World Bank Reprint Series: Number 406 REP-406 Bela Balassa Public Finance and Social Policy -Explanation of Trends and Developments The Case of Developing Countries Reprinted from Public Finance and Social Policy, 1985, pp. 41-58. Copyright (© 1985 by Wayne State University Press, Detroit, Michigan 48202. Public Finance and Sociall Policy-Explanation of Trends and Developments: The Case of Developing Countries Bela Balassal 1. Social Progress, the Government Budget, and Economic Growth Health and Education in Developing Countries, 1960-1980 Health indicators show. considerable progress in developing countries over the last two decades. BV 1980, low-income developing countries closely approached-and India surpassed-the 1960 results for middle- income countries as regards life expectancy, infant mortality, and child death rates. This has occurred notwA ithstanding the fact that 1980 per capita incomes in low-income countries ($230) and in India ($240) were much below 1960 incomes per head in middle-income countries ($660) [40: 110].2 The rate of improvement during the 1960-80 period was, however, greater in middle-income countries than in low-income countries. Average life expectancy at birth increased bv about one-fifth in low-income coun- tries, in India, and in middle-income countries alike; infant mortalitv rates fell by 21 percent in low-income countries, 25 percent in India, and 36 percent in middle-income countries; and death rates for children between I and 4 years of age decreased bv 29 percent in low-income countries, 35 percent in India, and 52 percent in middle-income countries (Table 1). The observed differences mav fin(d their origin in the differential avail- ability of health services and nutrition. Between 1960 and 1977, the number of people per physician decreased by 39 percent in low-income countries, 27 percent in India, and 66 percent in middle-income countries; the corre- sponding figures for nursing persons are 38 percent, 48 percent, and 59 Public Finance and Social Policv. Proceedings of thie 39th Congress of the International Institute of Public Finance. Budapest, 1983, pp. 41-58 Copyright ©) 1985 by Wayne State University Press, Detroit, Michigan 48202 41 42 BELA BALASSA percent, respectively. And, while the share of the population with access to safe water reached 50 percent in middle-income countries in 1975, the corresponding figures were only 29 percent in low-income countries and 33 percent in India. Middle-income countries also experienced larger increases (11 percent between 1961 and 1979) in calorie supplv per head than low-income coun- tries and India (slightly over 2 percent in both cases). Bv 1979, average daily calorie intake in middle-income countries surpassed minimum require- ments by 10 percent whereas low-income countries experienced a shortfall of 8 percent and India of 10 percent. In turn, protein supply per head rose by 8 percent in middle-income countries, declined by 2 percent in India, and remained stationarv in low-income countries. As regards educational achievements, between 1960 and 1977 adult liter- acy rates rose by 11 percentage points in low-income countries, 8 percent- age points in India, and 16 percentage points in middle-income countries. But, despite the progress made, adult literacy rates in low-income countrics (34 percent) and in India (36 percent) remained much below the average level reached in middle-income countries in 1960 (49 percent). In turn, the rise in primary school enrollment ratios (the number en- rolled in primary school expressed as a percentage of the age group) was greater in low-income countries, with an increase from 37 to 64 percent between 1960 and 1979, compared to 21 percentage points in middle- income countries, without however reaching the 1960 ratio in middle- income countries (76 percent). India represents a special case, inasmuch as it had a relatively high primarv school enrollment ratio in 1960 and reached a ratio of 78 percent in 1979, although it experienced smaller increases than either of the two groups of countries. The secondary school enrollment ratio (the number enrolled in secon- dary schools expressed as a percentage of the age group) nearly tripled in low-income countries and increased one-and-a-half times in middle-income countries between 1960 and 1979. Rapid increases in low-income countries permitted them to surpass, by 1979, the average ratio middle-income coun- tries had reached in 1960 (17 vs. 15 percent). India is again a special case, inasmuch as it had a higher secondary school enrollment ratio (20 percent) than middle-income countries in 1960, but fell much behind these countries by 1979 (27 vs. 39 percent). Finallv, the higher education enrollment ratio (the number enrolled in higher educational institutions expressed as a percentage of population aged 20-24) increased from I percent in 1960 to 2 percent in 1978 in low-income countries, but this average is based on relatively few data points. In the same period, the ratio increased from 3 percent to 8 percent in India and from 4 percent to 11 percent in middle-income countries. Social Policy: The Case of Developing Countries 43 Public Expenditures on Health and Education Having examined the progress made in developing countries in health and education, public expenditures on health and education need next be considered. The data of Table I show central government expen- ditures to the exclusion of local and, in the case of federal states, state expenditures; moreover, private expenditures on health and education are not included. This fact reduces the comparabilitv of the data as the rela- tive importance of the central government in health and education varies from country to country. Nevertheless, thev provide an indication of trends over time. The data indicate that public expenditures on health have been stagnant in low-income countries, rarely exceeding 2 dollars per head in 1975 prices in the late seventies. And, while these expenditures have increased over time in middle-income countries, they have remained low compared to other forms of public spending and, in particular, defense expenditures. At the same time, questions have been raised concerning the efficiencv and the allocation of health expenditures. According to a World Bank report on health, "the present health policies are not only inefficient, but also inequitable in most developing countries. Large number of people living in the countryside or city slums are allowed to remain beyond the reach of the modern medical sector" [37:38]. In some countries as little as 10 percent of the population has access to modern health services; these services often do not meet mini- mum standards; curative care is emphasized while prevention and earlv treatment are neglected; and health services are not based or focused in the community. Improvements in the allocation of resources devoted to health could be made by giving greater emphasis to primary health care, involving community participation, combined with improvements in water supply and sanitation as well as improved nutrition. Primary health care, with its reliance on community health w\orkers who have had limited training, would need to be supported, however, by referral services (physicians and hospitals). Public expenditures on education increased more rapidly than GNP in the developing countries during the sixties, followed by stagnation in low- income countries and by further increases in middle-income countries. At the same time, in the allocation of these expenditures, there has been a tendency to favor secondary education and, in particular, higher education over primary education. In 1975, higher education with 3.0 percent of enrollment received 31.8 percent of the budget in the developing countries, Table I SOCi1a Indicators M fiddle- Industrial Industrial low Inicome Iniconme M1arket Non-Alarket Countries India Countries 1conomies Economies /960 1980 1960 1980 1960 1980 1960 1980 1960 1980 Healthb Indicators Life expectancy at hirth Years 4(0 48 43 *2 S1 6(0 70 74 68 71 Infanit niortalitv rate (age (0-1) percent 164 130 165 123 125 )80 30 11 36 25 Child mortaliti rate (age 1-4) percent 31 22 26 1, 23 11 2 1 2 1 Population per phvsicana thousand 34.9 21.2 4.9 3.6 16.9 5.8 0.8 (0.6 0.7 0.3 Population per mirsing person' thousand 9.9 6.1 11.) 5.7 2.9 1.2 (1.5 (.3 (0.4 0.2 Population with access to safe atcr' percent na 29 na 33 na 5() na na na iia Daily calorie supplv' pper head 2(019 2067 20)03 20)5(0 2392 2646 3142 3434 3261 3433 Daily protein stipplyc grams per head 5(1.75().6 5().8 49.8 62.8 67.8 90.4 99.1 94.5 100.9 Educational Indicators 1960 1979 1960 1979 1960 1979 1960 1979 1960 1979 Percentage of age group enrolled in priniary school percenit Total 3 64 61 78 76 97 114 1(02 101 1()/) Male 5() 77 8() 92 84 1()4 1(07 1(04 1()1 95 Female 24 4, 40 63 68 93 112 10)4 1()1 96 percentage of age group enrolled in secondarv school percent 6 17 20 27 1I 39 64 88 48 93 Percentage of age gro (210-24)' enrolled in higher C. iication percent 1 2 3 8 4 11 17 37 11 2() Adult literacv rate' percent 23 34 28 36 49 65 na 99 98 1()( Government Erpenditures 19,72 1979 1972 19,9 1972 1979 1972 1979 1972 1979 (in 1975 dollars) I lealth per head 2 2 na Ila 9 15 152 235 na na Education per head 3 3 na nia 21 35 8(1 1(19 na na Defense per head 6 7 na 4 26 39 3(01 283 na na Source: WNorld Banik, W1or/d Development Report, 1982, Washington, .. 