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Economic analysis 06 May 2016

Rafael Domenech: “The best employment protection creates more, and better quality, jobs”

Economist, professor, advisory and director of several organizations related to economic research… Rafael Domenech’s professional life has always been connected to economics, and in parallel, to teaching. Chief Economist of Developed Economies at BBVA Research since 2009, Domenech is also a Professor of Economic Analysis at the University of Valencia. This fact permeates all of his explanations, which those who attend his presentations describe as “very educational”.

Born in Sao Paulo while his parents spent a five year period there, he is Brazilian by birth but Valencian by adoption and believes that there is a great need for education in economics. He is the author of numerous articles in prestigious international and national magazine on human capital, growth, economic cycles and monetary and fiscal policies, and recently published a book, ‘En busca de la prosperidad (The Search for Prosperity)’ that includes measures the Spanish economy should take to increase employment, equity and well-being.

He holds a Master of Science degree from the London School of Economics and a PhD in Economics. He has also worked as a collaborating researcher for the OECD, the European Commission, the Ministry of Economy and Finance and the Rafael del Pino Foundation, among others.  The author of numerous publications, together with other BBVA Research team members he has prepared an Economic Observatory with proposals to reform the labor market in Spain, which was published today (in Spanish).

Q. Why does Spain have such a higher unemployment rate compared to other European countries?

A. It’s a question with no easy answers. Answers are often given that are not correct.Sometimes the productive structure of our economy is blamed. On other occasions the human capital of our workers and the problems of our education system are held accountable. But one thing for sure is that with the exception of the most advanced societies, most countries have worse productive structures and human capital levels than we do, and this does not prevent them from having lower unemployment rates. Spanish companies are more productive and competitive, and are more internationalized than many less diversified economies with lower unemployment rates. If you compare the Spanish regions with European regions that are equally or less productive, their unemployment rates are lower. In educational indicators it is more or less the same. Although there is room for improvement in Spain, our education levels are higher than 80% of the countries in the world, yet in 2014 we were the country with the sixth highest unemployment rate according to the ILO.

Q. So if Spain has a more diversified, competitive and internationalized productive structure than many countries, why is our unemployment rate higher than almost all of them?

A. Because compared to other countries there is a greater imbalance between our productive capacity and the institutional and regulatory framework that companies and workers in the labor market must follow. Relatively speaking, inflexibility, barriers and restrictions are greater than in other countries. In Spain we have a productive capacity that is the same or better than many economics, but at the same time, companies and workers operate under a much more adverse regulatory framework and business climate. The bar has been set very high, especially in terms of permanent contracts in relation to temporary contracts. Only the most productive companies and most qualified workers are able to attain stable contracts and quality jobs, condemning everyone else to unemployment or temporary contracts.

Rafael Domenech BBVA

Rafael Domenech, Chief Economist of Developed Economies at BBVA Research since 2009. - BBVA

Q. Is this the reason you report that Spain is an international anomaly?

A. Yes, this is the main reason. More than 20% or the active population is unemployed and 26% have temporary contracts. Very few countries in the world have worse figures.

Q. How does this affect the business world?

A. Spain has a very heterogeneous, two-tier productive structure, both for companies and workers. For companies, there are enormous differences in their size and productivity. Medium and large companies are just as productive as their European counterparts, but we have too many small companies, which are much less productive. For workers, there are major differences in education, professional experience and qualifications. While 35% of the adult population has received higher education, 43% have only completed junior high school or less. Regulatory restrictions are too excessive for less productive companies and less qualified workers. For example, there is a huge gap (one of the biggest in Europe) between the severance payments for workers with permanent contracts and those with temporary contracts, and this divides the labor market in two. Temporary, more precarious employment is concentrated among the weaker segments of the labor market when they are the ones who should receive more assistance to access quality employment.

Q. Why do regulations fail to promote the growth of these SMEs? How are theyregulated in other European countries?

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Small companies have more difficulties to grow than in other countries.

A. Small companies have more difficulties to grow than in other countries. This is due to the restrictions and limitations that discourage growth which are imposed on them. For example, a BBVA Research study in the Círculo de Empresarios reported a discontinuity in companies before and after they reached 50 workers. The number of companies close to this threshold drops dramatically. Nearly one third of them disappear. For many companies these restrictions include the obligation to create a company committee, discounts for companies with less than 50 workers and various tax obligations related to size, among others. There are companies that instead of growing and taking the leap to 80 workers, for example, prefer to stay below 50 workers or create two independent companies of 40 workers, losing out on the economies of scale and greater productivity that comes from growth. As a result, the economy ends up having smaller companies than in other countries. The solution isn’t eliminating necessary regulations, rather designing them better to avoid these disincentives.

