The Political Economy of Formal Sector Pay and Employment in Developing Countries

Abstract

Policymakers concerned about migration to high-income countries must take into account the political economy of the labor market. Labor market pathologies, like macroeconomic mismanagement, can be extremely costly - severely constraining growth of output and employment and increasing inequality. Domestic labor market outcomes influence the direction and magnitude of the flow of international migration. When wages are low and jobs are scarce, workers tend to migrate to environments where jobs are available at higher wages. But as labor demand grows, a labor-exporting country may become a net labor importer. Such a migration transition - already much in evidence in East and Southeast Asian countries and beginning for skilled workers in India - is analogous to the demographic transition. The process of political economy described by Banerji, Campos, and Sabot affects the level and growth of wages and of formal sector employment. So it is important for policymakers concerned about migration to high-income countries to take it into account. An efficient, flexible, responsive labor market contributes to growth by creating an appropriate economic environment. In this respect, labor policy is like macroeconomic and trade policy. Unlike the accumulation of physical and human capital and technical progress, a well-functioning labor market is not itself a source of economic growth. Yet labor market pathologies, like macroeconomic mismanagement, can be extremely costly, severely constraining growth of output and employment and increasing inequality. Similarly, failure to adequately address the labor-market aspects of policy reform can result in the failure of other dimensions of reform. The smooth functioning of the labor market feeds on itself, enhancing the credibility of both workers and the elite. Conversely, poor labor market performance can also be self-reinforcing. Attempts to reform the labor market are likely to be hampered by the lack of credibility of both labor and the elite. The payoff on labor reform can be high for both groups. The challenge is to find mechanisms whereby the credibility of both groups can be bolstered. This paper - a product of the Office of the Vice President, Development Economics - is a background paper for World Development Report 1995 on labor. Versions of the paper were presented at a World Bank seminar and to the 1994 Northeast Universities Development Conference at Yale University.