1982 and \Xorldl Baiik economiiic and social data base. Notes: (a) D)ata refer to 1977 rather than 1980); exclides Bangradesh and, for nursing plrsonis, the oil-cxjiortitig iiiiddle-inconie countries. (b) Data refer to 1975. (c) D)ata refer to 1961 rather thanl 1960 and 1979 rather than 198(0. (d) D)ata retcr to 1978 rather than 1979. (e) I)ata refer to 1977 rather than 1979. Social Policy: 7he Case of Developing Coun,tries 45 on the average, while the corresponding figures were 21.9 percent and 27.0 percent for secondarv education and 75.1 percent and 41.2 percent for primarv education. D)eveloped countries devotcd the same share of educa- tional expenditure to higher education, although thev had a much higher proportion of students enrolled at this level [38: 103, 122-23]. T hese differences reflect considerable disparities in per capita spending on education at different levels. Thus, while the ratio of public spending per student in higher education to that in primary education averaged 19.4 in the developing countries in 1975, it w-as onlv 3.4 in the developed coun- tries. And, the ratio was the highest iin low-income countries, averaging 20.5 in countries with per capita incomes b)elow 265 dollars in 1975 [38: 69, 103, 122-23]. At the same time, in a sample of 30 developing countries, the social rate of return in primary education (24.2 percent) much exceeds that in secondarv (15.4 percent) and, to an even greater extent, in higher education (12.3 percent). The differences are greater than the average in low--incomc countries (27.3, 17.2, and 12.1 pcrcent), although considerable disparities are shown in middle-income countries (22.2, 14.3 and 12.4 percent) as well [39: 49]. Private returns, however, tencd to bc relatively high in secondary and, in particular, in higher education, reflecting in part the 'certification svndrome" that has led to increasingly high educational qualifications, hox- ever irrelevant to the job in question, and has contributed to rural-urban migration. Available evidence thus points to underinvestment in primary educa- tion as compared to post-primarv education in developing countries. '[he resulting welfare cost to the national economv has been estimated to varv between 0.4 percent (MNlexico) to 9.7 percent (Venezuela) of the gross do- mestic product in a study covering 17 countries [6:454]. At the same time, the qualitv of primary education would need to bc improved. According to a World Bank report on education, "inefficiencies keep both the number of students in school and the quality of education they receivc much beloxv what the available funds might permit. As a result, only half of those who enter primary school reach the fourth grade, repeaters occupy 15 percent to 20 percent of school places, and academic achievement is far below desired levels" [38: 22]. Improvements in basic educational opportunities are of particular im- portance in rural areas that are disadvantaged in terms of both the quantity and the quality of education. It would further appear desirable to promote technical and vocational education in secondarv schools and to foster on- the-job training. Finallv, on the post-secondarv level, there would be need for a change in emphasis to better conform to the needs of developing countries for technical and managerial expertise. 46 BELA BALASSA Investment in Human Capital and Economic Growth There have been a number of studies, utilizing Denison's growth ac- counting framework and Solow's production function approach, to estimate the contribution of investment in human capital to economic growth in the United States and in other developed countries. Furthermore, utilizing the production function approach, Anne Krueger concluded that "the differ- ence in human resources between the United States and the less-developed countries accounts for more of the difference in per capita income than all other factors combined" [14: 658]. The production function approach has been employed in several studies to estimate the contribution of investment in human capital to eco- nomic growth in developing countries. Hector Correa concluded that im- provements in health (measured in terms of reductions in death rates and in work-days lost) and nutrition (measured in terms of increases in calorie intake) added .12 to .93 percentage points, with a median of .43, and improvements in education (measured as the average level of education of the working force) added .05 to .53 percentage points, with a median of .20, to the rate of economic growth in nine Latin American countries during the 1950-62 period [5: 24-27]. In turn, in a cross-section analysis of 83 coun- tries, Norman Hicks estimated that a ten-year increase in life expectancy (taken as a measure of health) would raise per capita GDP growth rates by 1. 