Q. Is this one of the reasons BBVA Research is proposing that collective negotiations are modernized?

A. The modernization of collective negotiations that we propose has to reach all companies, regardless of their size, including those with less than 50 workers. We need to make it easy for companies to have their own agreements. Why? Because within each sector there are companies with very different sizes and very distinct goals and needs. A company with 1,000 or 500 workers could have the goal of going international, with much higher productivity levels than a company with 10 workers whose market is local. It is hard for a single, collective agreement for the entire sector (national or provincial) to meet the needs of all the companies. We can’t expect a one-size-fits-all agreement to serve the needs of companies of all sizes.

The modernization of collective negotiations that we propose has to reach all companies, regardless of their size, including those with less than 50 workers

Q. Would this modernization mean amending the statute of workers’ rights?

A. It wouldn’t be necessary, but it also wouldn’t be a problem if it were amended. There is no reason for regulations to be set in stone. We can’t think that a statute of workers’ rights that was developed at a set point in time with a specific productive structure and a different context than what we have now has to remain unchanged for decades even though the economy has completely transformed. Also, if there’s something that isn’t working or a restriction that can be improved, it should be changed. We have to be ready for the statute of workers’ rights and labor relations framework to start adapting to society’s needs at every given time.

A. The reform made substantial progress. A large part of the jobs created over recent years have the reform to thank – but it’s not enough. More measures are needed. Some are related to the labor market and others to greater competitiveness or improving the education system. Our school drop-out rate is the highest in the EU meaning that future workers are not being properly prepared. Equal opportunities are not guaranteed and everyone does not receive the education they need to face their future.

At the same time we need to eliminate all the barriers to companies’ growth, which in many cases does not occur due to insufficient human capital at the managerial level. Competitiveness needs to improve in goods and services markets in order to avoid the power of the market on prices and salaries. Just like Europe created the Single Market to allow companies to compete across Europe, the unity of the market in Spain must be ensured so that companies can compete against each other, regardless of the autonomous community where they operate.

While eliminating barriers to competition in goods and services markets, the labor market also needs to improve in four areas: incentives for permanent contracts, modernization of collective negotiations, tax structure and active employment policies.

The goal of these measures should be two-fold. On the one hand, they seek to lower the barriers and regulations so that companies and workers can create more jobs, and with permanent contracts. On the other hand, they aim to assist underprivileged sectors of the labor market to increase their employability and help them access permanent contracts.

Q. If we adopted measures like this, what would our unemployment rate be?

A. With these reforms we should aspire to have unemployment rates like those of similar countries. This comparison is what makes Spain an international anomaly. In recent decades, the unemployment rate has oscillated around 15% while in other countries it was around 5 or 6%. That should be our goal. In addition to carrying out these reforms and trying other policies – sometimes with pilot program – they should be evaluated to see if changes are needed in their design or implementation. This should be repeated over and over again until the unemployment rate is close to the average of the most advanced societies. This would mean that when there is a crisis, the unemployment rate should not exceed 10%. In a period of expansion, the unemployment rate would reach 4% or even lower.

With these reforms we should aspire to have unemployment rates like those of similar countries

Q. One of the most widely talked-about measures has been the implementation of the mixed compensation scheme. Won’t this implementation translate into lower salaries and household consumption?

A. On the contrary, because one of the advantages that permanent contracts offer is that job stability and worker experience drive productivity. And as productivity rates increase, so do wages. The evidence for the Spanish economy is that after factoring in all the variables that influence wages, workers with permanent contracts earn 15% more than temporary workers. Therefore, by reducing temporality, the percentage of workers with stable and productive jobs, with higher wages, will increase.

Q. Is that why you are proposing to reduce the number of employment contracts to three: Permanent, temporary and training?

A. This simplification will remove a lot of complexity from the hiring processes for companies, and will especially help smaller businesses to grow more. These three types of contracts are enough to meet the contractual needs of companies. The contract by default must be the permanent contract. Most of the productive needs of companies should be satisfied through permanent contracts, not through a stream of temporary workers with high turnover rates. Temporary contracts must exist for particular cases and should be almost residual by nature. Even so, in fact, for companies engaging in seasonal activities, with lengthy periods of inactivity throughout the year.

Q. But, in the case of Spain, could the vast numbers of temporary contracts have something to do with the high severance costs entailed by permanent contracts?

A. That is indeed the main reason. A portion of the job market, with permanent jobs and collective bargaining processes dominated by these workers, is very rigid compared to other countries. On the other hand, the temporary job market is tremendously flexible. Therefore, the way that businesses handle uncertainty in their economic activity is through a high number of temporary workers.  The lower the internal flexibility of the permanent employment is, the higher the volume of temporary employment companies require.

Q. And in fact, that is why you have a proposal to change the compensatory system, the cost scheme…

A. To solve this issue we need to make it easier for companies – and encourage them – to hire permanent workers. We need to make it more expensive to lay off a newly hired temporary worker during his/her first few years than a permanent worker. Our proposal envisages, on one hand, the same temporary worker compensation scheme that is currently in force: 12 days  per year worked. On the other, on top of this compensation, there would be a monthly contribution debited by the company an individual account at the worker’s name. This contribution would be equivalent to 8 days per year worked. Adding these two parts, the total compensation would stand at 20 days per year worked.

