percent.

To what extent, then, has private sector expansion helped to reverse the labormarkets' vestiges of planners' preferences? To address this question, we must exam-ine private sector wage policies and the nature of labor market competition betweenthe state and private sectors.

Public-Private Pay Differentials

The analysis of labor market competition between private and state firms inEastern Europe is hampered by limited documentation of the private sector. Thefollowing discussion, therefore, considers three levels of information in an effort toascertain the role of wages in competition between the state and private sectors:official data (uncontrolled for human capital and other compositional influences)on average wages in each sector, household surveys of individuals (with statsticalcontrols for some influences on wages), and recent World Bank surveys of privatefirms in the region.2

For Bulgaria there is only survey evidence ro show that private firms tend to payhigher wages but lower benefits and bonuses (Beleva, Jackman, and Nenova-Amar1993), and no reliable information has been reported for Romania (Earle andOprescu 1993).

Two studies of Czech data find substantial differentials. An analysis of a June1991 government survey of wages in the Czech Republic found that men workingin the private sector earned more than one and one-half timnes what men of the sameeducation and age range earned in the state sector. The differential was smaller formen over forty-five years of age and negligible for women on the basis of averagemonthly wages (Flanagan 1993a). (At this early stage of Czech privatization, how-ever, the sample contained few private sector observations.) A year later, in June1992, Vecerncik's (1993) analysis of the Survey of Economic Expectations andAttitudes found-after controlling for age, education, and broad occupational andindustrial categories-that employees in private firms were earning about 13 per-cent more than employees in state enterprises and about 19 percent more thanemployees in cooperative organizations.

In Hungary wage differentials between private and state firms emerged before thefall of communism, yet the Hungarian Household Panel data suggest that wage dif-ferences are somewhat smaller there thian in the Czech Republic. After controllingfor age, schooling, occupation, and broad industrial category, Commander and oth-ers (1993) found that employees in the pardy private sector had monthly incomes(wages and earnings, including all cash payments) that were about 9 percent higherthan those offered in the state sector-and 6 percent higher for the fully private sec-tor. The results are much weaker for hourly earnings, possibly reflecting the greateruse of profit-sharing and other bonus arrangements in the private sector.Respondents to the World Bank survey of private manufacturing indicated that theytried to pay higher salaries than the state sector (Webster 1993a).

Flanagan 413

Official Polish statistics indicate that average private sector wages exceed averagestate wages in construction and transportation, but that state wages (which do not dis-tinguish between the old cooperatives and the new private sector) are higher in indus-try and trade. There is some evidence that private sector wages tend to be higher forhigh-wage jobs and lower for low-wage jobs (Coricelli, Hagemejer, and Rybinski1993). But for labor market behavior the key comparison is for jobs in which the pri-vate sector competes with the state sector. According to a World Bank survey of pri-vate manufacturing firms in Hungary and the Czech Republic, entrepreneurs reportedthat they typically paid unskilled workers 10 percent more than they could have madein state enterprises and skdlled workers what they could afford, which could be up totwice what state enterprises were paying (Webster 1993a; Webster and Swanson 1993).

To some extent, however, higher wages in the private sector are offset by highernonwage benefits paid by the state. It is widely believed-if not precisely docu-mented-that fringe benefits and services are greater in the state sector. The differenceappears to be greatest for the largest state firms. The World Bank survey of privatemanufacturing in Hungary found that fringe benefits were indeed lower than in thepublic sector but not by enough to offset wage differences. Nonwage benefits withinthe private sector are no doubt smallest in the smaller service firms, which are not wellcovered by current statistical systems. Bank surveys also indicate that private sectoremployers are likely to use dismissals as disciplinary and motivational tools. Althoughthere is some turnover among private firms, recent large-scale employment losses instate firms have sharply reduced differences in job security between the sectors

In summary, where private sector firms compete directly with state firms for par-ticular skills, private firms appear to pay higher average wages, although the mar-gin and composition of the overall compensation package vary aaoss sectors andcountries. Since the private sector appears to offer fewer nonwage benefits, someof the smaller wage differences may reflect compensating differentials. The largerwage differentials indicate two aspects of the labor reallocation process in transi-tion economies.