1 percentage points and that a 10 percentage point increase in literacy rates (taken as a measure of education) would raise per capita income growth rates by .3 percentage points, although the estimated effects of literacy rates are reduced if this is combined with life expectancy in the same equation [11: 21-22]. Finally, Havami and Ruttan found that differ- ences in educational levels explained 25 to 45 percent of the difference in agricultural labor productivity between the United States, on the one hand, and Colombia, Egypt, India, and the Philippines, on the other [9: 906]. The cited studies do not allow for the inverse relationship, i.e. the effects of economic growth on health and education. David Wheeler and Robin Marris set out to remedy this shortcoming bv the use of a simultane- ous equation framework in estimating a cross-sectional model for develop- ing countries. Wheeler performed a number of experiments utilizing data for 88 developing countries for the years 1960-70 and 1970-73, as well as pooled data for the entire period. In turn, Marris made estimates for 37 middle-income and for 29 low-income countries for the 1965-73 and the 1973--78 periods. Wheeler found that intercountry differences in nutrition levels (calorie intake) and in literacy rates significantlv affect differences in rates of eco- nomic growth. T his was not the case, however, for life expectancy that was Social Policy: The Case of Developing Countries 47 taken as a measure of health. The results were obtained by estimating production functions in the framework of "closed" and "open" economy models, with the latter including an export growth variable. The educa- tional variable was statistically significant at the 5 percent level in all the variants and the regression coefficients, indicating the effects of a one per- cent change in adult literacy rates on the rate of economic growth, were in the .008 to .016 range. In turn, a one percentage point difference in calorie intake was associated with intercountry differences in GDP growth rates ranging from .56 to 1.01 percentage points in the closed economy regres- sions, statistically significant at the 5 percent level; apart from the 1960-70 period, where the regression coefficient was 1.52, the coefficients were not significant in the open economy model, however [35: 19-20, 31-32]. Marris found that intercountry differences in primary education enroll- ment ratios significantly affect the rate of growth of per capita incomes and that increases in life expectancy and faLmily planning efforts have such an impact through reductions in the rate of growth of population [20: 28-33]. The results were obtained in a production function framework that also comprised exports and investment as variables; a variable for nutrition was not included. Marris' estimates for the two groups of countries and for the two periods were generally similar. A one percentage point difference in pri- marv school enrollment ratios was found to be associated with intercountry differences in per capita income growth rates of approximately .035 per- centage points, the exception being low-income countries in the 1973-79 period where the coefficient was .014; in turn, the coefficients for life expectancy and family planning varied over a wide range [20: 40]. MIarris also estimated benefit-cost ratios from his model, defining ben- efits as the gain in per capita incomes and costs as the income loss associated with the use of resources in the particular activity. In the 1965-73 and 1973-79 periods, benefit-cost ratios for primary education enrollment were 7.4 and 6.4 in middle-income countries, compared with 7.1 and 3.4 in low-income countries; the corresponding results for family planning were 5.6 and 1.2 in middle income countriles and 0.9 and 0.3 in low-income countries for apart from a ratio of 0.9 for middle-income countries in the 1965-73 period, they were practically nil for life expectancy. By compari- son, benefit-cost ratios for physical investment were 1.0 and 0.4 in middle- income and low-income countries, respectively, in 1965-73; they were 0.7 in low-income countries in 1973-79, for which comparable estimates in middle-income countries are not available [20: 42]. The estimates for primary education generally conform to the social return calculations made in a partial equilibrium framework that were cited earlier. They point to the desirability