Enforcement of labor regulations and job flows: evidence from Brazilian cities

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.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.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%.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.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,⁵ the impacts of employment protection rules likely vary for different workers and firms.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.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.

Starting in 1995, the Ministry of Labor and Employment (MTE), under the Secretary of Work Inspection (SIT), implemented a series of reforms aiming to increase the efficiency of inspections.⁸ The reform emphasized a new way of monitoring outcomes of labor inspections (see Miguel 2004). The primary objective was the standardization of the results of labor inspections at the national level. The creation of the Federal System of Labor Inspection (SFIT) was an important tool for this aim. First, the system allowed the creation of a routine to plan labor inspections throughout the country. Schedules with the targeted outcomes (goals) began to be sent annually by various Regional Offices of Labor to create a system of inspections. This reform made policies less reactive to complaints about labor standards and more proactive and based on long-term planning. In addition, the reform developed financial incentives so that labor inspections played became more efficient. The system awarded bonuses linked to performance. The bonuses were granted in accordance with the enforcement goals initially established. These goals generally considered the number of inspected plants and the total financial amount collected from fines. It is worth noting that the bonus system is not the only incentive mechanism. Pires (2011) argues that the formation of regional and sector teams with common goals is an additional incentive mechanism to individual bonuses.⁹

The reform also involved the change in the motivation of labor inspections. Miguel (2004) states that “the main objective was to make inspection less punitive and more educational, thus making it more effective from a social-economic point of view”. In this context, it is important to highlight two actions: (i) the creation in 1996 of handbook entitled “Mediator’s Manual” which contained advice to resolve labor conflicts, and (ii) the increase of available options for the labor inspector, beginning in 2001, when “tables of understanding” were permitted to debate solutions over difficult-to-solve irregularities during audit visits. Pires (2008) suggests that this new approach contributed to enabling the labor inspector to fulfill his role in a more efficient manner. Almeida (2008) also explores this point, arguing that this type of strategy is particularly successful in non-metropolitan areas cities that agglomerate small businesses.¹⁰

Column (1) of Table 1 displays the annual growth in the rate of formalization of workers following inspections which is captured by the number of workers registered during labor inspections divided by the number of workers covered by these same inspections. This ratio increases from 1.8% in 1996–2000 to 2.6% in 2001–2006. Column (2) shows that in these two periods, the annual average number of plants inspected by each inspector decreased from over 141 to less than 120. Therefore, an increase in the rate of formalization seems to have been motivated by better and more targeted inspections rather than by more inspections.

This hypothesis is indirectly supported in the third column, which shows that the mean size (captured by total number of employees) of the inspected plant increased by almost 50%, changing from 50 to 74.¹¹ If we consider that informal labor contracts are less frequent in larger plants, then an increase in the mean size of inspected plants may be related to a decrease in the rate of labor contracts that become registered because of the inspections. Nevertheless, the first column of Table 1 indicates an increase in the rate of contracts registered following the labor inspections. These facts are reconciled if, throughout this period, there is an increase in the effectiveness of inspections.

Note that this increased effectiveness of labor inspections could have come from any combination of the three dimensions outlined above. Identifying the specific contributions of each of these dimensions is beyond the scope of this work.

Another change in labor inspection in Brazil occurred outside the SIT. Since 1998, the Public Ministry of Work (MPT) began to play an active role in labor inspection, increasingly acting in parallel to the SIT. The most noteworthy fact is that in the last decade, five priorities were chosen for the SIT, one of them being the regularization of labor contracts. One should also take the performance of the MPT into account in the analysis. However, because we lack information about MPT’s results, we will focus the analysis on labor inspection under the SIT.

In the empirical work, we will explore different data sets covering the period between 1996 and 2006. First, we explore the report on social information RAIS (Relação Anual de Informações Sociais, RAIS) (see Appendix for correspondence between RAIS and SFIT data), published yearly by the Brazilian Ministry of Labor and Employment, and capturing all the sectors of the economy (agriculture, industry and services).¹⁴ This is our source of information to compute measures of job and worker flows. We consider the total number of accessions (A_i,t) and separations (S_i,t) each year (denoted with subscript t) in every formal plant.¹⁵ Those registered with the tax authority are denoted with subscript i. We compute net employment growth in each establishment (Δn_i,t) which are the basic inputs for job flow measures.

We also compute job and worker flow measures aggregated at the city level between 1996 and 2006. Job creation and destruction rates at the city level (denoted by subscript j) are defined as in Davis et al. (1996):

JC_j,t and JD_j,t denote the rate of job creation and destruction for year t and city j, respectively. The two job flow rates are based on the change in employment resulting from the contrast of accessions and separations (Δn_i,t) at the plant level i, in each city j from years t-1 and t. When this variation is positive, it will contribute to job creation in the city, and when it is negative, it contributes to job destruction in the city. This condition appears in the above formulas through the indicator function I(.). N_j denotes the city average employment in 12 consecutive months during year t, and it is used for normalization of both rates.

Finally, we also aggregate accessions and separations at city-level computing:

Second, we explore annual information on labor inspections at the city level. This is collected by the Brazilian Federal System of Labor Inspection (SFIT) which is part of the Ministry of Labor. The data is available at the city level for the years 1996, 1998, 2000, 2002, 2004, and 2006. Our period for the analysis coincides with these years since this is the most restrictive set of data in the time dimension. We measure labor inspections in the city j with an indicator of the average frequency of total labor inspections per plant in the city, where the number of plants in each city is computed using RAIS:

Third, we use additional variables to control for differences across cities/years such as yearly and city-level GDP, current city government expenses as a fraction of GDP, agricultural sector GDP, service sector GDP, population, and the number of homicides. GDP-related information was taken from IPEADATA, while population and homicides information are available at DataSUS.¹⁶

We consider a simple reduced form equation relating the different measures of job flow and job reallocation with enforcement of labor regulations, measured by labor inspections. As described in the previous section, we consider different dependent variables of interest: total job creation and destruction rates (JC and JD), net job growth (NET, equal to JC minus JD), reallocation rate (REALL, equal to JC plus JD), accession rate (A), and separation rate (S).