First, the prevalence of a private sector wage premium in most transitioneconomies implies that new firms favor the relative wage mechanism over the jobvacancy mechanism as a strategy for attracting workers from state enterprises. Givencurrent conditions in Eastern European labor markets, the existence of job vacan-aes in private firms should be sufficient attraction to the unemployed even in theabsence of a wage differential. Throughout Eastern Europe, however, private sectoremployers are filling most vacancies by hiring employees directly from state jobsrather than from the pool of unemployed (Beleva, Jackman, and Nenova-Amar1993; Commander and others 1993; Vecernik 1993). A large proportion of work-ers who lose state jobs and leave the unemployment rolls return to jobs in the statesector. Indeed in Hungary the private sector is a net contributor to unemployment.

The composition of the private sector pay package is also consistent with a strat-egy for selecting out of the state sector workers who are generally younger and moremotivated to acquire extra rewards for extra effort rather than to seek social benefits.The preliminary impression is therefore that private firms are using wage policy to

414 Labor Markn Responses to a Change in Economic System

attract relatively qualified workers away from the state sector and that unemploy-ment is seen by employers as a signal of lower qualifications.

Human Capital Returns

Compared with rates of return in market economies, returns to schooling and expe-rience under central planning were positive but low. Average returns to schooling in1988 for men in the Czech Republic were lower than in any of a comparison groupof market economies (table 2).3 Returns for Hungarian men, which were about 1percentage point higher, were well within the range of estimates for marketeconomies with centralized bargaining systems (German Federal Republic, Norway,Sweden), which often share the socialist economic objective of narrowing the struc-ture of earnings across occupations. Rutkowski (1994) reports similar pretransitionreturns in Poland. Differences in returns are particularly notable at the universitylevel. Relative to a high school education, a university degree provided a wage pre-mium of 65 pe¶.cent (in 1987) for U.S. males, 32 percent (in 1990) for Polish males,and 16 percent (in 1988) for Czech males (Goldin and Margo 1992; OECD 1993b;Flanagan 1993a). Pretransition wage structures also showed comparatively lowreturns on experience potential.

The pretransition pattern of returns to education reflects the type of human cap-ital development encouraged under central planning. Central planners tended tovalue physical over mental work and productioni over service sectors. Young menwere oriented toward vocational schools and apprenticeships, and-except for thenomenklaura-university-level education was devalued. In the late 1980s roughly8 to 10 percent of the labor force in centrally planned economies had a universityeducation, compared with 10 to 20 percent in most advanced market economies.Eastern European enrollment rates in secondary and higher education were also

Tablc 2. Returns to Schooling, 1980s(percent)

Country,year Men Women

Czech Republic, 1928 3.8 5.4Hunpry, 1928 4.7 6.1Australia, 1936 4.S 4.1Federal Republic of Germany, 1985-88 4.9 SANorway, 1982 4.5 3.8Sweden, 1929 4.3 4.3Switzerland, 1987 5.5 7.4United Kingdom, 198S-88 7.0 9.3United States, 1985-88 7.0 8.1

Note: All estinates aze from a basic human capital earnings function specification in which the natural loaridunof dhe wage is a function of schooling. Porenial experience is specified as a quadratic. AUl estimates are significant at.01 level.

S&ow Flanagan 1993b; unpubished regression resuls provided by Francine Blau and larry Kahn.

Flanagan 415

lower than in industrial countries. Most enrollments in secondary education inEastern Europe were in vocational programs, compared with 35 to 40 percent incontinental European market economies and about 10 percent in the UnitedKingdom (Boeri and Keese 1992). This appears to be the major distortion in humancapital formation under central planning.