of increasing expenditures on primary education not only within the educational budget but also vis-a-vis invest- 48 BELA BALASSA ment in physical capital. It should be added, however, the simulations made by Wheeler did not give similarly strong results [35: 72]. While estimation in a simultaneous equation framework represents an important advance over single-equation estimation, problems remain with the definition of the variables utilized for health, nutrition, and education that can only approximate investments in human capital. George Psacha- ropoulos put forth several reasons for which the effects of education on economic growth would be underestimated, emphasizing in particular the importance of maintenance expenditures [26]. II. Social Policies and Economic Efficiency Social Security Systems Social security systems in deve loping countries generally rely on em- ployer and employee contributions to finance old-age pensions, health care, maternity benefits, and family allowances; there are practically no unem- ployment compensation schemes in these countries. The question arises if the linancing of social securitv schemes from emplover and employee con- tributions introduces distortions in labor markets. In an early discussion of economic integration, the author suggested that "under perfect price and wage mobility, any increase in social changes would be shifted to the wage earners if they regarded the corresponding social benefits as part of their earnings" [1:218-19]. The latter assumption was tested in the United States, where it was found that the elasticitv of substitution was 7.7 be- tween wages and non-wage benefits but only 1.6 between wages and health insurance benefits alone [36: 178]. I lowever, the stated assumptions are much less likely to be fulfilled in developing countries than in developed countries [30: 118]. In fact, in coun- tries where the supply of labor is infinitelv elastic in terms of the real wage (excluding social benefits), social charges will increase the cost of labor bv their full amount, irrespective of whether they are paid by employers or employees, with adverse effects on employment. And while this may be a rather extreme case, according to Carmelo Mesa-Lago "accumulated evi- dence in Latin America . . . indicates that social securitv systems financed by contributions upon wages have a negative effect on emplovment" [2 3: 16]. 'thus, it would appcar that social securitv schemes in developing coun- tries distort labor markets by raising the cost of labor, where the extent of the distortion will depend on the ratio of social charges to wage payments. Data collected bv the U.S. D)epartment of Health and Human Services Social Policy: The Case of Developing Countries 49 Social Security Administration shows social charges to exceed 20 percent of wages in India and to range betw,een 15 and 45 percent in most lIatin American countries [33]. Carmelo MNesa-Lago further reports that employer and emplovee contributions, taken together, were in the 55-65 percent range for blue- and white-collar workers in industrv and commerce in 1969 in Uruguav; the ratio reached 46 percent for blue-collar workers and 65 percent for white-collar workers in 1968 in Chile that, however, subse- quently privatized its social security system [22: 50, 96]. Alinimum Wage Legislation ILabor costs mav also be raised bv ithe statutorv determination of mini- mum wages. In this connection, one needs to consider the extent to which raising minimum wvages leads to increases in the entire wage structure as well as the effects of the resulting -,vage increases on employment. The classic study of the effects of minimum wvage legislation on wages and employment is Wages, ProductivitY, and Industrialization in Puertr. Rico bv Llovd Revnolds and Peter Gregorv. The authors notc that "the closeness of actual hourly earnings in most industries to the legal minimum, the parallel- ism in the timing of upwvard movements, and the tendencv for the mini- mum to encroach gradually on the actual earnings level all suggest that it is minimum wage awards which have been forcing the pace of Nwage advance in Puerto Rico since 1950" [27: 60]. On the basis of an econometric esti- mate, thev further conclude that "a change in the wage could be expected to be associated with an approximately equal proportionate change in employ- ment in the reverse direction, with the wvage bill remaining roughly con- stant" [27: 100]. It has been suggested that Puerto Rico is a special case because of its close association with the United States and its superior administrative machinerv [34: 347], as well as because of its relatively high per capita income, its small labor force, and the high share of the labor force engaged in non-agricultural occupations in the mid-fifties [30: 111]. 