We will also test the robustness of the results by including in Eq. (8) state-level time trends, possibly correlated with city-level trends in the enforcement of labor regulations and with trends in job flow rates. Hence, we will estimate the following specification:

Table 4 presents the evolution of worker flows between 1996 and 2006. Column (1) reports accession rates which have increased substantially, especially in the 2000’s, when JC was relatively stable. Separation rates, in column (2), display a U-shape varying from just above 40% in 1996 to its lowest value of 37.2% in 2000. Again, this contrasts with the JD evolution which was stable. It is interesting to note that worker flow rates are on average higher than job flow rates in the data. Although this should be the case since workers can move over and above the shifts in jobs, the difference between the two rates is substantial. In the US economy, where worker and firms may be the most unencumbered from moving, hiring, and separation rates in 2010 stood at only 18.7 and 18.5%, respectively (Hyatt and Spletzer 2013).

Table 5 reports substantial variation in the distribution for inspection intensity in our sample. The 10th and 90th percentiles go from less than 0.10 to 0.36. Almeida (2008) suggests that the logistics of labor inspection vary significantly by the size of the city and the size of its establishments. The cross-sectional variation in the main variables of our analysis related to job and worker flows may be driven by city characteristics. This suggests that accounting for city differences helps to isolate part of confounding effects that might jeopardize the interpretation of our estimates in a univariate regression analysis.

Figure 1 shows the average inspection intensity indicator at city level aggregated by selected states in different regions. Results show sizeable spatial and temporal variation in inspection intensity across the sample. Lastly, Table 7 reports summary statistics for the main control variables.

Average establishment size	15.3
Percentile (75th) of establishment size	6.6
Median of establishment size	2.5
Av. city GDP (R$ thousand)	27,282,547
Share of workers with secondary education	0.34
Percentile (75th) share of workers with secondary education	0.64
Median of share of workers with secondary education	0.21
Share of establishments in agriculture	7.7%
Share of establishments in industry	10.8%
Av. city population	2,131,696
City homicide rate	1.025

Source: RAIS and IPEADATA Sample 1996–2006

Note: table reports the summary statistics (means) for the whole sample across years 1996–2006. GDP is measured in year 2000 R$ (thousand). Homicide measured as number per 100,000 persons

The positive effect of labor inspections on both margins of worker flows may seem a surprise. However, the main data we exploit, RAIS, only captures formal sector jobs even if the establishment keeps some unregistered workers. Hence, what is computed as accession may represent a worker flow within the establishment from an informal to a formal position. That could explain the positive effect on accessions. The positive effect on separations is interpreted in two ways: firstly, as an employer’s reaction aiming cost reduction. Dismissing employees compensates the labor cost increase due to the formalization procedure aforementioned. Secondly, for a given turnover rate, the more formal workers the establishment has, the more separations will be registered at RAIS. This interpretation depends on firms employing part of their workforce under informal contracts. Hence, the magnitude of our results should increase the higher the propensity of firms to hire workers under informal contracts. We will provide some suggestive evidence consistent with this interpretation.

Because the degree of enforcement of labor regulations varies at the city level and over time, it is not possible to account in the reduced form for unobservable city trends. Nevertheless, we acknowledge that there may be trends at a sub-national level, correlated with changes in enforcement (for example, changes in the quality of other institutions at the sub-national level). Hence, we test the robustness of the main specification to the inclusion of state level trends. The main findings are reported in Table 9.¹⁸ Reassuringly, our main findings are robust to the inclusion of state-time trends.

As we have claimed, our estimated effects for labor inspection are more intense for settings with higher incidence of informal labor contracts, such as small municipalities. We interpret the outcome as follows. De jure rules are the same for all cities. But large cities are likely to already face scrutiny by labor inspectors and comply with regulations. Establishments in small cities infringe rules under fewer inspections. Hence, the marginal effect of more enforcement in small cities and establishments is higher, forcing employers to adjust hiring and firing in the face of de facto stringent rules. Since the firm-size distribution in Brazil is left-eschewed, the aggregate results show a positive correlation between flows and inspection frequency.

In this paper, we explore the relationship between the enforcement of labor market regulations and job and worker flow measures. We explore city-level data across Brazilian cities, between 1996 and 2006 to identify whether and how the enforcement of labor regulations is related to different indicators of job and worker flows. The analysis is based on unique city-level and time series administrative data for Brazil, exploring both the census of all plants in Brazil—RAIS—and administrative data on labor inspections. Both data sets are collected by the Brazilian Ministry of Labor and Employment.

Our results suggest that increases in the enforcement of labor market regulations at the city level is strongly correlated with higher job creation rates. This result is also present between labor inspection and net growth, reallocation, and accession and separation rates. The estimations are consistent across samples by city and establishment sizes.

These findings are in line with Almeida and Carneiro (2012). There, the authors find that, in a response to a rise in labor inspections, there is also an increase in formal employment, together with 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. Their argument is that as inspectors started enforcing compliance with mandated benefits, formal workers pay for 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) prevents 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. In the process, wages in the informal sector adjust upwards.