Central planning appears to have produced overinvestments in vocational andapprenticeship education and underinvestments in university education. To theextent that markets correct distortions associated with planner preferences, returnsto university education should increase while those to vocational training shoulddecrease during economic transition.

In fact, when the tariff wage system was abandoned, overall wage variationincreased and returns to schooling began to rise. By mid-1991-just eighteenmonths into the transition-the average rate of return to schooling for men in theCzech Republic had increased by 0.6 percentage point, reflecting rapidly decliningreturns to vocational education and rising returns to university education (Flanagan1993a). (Returns for women were unchanged.) Returns in Hungary rose from 4.7percent in 1988 to 7.5 percent in March 1992 (Commander and others 1993). Inseveral countries, vocationally trained workers not only saw their wages fall relativeto those of university graduates but also experienced relatively high rates of unem-ployment. In contrast, in Romania, where there has been little private sector devel-opment, the wage structure for different schooling levels barely changed in the earlytransition years. In 1992 a Romanian university degree provided only a 30 percentwage premium over high school completion. Contrary to the pattern in other tran-sition economies, post-transition movements in industrial relative wages in Romaniaappeared to reinforce the traditional preferences of central planners (Earle andOprescu 1993). With the exception of Romania, then, the first years of economictransition have reversed the main pretransition distortions in human capital forma-tion brought about by central planning.

What mechanisms produced these changes? In a well-functioning market, changesin the structure of wages in the state sector would mirror pay developments in theprivate sector, as state firms attempted to retain employees. For most countries inEastern Europe except the Czech Republic, however, there is too little data on theprivate sector to test this hypothesis. In the Czech Republic the emerging private sec-tor appears to be competing primarily for middle-level educated workers rather thanuniversity-educated workers. Rising returns to schooling appear to be an artifact ofthe pattern of structural changes in the state sector rather than of increased demandin private business. Public enterprise restructuring has increased the relative impor-tance of industries that have always provided the highest returns to university educa-tion. Higher returns to education are available in the market, but not in most sectors.

Institutional Influences

From the perspective of labor in transition economies, the key questions are whetherlabor market institutions inhibit transfers to the private sector and the development

416 Labor MarkAt esponses to a Change in E&onomic System

of more rational pay structures. In the case of unions there is also the concern overtheir potential for generating wage pressures.

Labor Unions

Eastern Europe has only recently introduced collective bargaining over wages andworking conditions. The extent of union representation, moreover, is difficult toassess given that membership figures are provided by the unions-a dubious sourceeven in Western countries. Early estimates place union densities across EasternEurope in the range of 35 to 70 percent (Freeman 1992). In no country of the regionis the domain of unions as broad as in the most unionized Western countries (suchas Scandinavia) and in no country is it as limited as in the least unionized Westerncountries (France and the United States).

Throughout Eastern Europe unionization is ersentially limited to the state sectorand is far from complete even there. Most private firms are nonunion and have lit-tle expectation of becoming unionized. World Bank surveys of firms in the regionfound little evidence of unionization. In the former Czechoslovakia none of the sur-veyed firms had unions, although about 10 percent of firms had workers councilsthat mostly abided by earlier contracts made under state ownership (Webster andSwanson 1993). None of the firms in the Bulgarian survey were unionized (Beleva,Jackman, and Nenova-Amar 1993), nor were the few firms in Romania's private sec-tor (Earle and Oprescu 1993). In Hungary employers were amused that interview-ers asked whether their workers bargained through a union or council (Webster1993a; Lado 1993 reports similar findings). In Poland neither unions nor workerscouncils represented workers in any of the establishments surveyed, and employersclaimed that their workers did not see the need for unions (Webster 1993b).4 Norespondent in any of the firms surveyed listed unions as a constraint on the firm'sprogress. It appears that private employe.-s can set pay levels, pay structures, andemployment conditions unilaterally, subject only to state regulations.