1lowvever, one mav doubt the relevance for the problem at hand of Puerto Rico's associa- tion with the United States and the superior skills of its administration. Also, there were a number of developing countries with urban incomes exceeding that of Puerto Rico in the earlv fifties wvhen minimum wvage legislation wvas introduced there, and rnore countries have since surpassed this level. Finally, the size of the labor force is of little importance for the effectiveness of minimum wage legislation. In fact, according to an ILO report, "the evidence . . . suggests that conditions in which increases in minimnum wages exert a substantial influ- 50 BELA BALASSA ence on wages actually paid are widelv encountered. This influence is particularly strong where minimum rates are the going rates for large num- bers of workers, which seems to be the case in most African and in many other (but not all) developing countries" [12: 19]. And, while the evidence provided on this point in a subsequent ILO report is inconclusive [31: 160- 84], it should be recognized that minimum wage legislation mav have ad- verse economic effects even if it does not lead to proportionate increases in the wage structure. To begin with, the narrowing of wage differences will discourage socially profitable investments in human capital as incentives for such investment are reduced. Also, distortions are introduced in the choice between labor and physical capital, between unskilled labor and skilled labor, as well as between labor in the formal sector and the informal sector, where minimum wage regulations are rarely applied. There is evidence on the effects of minimum wage legislation in several countries. In Argentina, minimum wage legislation is reported to have increased unskilled wages by 25 percent [17: 131]. In the Ivory Coast, a 20 percent increase in the wages of unskilled labor through minimum wage legislation is said to have led to a commensurate decline in employment [24: 273-74]. Finally, in Canada the rate of unemployment is show n to have increased in the same proportion as the minimum wage [28: 97]. This is not to say that minimum wage legislation would have had a pervasive influence in developing countries. In some countries, such as Brazil, its effects have been largelv eroded by inflation [17: 132]. By con- trast, minimum wages are particularly high in socialist-oriented countries [34: 354]. Thus, The Economist (April 30, 1983) reports in regard to 'I anzania that "in the towns minimum wages in some industries were set three times as high as India's, whose labor productivity was three times higher." According to a recent ILO report, "the problem [of setting minimum wages] is essentially viewed as one of striking a balance between the social gains to be made, in the form of improvement in the relative wage position of the lowest paid, and any costs these might entail in the form of reduced employment, slower growth and increased inflation" [31: 153]. An attempt to measure these effects has been made in the United States. It has been found that the income distributional effects of minimum wage legislation are very weak and "even if the elasticity of demand for low-wage labor is as low as 0.2, the reduction in national income is as large as the entire gain to the lower half of the income distribution when marginal taxation effects are ignored, and the reduction in national income is about twice as large as the net gain to the lower half of the income distribution when they are incorpo- rated" [13: 211]. Also, to the extent that minimum w age legislation benefits a privileged urban labor group, the social gains themselves mav be open to question. According to one observer, "this is directly contrary to the initial objective of minimum wage legislation, i.e. the protection of unorganized Social Policy: The Case of Developin,g Countries 51 workers whose wages are exceptionally low" [34: 356]. Yet, as noted in an ILO report, "for Latin America it has been estimated that 80 percent of the urban workers receiving incomes belowx the legal minimum wage belong to the informal sector" and "the enforcement of minimum wvages in developing countries encounters its most serious obstacles in traditional agriculture, outside the larger plantations and modernized farms" [31:140]. Labor Policy Another important channel througlh which the government mav affect the wage structure is public sector emplovment and wages. fIeller and 'ait have found that in thirty-eight developing countries, on the