As more micro-level data becomes available, the understanding of labor market adjustment has benefited considerably from a literature looking into jobs or worker flows as the main outcome variables.Footnote 1 This new approach has unveiled new results on labor market adjustments to changes in the environment such as business cycle fluctuations (Shimer 2012), or minimum wage shocks (Brochu and Green 2013). This paper looks at a shock that has been substantively overlooked: how labor markets in emerging economies react to changes in the enforcement of labor legislation. In spite of the importance of the topic, the literature has not been conclusive about the relation between enforcement of labor regulations and rates of job flow in emerging economies.Footnote 2 On the one hand, enforcement of labor regulations increases (formal) labor costs and could lead to lower rates of formal job creation. On the other hand, enforcement can directly impact job creation though the regularization of informal jobs at the plant level. Moreover, higher compliance formal sector jobs can become more attractive to workers, lowering job destruction and separations.
This paper exploits unique Brazilian administrative data at the city level to answer this question. In particular, it exploits information on job and worker flows and administrative data on the enforcement of labor market regulations, captured by the incidence of labor inspections, across cities between 1996 and 2006. We measure enforcement of labor regulations using the frequency of labor inspections at the city level. During this period, Brazilians went through an important expansion in labor markets with employment growing 7% in the formal sector on average and average rates of job creation and job destruction of 15.4 and 8.6%, respectively. Along with the increase in employment, the average annual GDP growth of 2.6% contributed to the decline in informality in the labor market from 54.9 to 51.5%.Footnote 3 Simultaneously, during this period labor inspections on fundamental aspects of the de jure labor code, such as contributions to the job severance fund, also increased significantly.Footnote 4
Simply relating labor regulations with aggregate indicators of job growth or job flows would, however, not be likely to yield a good estimate of the impact of enforcing labor regulation on job flows. The main empirical challenge lies in that enforcement of labor regulations is, in practice, not randomly distributed across all Brazilian cities. On one end, enforcement may be stronger in cities where reports of labor violations are more frequent as a significant part of inspections are triggered by anonymous reporting. On the other end, enforcement may be stronger in richer and larger cities, also with better institutions. Moreover, Brazilian firms likely faced other policy shocks, over this period, possibly affecting their patterns of jobs and workers flows. Two examples are the expansion of firms’ business credit lines (Catão et al. 2009) and significant tax simplification programs for small businesses (Fajnzylber et al. 2011).
To mitigate this concern, we consider a simple reduced form equation exploiting time and within-country variation, across cities, in the enforcement of labor market regulations and in the rates of job creation and job destruction. In other words, our reduced form compares changes over time in the degree of enforcement of labor regulations at the city level and relates that variation to changes in job and worker flow rates. The advantage is that, by exploiting subnational variation, this reduced form accounts for any time varying nationwide shocks that could have simultaneously contributed to the increase in employment formality during this period. In addition, our data includes a robust set of time-varying observable characteristics at the city level (e.g., city GDP, the distribution of plant size, and the share of educated workers at plant level, total city population, and total city homicide rates). In addition, because we exploit city-level panel data, we can account also for unobservable city-year time trends.
Our findings suggest that, all else being constant, cities facing an increase in the enforcement of labor market regulations tend to have higher rates of worker flows in both margins: accessions and separations. Stringent enforcement is also related to increases in job creation rates. In contrast, changes in job destruction rates as measured in our administrative data set are not related with changes in the degree of enforcement of labor regulations. Our main findings are robust to the inclusion of state-level time trends, considering different sub-national samples.
The paper draws upon and contributes to different literatures. First, it relates to the literature analyzing, at an aggregate level, indicators of job growth/flows with country regulations and institutions. While earlier empirical cross-country work did not find a significant link between labor regulations and job reallocation (see Bertola and Rogerson 1997; Davis and Haltiwanger 1999), more recent findings show that, even after accounting for differences across countries in technology and sector composition, there is still sizeable unaccounted variation in job reallocation across countries. This unexplained variation can be related to institutional or policy variables or to measurement error inherent to cross-country studies (see Bartelsman et al. 2009). The literature looking at the institutional role in explaining this cross-country variation in job reallocation shows that labor regulations may play an important role.