Given the distribution of union representation in Eastern Europe, differencesbetween state and private wages provide tolerable estimates of union-nonunion wagedifferentials, since unions only have a life in the public sector. The evidence thereforeindicates that the union wage 'premium" in Eastern Europe is largely negative-aresult that is either rare or nonexistent in Westem countries. That wages in the declin-ing (public) sector are lower than in the expanding (private) sector is good news forthe allocational objectives of the economic transitioni and should challenge the wide-spread presumption that incomes policies are needed to restrain union power in thestate sector. The absence of unions in the private sector, moreover, has enabledemployers to lay off workers as a response to performance and discpline proolems.

Union power is notoriously difficult to measure for a single country, andcross-country comparisons are particularly hazardous where unions have such dif-ferent objectives as wage levels, security of employment, and income equality. Evenwithin a single country, moreover, reports from the field are often conflicting. Manyobservers, for instance, stress the potential power of the Polish workers councils,

Flanagan 417

which have had a highly variable effect according to enterprise surveys. Managers inPoland's state enterprises cite incomes policy regulations and not pressure fromworkers organizations as ahe major barrier to restructuring (Pinto, Belka, andKrajewski 1993). Similarly, Romanian unions cannot mobilize their members forwidespread collective acton even though they represent about 60 percent of work-ers and, according to one survey, have negotiated agreements covering about 90 per-cent of employment (Earle and Oprescu 1993). Unions in Hungary and the CzechRepublic have been particularly quiescent.

Because of the confounding effect of incomes policy regulations in EasternEurope, the effect of unions on the wage structure is difficult to assess.Nevertheless, the decentralization of some bargaining structures, such as those inBulgaria and Romania, has contributed to pay dispersion among enterprises. Instate enterprises unions continue to inhibit the use of dismissals for poor perfor-mance or disciplinary reasons. They may also be able to impose conditions onrestructuring when large state enterprises are privatized. Although potentially sig-nificant, these union restrictions on operation are poorly documented. Unions can-not, however, thwart transfers to the private sector because workers can quit stateenterprises with impunity.

Minimum Wage Policies

Throughout Eastern Europe minimum wage policies have been instituted to assistthe least productive workers, with little consideration for any potentially adverseeffects on employment At this stage of massive state employment reductions inEastern Europe, howev.r, it is impossible to isolate the effects of minimum wagepolicies on employmenc. Attention has therefore focused on their effects on thewage strucure. Relatively high minimum wages produce (or maintain) compressedwage structures, which could inhibit the reallocation of labor from less productiveto more productive tasks.

Some Western countries index the minimum wage to consumer prices, whichwas also the initial intention in several Eastern European countries. But whereother wages were not indexed (or were indexed less generously), some unions(notably in Czechoslovakia) negotiated tripartite agreements with explicit realwage reductions. In addition to affecting the wage structure, minimum wage poli-des also have direct implications for government budgets, since many social bene-fits (pensions, family allowances, unemployment benefits) are linked to the level ofthe minimum wage (UNECE 1992).

Faced with these considerations Eastern European governments have moderatedand even abandoned explicit indexation procedures, and minimum wages declinedas a proportion of the average wage to levels well below those typical of industrialmarket economies (table 3). Thus far, there is little evidence that minimum wagepolicy has seriously interfered with wage structure adjustment during transition.