average, public jobs account for 44 percent of nonagricultural employment. This ratio is inversely correlated with per capita incomes in the countries of the sample; regional averages are 59 percent in Africa, 36 percent in Asia, 27 percent in Latin America, compared with 24 percent in the developed countries. Also, the ratio tends to be higher in the countries that, at one time or another, adopted a socialist orientation; it is 87 percent in Benin, 81 percent in Zambia, 78 percent in Tanzania, 72 percent in India and 74 percent in Ghana [10: 7, 42-43]. As the authors suggest, "the clear message from these statistics is the significant impact that government policy on wages and salaries is likely to have on the overall remuneration of employees in the nonagricultural sector in developing countries" [10: 7]. In this connection, note that the ratio of the average central government wage to GDP per capita is inversely corre- lated with per capita incomes; it is 6.05 in Africa, 2.90 in Asia, 2.94 in Latin America, and 1.74 in the developed countries [10:18]. According to the same authors, "this situation is not necessarilv sur- prising, as, in poorer countries, the educational requirements of public sector employment are often much higher than that of private sector em- ployment" [10: 18]. Differences in educational requirements provide only a partial explanation for public-private wage differentials, however. For example, in 1971, average wages were 16 percent higher in the govern- ment and 23 percent higher in parastatals than in ihe private sector in Tanzania, if adjustment is made for differences in occupational composi- tion. Moreover, the scope of fringe benefits wXas considerablI greater in the government and in parastatals than in the private sector [19: 141-43]. Available information indicates that fringe benefits are more prevalent in the public than in the private sector in other developing countries as well. WN'ages in the public sector exceed wages in the plrivate sector at lower, 52 BELA BALASSA although not at higher, levels of education in Brazil, Colombia, G(rece, Malavsia, and Portugal. In contributing to higher wages for the Icss-edu- cate(d worker, public sector vwage policics tend to compress the wage distri- bution, thereby creating distortions in rcsource allocation as noted above. Distortions are created also between the private and the public sectors as rates of return to education are generally higher in the former than in the latter [25]. Finallv, it has been reported that in P'akistan increascs in pul)lic w ages spilled over to the private scctor [8: 325-26]. Labor costs mav also be raised by labor legislation aiimed at reducing unemployment in the form of redundancy payments or outright prohilbi- tions of discharging workers. Redundancy payments are extensively used in the Southern countries of Latin America where they may exceed twelve months of pav; Turkev is a recent example of prohibiting the (dismissal of workers. 'I'hc effects of these schcmes havc been analysed bv Laidler w,vho note(d that, apart from creating inefficiencies, redundancI schemes may increase rather than reduce unemployment: -They (discourage w orkers from (qu itting voluntarily to search for other employment. -They make it expensive for an otherwise viable firm to close down a particu- lar loss-making operation -Moreover, thev inhibit employers from taking on new\ workers because of the prospective cost of declaring them redundant at some time in the future. Such schemes inhibit resource mobility, sloA down the pace of economic change, and increase unenmployment. 'I'hey do not serve simply to redistribute wAealth, but to reduce the total amount of wcalth available foir redistribution [18: 81]. Finally, labor costs may be raised by the high taxation of wage in- comes as labor attempts to shift income taxes to the entrepreneur. An extreme case w as provided by Turkey in 1980, when minimum wage income was subject to a tax of 28 percent. Under the nev,- schedule introduced on January 1, 1981, the minimum wvage is not subject to tax but the marginal tax rate is 40 percent on incomes immediately above this level. In turn, the marginal tax rate is 75 percent on incomes in the 75- 100 thousand dollar range [3: 177-79]. All in all, social securitv schemes, minimum wage legislation, wvage determination in the public sector, and labor legislation tend to raisc wages in developing countries, contributing to losses in efficiencv and in emplov- ment. Additional distortions are created through differences in labor costs between the formal and informal sectors, owing to the fact that thesc schemes are rarelv applied, or are evaded, in the informal sector. Social Policy: The Case of I)ev'eloping Countries 53 Distortions in Wage/Rental Ratios Wk'hile policv-imposed labor market distortions tend to increase the cost of labor, government policies also tend to reduce capital costs in the devel- oping countries. 