There is a paradox in labor regulations around the world. Some countries have relatively protective labor codes but only enforce them in large firms. Others have less stringent regulations but these are implemented across the economy. Why is this? I will provide an explanation in the second part of the blog, but let me first emphasize the importance of enforcement.
Enforcement matters: Going beyond the letter of the law
When looking at labor regulation, what is important is effective regulation. That is, the combination of both de jure regulations and their enforcement. For example, labor demand depends not only on the letter of the labor code but also on the probability of being caught - and the expected fine in case of noncompliance.
Most work, however, has generally focused on the letter of the labor code. This is due to a lack of enforcement data. But how can we credibly estimate the effects of labor regulation if we only consider the letter of the law, ignoring the possibility that enforcement may be weaker in those places where the regulation is more stringent? This is not a purely hypothetical question. Noncompliance with labor regulations is pervasive in less developed countries, and at the same time, those countries tend to have the most stringent laws.
In a recent paper, I compiled data on labor inspection resources, activities and fines for almost every country in the world. Interestingly, the results show that countries that have the most protective labor codes tend to enforce less, and the negative relationship remains after taking into consideration differences in GDP per capita. For example, the letter of the labor law in Venezuela and Angola is quite protective, but enforcement and compliance are very low. The opposite occurs in Canada or New Zealand.
A colonial origin hypothesis of effective labor regulation
Why do a large number of countries have quite protective labor codes but very low levels of enforcement? Why do they choose that combination? If there is a dislike for private market outcomes, they should not only have stringent laws but also enforce them.
I argue that this apparent paradox can be explained by considering the long-lasting effects of European colonization strategies and the actual distribution of enforcement across firm size. Let me explain. As shown by Acemoglu et al. (2001) and other economic historians, in those territories where the Europeans pursued an extractive strategy, they created an economy characterized by monopolies and the exploitation of labor. This situation led to social unrest, and ultimately to the introduction of stringent labor laws in an attempt to buy social peace.
In Latin America, those reforms typically occurred a century after the countries gained independence. In Africa they were usually introduced at the end of the colonial period. But because the rent was focused in a few privileged firms and sectors, and because those who had the capacity to mobilize also worked there, the labor laws only applied in those sectors. Enforcing such a complex labor code on small production units was both unfeasible and economically disruptive.
In North America and Oceania, on the other hand, Europeans were more interested in developing places where they, and their descendants, could live. They created more competitive markets, which led to higher wages, a smaller imbalance between capital and labor, less social unrest and demand for redistribution. Furthermore, more competitive markets produce more pressure on the government towards ensuring high levels of compliance across all firms to avoid unfair competition.
In those countries where the Europeans pursued an extractive strategy as opposed to former settler colonies, we see more protective labor codes, lower overall enforcement, and different levels of enforcement between larger and smaller firms.
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