To summarize, two distinct wage determination mechanisms have emerged duringthe economic transition in Eastern Europe. In the growing private sector, one mech-

418 Labor Market Responses to a Change in Economic System

Table 3. Minimum Wage Relative to Average Gross Wage, Selected Countries, 1989-93(percent)

Czech SlouakYear Bulgania Republic Hungary Polnd Romania Republic

1989 S.l - 35.0 11.6 63.71990 44.6 - 42.0 21.4 73-01991 5.4 S3.0 39.0 34.7 60.3 52.01992 353 45.9 36.0 37.0 45.7 47.51993First quarter - 41.1 39.0 41.1 - 46.4Second quartcr - 36.6 35.0 39.3 - 42.5

- Not avaiable.Sow: Commission of the European Communities 1993.

anism resembles the nonunion wage determination found in some advanced marketeconomies. Because employers are subject to hard budget constraints, performancemust uliimately support pay lelveEs. Unions are absent, and-subject to marketconditions and incentive consideration-employers appear to have considerablediscretion in wage-setting. In the large (but diminishing) state sector, enterprises arestill subject to soft budget constraints. In many state enterprises unions or workerscouncils exist and have initiated collective bargaming, although at this point neitherunion activity nor government minimum wage legislation has substantially influencedrelative wage structures in the state sector. Unions may, however, have slowed thedownsizing of the state sector.

O azatonal Efficiency during Transition

The discussion so far has focused on improved allocation of labor as a source of pro-ductivity gain in transition economies. In a world of long job tenures and "career-relationships, productivity gains also depend on incentives in firms' internal labormarkets. Training systems, performance evaluations, and payment systems that linkpay to performance all contribute to internal efficiency, and all these mechanismswere generally absent from public enterprises under central planning. The problemof determining appropriate managerial pay mechanisms, therefore, is particularlyacute in transition economies.

Information on the role of the emerging private sector in introducing more sophis-ticated internal wage payment incentives and human resource management systemsis regrettably scarce. The practices of foreign firms and joint ventures (which linkwages to performance through merit systems, profit sharing, and other performance-related bonuses) contrast sharply with past practice in the state enterprises, where thelarge nonpecuniary component of compensation was unrelated to performance.

It is not yet known to what extent market incentive practices have been adoptedby state enterprises and the indigenous private sector in Eastern Europe. Sharper

F1anhan 419

competition between the two sectors would hasten such transference, but privateand state firms rarely compete direcly in product markets. Where competition doesoccur, incomes policies tend to impede the efforts of state enterprises to emulate theincentive systems of private firms (Pinto, Belka, and Krajewski 1993).

Evidence is lirnited to Hungary, Poland, and the Czech Republic. Private manu-facturers responding to World Bank surveys noted that vocational schools and theorganization of work in state enterprises had produced overspecialized workers wholacked the flexibility to adjust to new technologies (Webster and Swanson 1993;Webster 1993a,b). Many respondents also reported poor motivation among employ-ees who had worked for years in settngs where there was little connection betweenproduceivity and profitability. Only in Hungary-where workers no longer looked tothe state sector for employment security-did entrepreneurs comment favorably onworker motivation. When faced with nonproductive employees, most Hungarianemployers were quick to lay off workers and establish acceptable norms (Webster1993a). A World Bank survey of private manufacturers in Poland found that severalemployers had instituted profit-sharing schemes and escalating production incentives(Webster 1993b).

From the limited evidence it appears that the changing wage signals observed inthe aggregate data do not necessarily describe changes within organizations. This dis-junction is mainly an issue for state organizations. Training systems developed undercentral planning, moreover, are inadequate for modern jobs and work organization.

Macroeconomic Policy and Micro economic Objectives

While the government's role in pay deterniination has diminished throughoutEastern Europe, all countries in the region adopted incomes policies as part of theirtransitional macroeconomic policy packages. Such policies present an inherent ten-sion between macroeconomic and microeconomic objectives in any economy, sincethe policy rules advanced to contain upward wage pressure may distort wage struc-tures. This tension is particularly acute in Eastern Europe, where wage structures :remuch furither from equilibrium than in the West. Incomes policies that thwart thedevelopment of incentive structures in labor markets can therefore inhibit laborreallocation and restructuring.

