Economic Research Forum (ERF)

Job creation and labour market regulation: flexibility versus security

Job creation in the formal private sector is vital for inclusive economic growth in many MENA countries, but in some cases, it is being hampered by over-protective labour regulations. This column emphasises the importance of a balanced approach between flexibility in the labour market and the security of workers’ earnings.

In a nutshell

Over-protective labour regulations may result in higher informality and unemployment, as well as hurting ‘outsiders’, typically women and young workers.

A balanced approach between flexibility in the labour market and security of workers’ earnings is needed.

Reforming social protection schemes and the introduction of unemployment insurance would protect workers rather than jobs and lead to more efficient labour markets.

Job creation is a major bottleneck for the many MENA countries in which a growing labour force and shrinking public sector are leading to high youth unemployment. Absorbing new entrants to the labour market requires that private firms are willing to generate employment opportunities at a much faster rate than they currently are.

At the same time, increasing the flexibility of labour regulations is central to reducing the incentives for employers to hire workers informally with no employment security. It is also essential to ensure that firms are not discouraged from creating jobs or resort to using more capital-intensive technologies to get round rigid employment laws.

Yet most MENA countries (excluding those of the Gulf Cooperation Council, GCC) have over-protective labour regulations. In particular, they tend to have high firing costs involving notice requirements, severance payments and fines for terminating redundant workers. According to the World Bank’s Doing Business measures, the region ranks as the most rigid on the redundancy index and is third from top on the ‘difficulty of hiring’ index.

But while labour markets in MENA countries are heavily regulated, many workers remain largely unprotected. Labour laws tend to be binding only in the public sector and the relatively small private formal sector. This leads some to argue that it is in fact the stricter labour regulations and employment protection legislation that lead to large informal sectors.

There are several channels through which over-protective employment laws can influence the balance between formal and informal employment. First, job security regulations that require employers to provide mandated benefits, such as maternity leave, holiday pay or sick leave for incumbent workers, increase costs for employers and hence reduce their capacity to hire more formal workers.

Second, employment protection regulations that protect the jobs of current workers by requiring severance payments and notifying third parties such as labour authorities, increase the costs of firing workers. Firms respond by hiring fewer workers formally and they are more reluctant to hire inexperienced workers whom they cannot lay off.

At the same time, more protective employment regulations and provisions make informal employment more attractive and worth queuing for, hence increasing unemployment and prolonging unemployment durations. Thus, overall, these regulations reduce demand for protected labour, resulting in higher informality and higher unemployment.

One example is Egypt, where a labour law was passed in 2003 with the goal of increasing the flexibility of hiring and firing in the private sector and state-owned enterprises. The law, which came into effect in early 2004, comprises 257 articles addressing all the legal aspects regulating the labour market by providing comprehensive guidelines for the recruitment, hiring, compensation and termination of employees.

The labour law allows employers to issue fixed duration contracts, to renew contracts an indefinite number of times and to lay off workers for economic reasons, subject to payment of severance pay. Hence, it is seen to provide more flexibility in hiring and firing.

Analysis of the impact of the law on workers who were employed informally without contracts shows that it has had a positive impact on formalisation of employment in Egypt. The law has also reduced informal work that is non-contracted as formal private sector employers became more willing to hire workers formally. The passage of the law increased the probability that non-contractual workers employed in formal firms would make the transition to formal employment by about 3-3.5 percentage points. That is the equivalent of at least a fifth of informal workers in formal firms.

This result suggests that more flexible labour regulations increase formal employment and reduce informal employment. But the changes in employment protection regulations do not have the same effects on all types of workers. They tend mainly to favour ‘insiders’: prime-age males, who are already employed. Thus, the evidence suggests that the 2003 law has affected insiders (those already employed), but had no effect on young entrants to the labour market (outsiders).

Another example of the impact of employment protection laws is a Palestinian labour law passed in 2000, which increased severance payment to older workers, especially in the West Bank, resulting in a substantial increase in the cost of dismissing workers. Evidence suggests that there is an association between the introduction of the law and longer unemployment duration among youth: the increase in firing costs made employers less likely to hire new workers.

The challenge for policy-makers is to implement regulations that protect vulnerable workers but, at the same time, provide flexibility in the labour market that does not deter employers from hiring workers. Hence, there is a need to have a balanced approach between security and flexibility. This balanced approach needs to reduce the cost of job creation but also provide workers with earnings security. In other words, the aim of policy-makers should be to protect workers’ earnings rather than their jobs.

For MENA countries to introduce more flexible labour regulations, a prerequisite is ensuring that vulnerable workers have a social safety net if they become unemployed. For many non-GCC countries in the region, this could lead to a huge fiscal burden. But with the reduction of public sector employment, governments could direct their public spending toward financing safety nets that reach and protect vulnerable workers.

The challenge is to design instruments of social protection that can accomplish their intended objectives while minimising the associated inefficiencies. At the same time, the introduction of active labour market policies that provide the required training is paramount to lift the unemployed out of poverty and get them into productive employment.

Further reading

Wahba, Jackline (2016) ‘Labor Market Regulations: Job Security versus Labor Flexibility’, ERF Policy Brief No. 19.

Wahba, Jackline (2009) ‘The Impact of Labor Market Reforms on Informality in Egypt’, Gender and Work in the MENA Region Working Papers Series Number 3, The Population Council, Cairo.

Wahba, Jackline, and Ragui Assaad (2015) ‘Flexible Labor Regulations and Informality in Egypt’, ERF Working Paper No. 915.

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