This contribution would be equivalent to 8 days per year worked. Adding these two parts, the total compensation would stand at 20 days per year worked.

Permanent workers would receive the same contribution to their individual account (8 days per year worked) and a compensation that increases with seniority. In the fourth year, in the case of fair dismissals, it would be of 12 days. And higher in the case of unfair dismissals. So, costs of layoffs for the first four years would be higher for temporary contracts than for permanent contracts, in order to discourage businesses from resorting to them.  It would work as some kind of no-claim discount system (bonus malus): cheaper for companies that create permanent jobs and more expensive for those that create temporary jobs.

In the case of both temporary and permanent contracts, the contribution to the worker’s individual account would work much like an insurance policy.

Rafael Domenech, Economista jefe de Economías Desarrolladas de BBVA Research desde 2009

"To change the compensatory system we need to make it easier for companies – and encourage them - to hire permanent workers", Rafael Domenech said.

Q. This is what is known as the Austrian model. How would it affect current contracts?

A. Logically, these proposals are only for new contracts. As of a specific date, companies would be required to start contributing to the individual accounts of each new temporary and permanent hires. This account would be managed by the Social Security. So, each worker would have their own account, into which a monthly contribution would be made. Although the proposal is only for new contracts, we are also proposing the possibility of transforming current contracts to the new system, if companies and workers, by mutual agreement between the companies and the workers.

Q. One of reasons why this system is criticized is because, with the Austrian model, laid off employees would have lower living standards, lower unemployment benefits, compared to what we currently have in Spain. Is this right?

A. No, these two issues are completely unrelated. On the one hand we have unemployment benefits. On the other, severance payments, which – and we should all keep this in mind – in other countries it just does not exist. In Spain we decided to have it, but we have to improve its design, in order to prevent its detrimental effects on employment and job insecurity. What is happening now is that the differences between the severance costs corresponding to each type of contract are acting as a barrier for the creation of permanent jobs. And we need to avoid this, because it creates different segments in the job market, and, precisely, harms those that have a harder time getting quality jobs. The current situation is not very equitable, and unemployment and a precarious job market are two of the main reasons behind inequality.

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The best way to protect employment is to guarantee that workers can get stable and quality jobs quickly

Many countries that we see as quintessential welfare states – such as Austria, Denmark or Finland – don’t have statutory severance pays. And this does not mean that employment lacks protection in these countries. On the contrary. We need to start looking at employment protection from a comprehensive point of view. It is not just a matter of severance packages. Active and passive policies are just as important, if not more.

Q. And what happens if it is not used?

A. Once the worker retires, they can capitalize all the money accumulated in their accounts, which they haven’t used.

Q. Another one of the topics sparking debate is the social contribution issue. Can they be reduced?

A. Of course, if we replace it with other taxes with which to pay pensions. Country benchmarks show that, in Spain, social contribution levels are very high when compared to indirect taxes. Furthermore, in EU countries with lower social contribution to indirect taxes ratios, unemployment rates are also lower. Why? Because social contributions are taxes that affect labor, while indirect taxes affect consumption.

In Spain, social contribution levels are very high when compared to indirect taxes.

Also, social contributions end up being driving up the price of the goods and services produced in the country, regardless of whether they are sold in the domestic market or abroad. Indirect taxes, on the other hand, only affect the goods consumed domestically, regardless of whether they are imported or not. Therefore, changing the tax structure by reducing social contributions while increasing indirect taxes, lower the country’s production costs compared to the rest of the world. It ends up working as a currency devaluation.

Q. And what effects would we be talking about?

A. Cutting the effective rate of social contributions by 2.3 points and increasing indirect taxes – not only VAT, but also taxes on mineral oils and other goods – by 2 points, would result in about 200,000 new jobs. Therefore, with a social contribution reduction of approximately 5 points we would be creating almost half-a-million jobs. Some countries such as Denmark have decided to keep social contributions at virtually marginal levels, under 2%. In other words, less than one-tenth of Spain’s rate. In exchange, they have higher indirect taxes. All countries that have transitioned towards this tax structure have lower unemployment rates. Also as a result of other factors, but this one would help. Because they have changed relative prices, lowered severance costs and bolstered savings vs. consumption.

Paradoxically, when we take into account all the direct and indirect effects, when increasing indirect taxes and lowering social contributions, the aggregate consumption rate also ends up increasing. Indeed, the positive impact on the job market and GDP growth drives income, and ultimately consumption.  What we get is more people working, increased production, and higher income and consumption rates. People pay higher taxes on what they consume, but this negative effect is more than compensated by higher income levels, and therefore consumption also increases.

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