The Case for Incomes Policy

Two motivations underlie most applications of incomes policies in Western coun-tries. The first is a belief that market power, particularly that of labor unions, is asignificant source of upward wage pressure and that postwar economic develop-ments were favorable to union bargaining power. A second motivation is to reduceinflationary expectations. Incomes policies have thus been used in efforts to preventthe emergence of inflation and to wind down existing inflation. Eastern Europeangovernments face a third consideration. As the residual claimants on the incomes ofstate enterprises, Eastern European governments have a distinct budgetary interest

420 Labor Markt Responses to a Change in Econcomic System

in moderating wages in the state sector. Because government tax revenue dependson the difference between sales revenues and the wage bill of state enterprises, wageincreases in the state sector implicitly lower tax revenues.

The standard arguments for incomes policies appear weak in Easten Europe.The bargaining power of most unions in Eastern Europe is limited. Policies torestrain inflationary expectations would cover the entire economy, not just the statesector. Nor can resort to incomes policies rest on the demonstrable achievements ofthese policies or on careful analyses of compliance incentives and responses at themicrceconomic leveL In the West, policies based on explict guidelines for wage andprice increases or social contracts (or multilateral negotiations among labor, man-agement, government, and other economnic interest groups) regarding the growth ofincomes have foundered because of unresolved distributional conflicts and weak tononexistent compliance incentives. Such policies have never achieved durable suc-cess, with the possible exception of Austria (Ulman and Flanagan 1971; Flanagan,Soskice, and Ulman 1983). Tax-based incomes policies, which have been moremlked about than used in the West, would give firms and workers tax incentives tomoderate wage and price increases, thereby providing incentives for compliance andscope for allocational flexibility, since finns could exceed the guidelines and ratio-nally incur the tax if economic circumstances warranted.

The inexperience of and lack of incentive for Eastern European managers in thestate sector to bargain hard provides a stronger basis for concern about wage pres-sure. Soft budget constraints have permitted state-owned enterprises to be sloppyabout costs and weak m resisting wage demands. Managers who expect to revert toemployee status as their enterprises are privatized, furthermore, have even lessincentive to resist union wage demands. Weak bargaining effectively reduces gov-ernment revenues from state enterprises. Through incomes policy governments inthe region effectively avoid ceding authority for tax reductions to enterprise man-agers. The case for such policies in Eastem Europe thus rests more on the weaknessof management than on the strength of workers organizations. It remains to be seenwhether incomes policies actually stem inflation.

Policy Effects

Eastern Europe has adopted tax-based incomes policies-the policies advocated inthe West-because they seem to offer greater allocational flexibility than other pol-icy designs. Yet the mechanism of these policies seems flawed when applied to thestate enterprises of the region. Incomes policies are supposed to increase manage-mentes bargaining resistance by threatening the loss of a firm's marginal profits asthe penalty for noncompliance. These policies are best suited for managers who areaccustomed to seeking profits. Such policies should follow rather than precede thedevelopment of property rights and hard budget constraints, since managementmust face financial incentives in order to take the consequences of noncomplianceseriously. Policies motivated by managerial weakness under soft budget constraints,therefore, cannot depend for their effectiveness on managerial responses to (nonex-

Flanagan 421

istent) hard budget constraints. The willingness of many Eastern European managersto grant "excess" wage payments despite punitive taxes underscores this flaw, andgovernments are often unable to collect such taxes (Jackman and Pages 1993; Earleand Oprescu 1993).

Even where successful, tax-based incomes policy designs in Eastern Europe donot allow the allocational flexibility permitted in poliqc formulations in the West.Tax-based incomes policies have a longer history in centrally planned economicsthan in the West because they were used by central planners to restrain the growthof enterprise wage bills to limit consumption demand. Such policies included puni-tive tax rates for wage increases in excess of the target-a feature that has beenincorporated in the current incomes policies of transition economies. Thus EasternEuropean incomes policies have great potential to interfere with government effortsto achieve greater allocational efficiency through systemic reform.