Difference-in-difference estimations exploiting cross-country variation in the firing and hiring costs show a strong and negative relationship between restrictive regulation and the reallocation of resources (e.g., Micco and Pages 2004; Haltiwanger et al. 2010). Because our work explores within-county variation in the degree of enforcement of labor regulations, our empirical approach bypasses some of the measurement issues and assumptions in previous research by using time and within country variation in de facto regulation within a single country. As the enforcement of policies is not uniform across regions in Brazil, we discuss a tighter link between the degree of stringency of the de facto labor market regulations and job reallocation in cities under a similar institutional environment.
Secondly, it relates to the literature studying the impact of labor regulations on firm dynamics and labor market outcomes. The literature here is extensive and considers several dimensions of labor market regulations, from the compliance with mandated benefits (such as unemployment or health benefits) or the minimum wage to alternative employment protection measures. The theoretical predictions on how these regulations affect firm outcomes are diverse. While the literature on the effects of mandated benefits on labor market outcomes in developing countries has produced mixed results,Footnote 5 the impacts of employment protection rules likely vary for different workers and firms.Footnote 6 Because our empirical approach will explore variation in labor inspections, we are effectively considering the de facto enforcement of a diverse mix of labor policies. This has advantages and disadvantages relatively to comparing the variation in de jure regulations. While on the one hand, one cannot try to identify the effect of each regulation, on the other hand, any effect identified already considers the interactions of de facto regulations and of their enforcement, which is ultimately what impacts individuals.
Thirdly, we relate to the literature analyzing how changes in the enforcement of labor market regulations impacts labor market outcomes. This work was initiated by Almeida and Carneiro (2009) and proxied enforcement of labor regulations with the average labor inspections in the city.Footnote 7 Almeida and Carneiro (2012) look at the impacts of enforcement of labor regulations on different labor market variables, also exploring administrative city-level data on labor inspections. Exploring only the within-country variation across cities, they show that, in response to a rise in labor inspections, there is an increase in formal employment, a decrease in informal employment, a rise in non-employment, a decline in wages at the top of the formal wage distribution, and an increase in informal wages. All of the movement from the informal to the formal sector is among the self-employed. There is little change in the employment and wages of those who are informal employees. Almeida and Carneiro (2012) argue that, in the early 1990s, labor inspectors started enforcing compliance with mandated benefits, namely contributions in advance to the job severance fund, and job severance payments upon dismissal. As a result of increased enforcement, formal workers support more generous mandated benefits by receiving lower wages. The value that workers place on these benefits is potentially higher than their cost to employers because they are untaxed. In addition, wage rigidity (e.g., through minimum wages) may prevent downward adjustment at the bottom of the wage distribution. This causes formal sector jobs at the bottom of the wage distribution to become more attractive to informal workers, leading them to switch to the formal sector.
Our work contributes to this literature by exploiting within-country and time series variation in the enforcement of labor market regulations between 1996 and 2006 and focusing now on job and worker flows, including indicators of job creation, job destruction, reallocation, accessions, and separations. In addition, our results are aligned with Almeida and Carneiro (2012) on how labor inspections are related to employment in the formal sector. There are different ways that labor inspections can affect job and worker flows, and the direction of the relationship is not clear a priori. On the one hand, inspections can directly impact job creation though the regularization of informal jobs at the plant level. Indirectly, with higher compliance, formal sector jobs can become more attractive to workers, lowering job destruction and separations. On the other hand, more inspections increase the cost of formal jobs and can lead establishments to shed workers. Almeida and Carneiro (2012) show that in cities with more frequent inspections, formal employment tends to be higher. This finding is fully consistent with our results of higher formal net employment growth and job creation rates in cities with more frequent inspections.
One fact is worth highlighting. Unlike Almeida and Carneiro (2012) who explore the Brazilian population census, our paper explores administrative data only on formally registered firms. It thus only captures the formal labor contracts and one cannot make any inferences about the relationship between inspections and the subsequent regularization of labor contracts as we do not observe informality.
This paper is organized as follows. Section 2 presents an overview of the main changes in the procedures of labor inspection implemented in Brazil, arguing that changes in these policies have made them more effective. Section 3 discusses the data used and indicators computed. Section 4 presents the empirical methodology and the proposed reduced form. Section 5 reports the main descriptive statistics for the final sample, and Section 6 discusses the empirical results. Section 7 discusses conclusions and main policy implications.