When Do Structural Reforms Work? On the Role of the Business Cycle and Macroeconomic Policies

Abstract

The effects of structural reforms are surprisingly difficult to pin down empirically due to their potential endogeneity to the economic environment in which they are conducted. This chapter develops robust estimates of the impact of labour and product market reforms by using local projection techniques while controlling for endogeneity of reforms and other biases. The results suggest that reforms have a lagged but positive impact on employment creation, and the positive effect remains even after controlling for the endogeneity of the decision to reform. Supportive macroeconomic policies are found to increase the effect of labour and product market reforms.

The views expressed are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. We are indebted to Helge Berger for his valuable inputs and guidance. We thank Romain Duval, Davide Furceri, participants at the IMF EUR surveillance meetings and SPR-RES Jobs and Growth seminar and participants at the IMF-DNB October 2015 Conference on Structural Reforms in Amsterdam for their comments and suggestions.

Appendices

Appendix 1: Country Sample

The sample covers OECD countries with population of more than 5 million, with large episodes of labour market reforms for regular workers (EPLR) and product market reforms (PMR). Additional restrictions, such as non-missing output gap and employment rate variables with at least 3 lags, are also imposed, given the specification used in estimation. Finally, the first stage AIPW regression required some political variables, the unavailability of which constricts the sample further. All in all, the baseline EPLR regressions, reflected in Tables 7.1 and 7.3, include 555 observations from 29 countries (see Table 7.8 for the list of countries). The baseline PMR regression, reflected in Tables 7.1 and 7.3, include 709 observations from 26 countries. Regressions in Tables 7.2 and 7.4–7.6 that include policy variables further restrict the sample.

Table 7.8 Sample of countries

Appendix 2: Determinants of Labor and Product Market Reforms

In the first stage, propensity scores to implement reforms are estimated using a probit regression of the probability of implementing either a labour or product market reform on lagged GDP growth (to account for cyclical conditions), a legislative election dummy (political variable), an EU accession dummy (economic integration factor), the age dependency ratio (demographic developments), and the political leader’s educational background (either captures the competency of the leaders or their proximity with liberal views). ¹⁶

Lagged GDP growth is included to capture the notion that countries in a recession may be more likely to implement reforms.

A legislative election dummy is 1 when there is a legislative election in that year. The variable is drawn from the database on political institutions (DPI). It helps capture previous findings that reforms are often times implemented early in the political cycle (Tompson 2009).

The EU accession dummy is 1 if the country is in the EU. External pressures from the EU or from other member countries can induce countries to implement reforms.

The reform implementation literature also includes the age dependency ratio—capturing the notion that the population aged 65 and older will tend to push for more pro-competitive labor market reforms to beef up pensions and social security contributions.

The political leader’s educational background variable is drawn from Hallerberg and Wehner (2016) and takes the value 1 whenever the Prime Minister or the Minister of Finance has a degree in economics. It represents the idea that more technocratic leaders with a background in economics are more likely to initiate reforms. For instance, one of the main finding of Hallerberg and Wehner (2016) is that leaders that take office during a banking crisis in advanced economies are more likely to have an economics background.

Table 7.9 shows the regression results of the probit model. Results are based on the estimation of a pooled panel or random effect probit model where key determinants of the probability of observing labor and product market reforms are identified, respectively. The results for labour market reforms show that structural reforms are more likely to be implemented following periods of lower growth, off election cycles, and in countries with EU accession commitments. Product market reforms tend to occur in good times, in countries with a high dependency ratio and where key political leaders (Prime Minister or Minister of Finance) have an economic background.

Table 7.9 Determinants of structural reforms (pooled probit regression; dependent variable: probability of adopting a reform)