A policy that targets the average wage, for instance, can penalize companies thatdownsize to shed their least-efficient workers or those that expand and hire work-ers who are more highly skilled. In each case changes in work force compositioncould raise the average wage sufficiently to incur a penalty tax. Average wage tar-gets also create incentives to freeze or further compress the internal wage structuresof organizations-the opposite of what is desired, in most cases, to provide incen-tives for training and additional effort. Policies that target the enterprise wage bill,by contrast, do not penalize the downsizing of the work force. Indeed, the down-sizing can be accompanied by an increased average wage to attract and retain supe-rior workers. However, a wage bill target taxes employment growth, making firmsreluctant to hire, slowing outflows from unemployment, and creating incentives forfurther skill compression.

Evidence from Eastern European labor markets increasingly indicates that theseconcerns are far from theoretical. Both wage bill and average wage targets have beenapplied to Polish enterprises, for instance, at different times. Under the average wagetarget, managers of state-owned enterprises complained of restraints on downsizingand restructring. They clearly preferred wage bill targets. They also reported thatwage targets had induced pay compression and that policy discrimination betweenstate and private employers inhibited public enterprise managers from transformingtheir enterprises and emulating the behavior of private managers (Pinto, Belka, andKrajewski 1993).

Wage structure developments at the sectoral level in Bulgaria, the CzechRepublic, and Hungary are consistent with these reports. Without violating theincomes policy wage rules and incurring penalty taxes, state enterprises in Bulgariawere unable to alter the compressed wage strucmre inherited from central planning(Beleva, Jackman, and Nenova-Amar 1993). In the Czech Republic, although theoverall return on schooling-especially the return to university education in thestate sector-increased rapidly during the first eighteen months following the 'vel-vet revolution," the relative wage of university graduates fell in virtualy all indus-trial sectors. The general increase, therefore, was an artifact of structural change(Flanagan 1993b). Similarly, in Hungary, although the relative wage of professional

422 Labor Market Responses to a Change in Exonomic System

workers rose by 8 percent between 1989 and 1992 in industry as a whole, there waslittle change in the relative wages of professional workers or manual workers withinsectors. Nor was much change in pay differentials for skill discernable amongbranches of Hungarian industry (Jackmran and Pages 1993).

When wage policy is applied to sectors with a large nonwage component, itencourages the substitution of nonwage (and untaxed) benefits for wages, dilutingthe incentive effects of the compensation system. There is evidence that tax-basedincomes policies in the USSR 'merely induced enterprises to shift further still to theuse of bonuses and direct payrnents in the form of goods and services, oftenacquired on a barter basis from other enterprises.... At the macroeconomic level theratio of nonwage to wage forms of remuneration rose steadily from the 1950sonward, at least until the advent of perestroika" (Standing 1991/92, p. 244).

If incomes policy has not had a beneficial effect on wage structures in EasternEurope, its use to achieve macroeconomic stability has had equally questionableresults. In several of the countries where it was tried, wages were actually belowincomes policy norms in the early months of the transition. The fear of a wage pushfrom workers was strongest in Poland. Yet recent analyses have conduded that wagepolicy was not effective in Polandliquidity constraints at the beginning of 1990made such policy redundant (Coriceili, Hagemejer, and Rybinski 1993). Othercountries also stressed the role of liquidity constraints and concerns for job securityas more important reasons for wage setting (Jackman and Pages 1993). No analysisof Eastern European labor markets in the World Bank country studies has claimedevidence of a substantial macroeconomic effect of the policies.

In summary, incomes policies seem rather poorly suited for the transition envi-ronment. Such policies always present a tradeoff between macroeconomic andmicroeconomic objectives, but the tradeoff seems particularly acute in transitioneconomies. To the extent that incomes policies are effective in their macroeconomicobjectives, their potential for inhibiting the allocative functioning of wage structuresis great. While this potential may be acceptable in market economies with strongallocational signals, in Eastern Europe today such policies impose delays on adjust-ment and restructuring that run counter to systemic reform. Even if incomes poli-cies were instrumental in stabilizing the macroeconomy (which has yet to be shown),the lack of change in wage structures in the region would be troublesome.

