The challenges of regulating the labor market in developing countries

Regulating the labor market can be especially contentious. Interventions like job security rules and minimum wages not only highlight ideological differences about the role of government and the social contract between capital and labor, but they directly affect the livelihoods of people. 

In the end, the challenge is to get the balance right between enabling decent working conditions and incomes for employees and allowing employers the flexibility to run their operations efficiently and at a reasonable cost. While politics cannot be eliminated, careful data-driven analysis can inform the policy process by illustrating the likely effects of different regulatory options on important social and economic outcomes.  Decision-makers in high-income countries have access to an extensive and continually expanding body of research to guide their deliberations on regulating the labor market.

What about developing countries? There has not been as much analysis in these settings, but more and more research is now being carried out. The evidence we now have suggests that many developing countries set labor market rules in a zone where some protection is provided to those workers who are covered without imposing major costs on firms or the economy.  However, it should be noted that this is not always the case. Take minimum wages for example. There are several developing countries where the minimum wage is set above the average value-added per worker, so employers have a strong incentive to bypass the law. And there are others that have no minimum wage at all.

Furthermore, there are two unique considerations when thinking about labor market regulation in developing countries. One is that these policies, adopted from industrialized models predicated on wage employment, actually apply to a very small part of the employed workforce in developing countries.  In low-income countries like Ethiopia and Tanzania, to take just two examples, more than 80 percent of the working population is either self-employed or engaged in family work, so job security rules, minimum wages, and other regulations cannot be applied in any relevant way. The same point applies even in middle-income countries: in Morocco, for example, only half of workers are wage employees.

The other consideration is that, even in the more structured parts of developing country labor markets, compliance is a formidable challenge.  Employers who would like to avoid the costs of complying with labor regulations and employees who would prefer to maximize their take-home pay can more easily work “off the books”. For example, in most developing countries, between a quarter and a half of wage-earners receive less than the statutory minimum wage. 

In part, low compliance reflects the costs of labor regulations and social protection schemes financed by payroll taxes, which can create disincentives for formalization.  It also reflects the uncertain benefits provided by protections that are in place. Take the example of high severance obligations in some countries: these can not only be expensive for employers and thus discourage formal hiring but ultimately may offer little or no benefit for employees who lose their jobs. This is because of low compliance and costly processes to ensure enforcement. Unemployment insurance is usually a better alternative for compensating job losers. 

Indeed, weak enforcement capacity is a serious constraint for achieving effective labor market regulation in developing countries. The inspector-to-working population ratio in these countries is often 3-10 times lower (and sometimes even considerably worse) than in European countries. Moreover, this does not take into account the quality of enforcement when inspectors do monitor workplaces.

Ultimately, the biggest challenge in regulating labor markets in developing countries is what to do about the hundreds of millions of workers (or even more) who are beyond the reach of formal labor market rules and social protections. At one time, it was presumed that, with time, the industrialized country model of regulation would apply to more and more developing country labor markets. It is now clear, however, that this is happening extremely slowly, if at all. 

New approaches are needed that provide universal labor and social protections to workers in the diverse forms of employment that persist in low- and middle-income countries.  The vulnerability of so many of these workers during the past 18 months has exposed how serious this situation is. 

This is a revised version of a commentary first published by IZA Opinions.