Conclusion

With few exceptions the aggregate supply of labor in Eastern Europe has contractedand threatens to contract still farther if the long duration of unemployment (impliedby current flows in and out of unemployment) continues. The principal problem isinsufficient demand. Until the demand problem is solved, moreover, labor marketpolicy alone is unlikely to have much impact on unemployment. When job vacan-cies and unemployment are more closely aligned, a reorientation of labor marketpolicies away from passive measures and wage subsidies toward training programsseems desirable. There is ample testimony from the emerging private sector regard-

Flanagan 423

ing the limitations of traditional Eastern European vocational training for produc-ing workers skilled in modern production methods. And the problem can onlyworsen as the private sector expands.

With respect to the allocation of labor the evidence is mixed. New private firmsappear to have little trouble expanding (subject to the training problems notedabove), but they take few risks in hiring the unemployed. Within the state sectorthere is evidence that some of the distortions in labor market signals under cen-tral planning have been reversed, if not eliminated, at the market level. Limitedevidence indicates, however, that the private sector has not yet become the forcedriving these changes. Rather, the changes have resulted from the downsizing ofstate enterprises.

In virtually all the transition economies in the region the major institutional bar-rier to adjustments of pay structures and to employment restructuring within the statesector has been incomes policy regulations. These policies seem poorly designed forthe transition environment, and their use rests more on tradition than any demon-strated effectiveness. A better option might be to alter management bargaining incen-tives by altering management compensation schemes, which would give managers apersonal stake in resisting demands for pay increases. Broader use of arrangementsthat link pay to enterprise surpluses could also provide incentives to resist general paydemands and create stronger internal performance incentives. Each country, further-more, could fix its exchange rate to a basket of Western currencies-much like thehard currency policy adopted by Austria for many years. While this solution does notdirectly address the problem of managerial bargaining incentives, it would under-score the fact that excessive wage increases could lead to job loss and would there-fore strengthen managers' bargaining hand.

Notes

1. Atkinson and Micldewright (1991) warn chat the broad descriptive parameters of unemploymentinrance systems may be a poor guide to the incentives actually at work. To discover their true effcctson job acceptance, detailed research into the implementation of these systems wilU be necessary.

2. Three surveys covered the manufacturing sector and included interviews at 121 firms in the formerCzechoslovakia in January 1992, 106 Hungarian firms in September 1991, and 93 Polish firms in May1991. In each country firms were drawn randomly from the population of registered, majority privatelyand domestically owned manufacturing firms with seven or more employees. Sec Webster (1993a,b) andWebster and Swanson (1993) for details. A fourth survey of 200 firms in the two largest cities in Bulgariaincluded respondents from industry, trade, construction, business services, and publishing (Beleva,Jackman, and Nenova-Amar 1993).

3. These conclusions would not be altered by comparing returns to schooling in centrally plannedeconomics with returns in countries whose level of economic development is lower than that of advancedmarket economies, for returns to schooling red to be inversely related to stage of development. A sur-vey of the international literature on educational returns reports baUpark returns to schooling Cderivedfrom the specifications used here): Africa, 13 percent; Asia, 11 percent; Latin America, 14 percent coun-tries with an intermediate level of economic development, 8 percent; and advanced industrial countries,9 percent (Psacharopoulos 1985, table 3).

4. The firms surveyed, like most private firms in Eastern Europe at tks time, were relatively smal,"with 60 percent having fewer than twenty workers and almost 75 percent of firms reporting monthlysales of less than US$50,000." Most firms in the survey were limited-liability companies owned by groupsof three to six people. Ninety percent had originated as private firms, mainly since 1988. The rest orig-inated in the state or cooperative sectors (Webster 1993b, pp. 2-3).

.

424 Labor Market Responses to a Chan in Economic System

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