'I'he price of capital may be lowered as a result of credit policies, wA-ith the government setting interest rates at levels where these are negative in real terms or are below equilibrium levels; through tax policies, involving accelerated depreciation pro\isions and tax holidavs; as well as through trade policies, entailing the overvaluation of the exchange rate and lowver than average tariffs on capital goods. 'I'he results of a comparative studs directed by Anne Krueger show that policy-imposed distortions in wage/rental ratios are the largest in coun- tries pursuing import substitution-oriented policies; followved bv countries that have reduced but not climinated the bias against exports; while thev are negligible in export-oricnted ccononies. In the years 1968 to 1973 (1961-66 for Pakistan), these distortions were estimated to have raised the wage/rental ratio by 316 percent in Pakistan, 87 percent in 'I'unisia, 45 percent in the Ivorv Coast, 38 percent in Argentina, 31 percent in Brazil, 11 percent in Korea, and nil in Hong Kong [17: 150]. 'I'he data refer to manufacturing industries in the formal sector; comparable data on differ- ences between the formal and informal sectors in the individual countries are not available. In the Krueger project, estimates were made of the employment effects of eliminating distortions in w-age/rental ratios, due to policy-imposed factor market distortions as well as the lowering of the cost of capital through trade policy. T'he estimates incorporate elasticities of substitution betwveen labor and capital clustering around I that have been derived by Jere Bchr- man on the basis of 1723 observations from twentv-seven three-digit indus- tries of seventy countries for the 1967-73 period [4: 186]. TI'he results for the individual countries are: Argentina, 16-25 percent and -6 percent; Brazil, 15 percent and n.a.; Chile n.a. and 7 percent; Ivorv Coast 25 percent and nil; Pakistan 2711 percent and nil; Korea 8 and nil; and 'I'unisia 17 percent and 38 percent [17: 178-79]. 'I'he estimates shoxv in- creases in labor input coefficients in the event that average distortions in wage/rental ratios in the manufacturing sector are eliminated. They do not, however, take account of the employment cffects of factor market distor- tions wvithin the manufacturing sector or between manufacturing and pri- mary activities. I'he employment effects of eliminating interindustry differences in protection rates among import-substituiting and among export industries in the manufacturing sector were also estimated. In the first case, labor input 54 BELA BALASSA coefficients would rise by 66 percent in Indonesia, 51 percent in 'I'unisia, 12 percent in the Ivorv Coast, and 10 percent in Colombia; in the second case, gains in emplovment would be 60 percent in Chile and 24 percent in Colombia [17: 178-79]. In turn, estimates of the efficiency gains obtainable through the elimi- nation of policy imposed distortions in wage/rental ratios were made in several studies. For Colombia, Dougherty and Selowsky estimated these losses to be no more than one or two percent of GNP in a partial equilib- rium framework [7: 398]. However, also for Colombia, Jaime de Melo obtained estimates of 5.7 percent of GNP with capital immobile, and 13.3 percent of GNP with capital mobile, in a general equilibrium framework, which allows for interactions of product and factor markets as well as for sectoral interdependence [21: 402]. Finally, Moshe Syrquin estimated the cost of misallocation of labor and capital due to distortions in the markets for these factors at 15.5 percent of output in the Mexican manufacturing sector [32: 664]. These estimates pertain to efficiency losses associated with interindus- try differences in factor rewards within the manufacturing sector, but do not differentiate between policy-imposed and endogenous distortions in fac- tor markets. At the same time, in interpreting the estimates, reference may be made to results obtained by Paul Schultz who found factor rewards to be higher in protected than in unprotected industries in Colombia [29]. The resulting distortions in wage/rental ratios are additional to those resulting from overvalued exchange rates, lower than average tariffs on capital goods, and the variability of tariffs among import-substituting and among export industries. Trade policies further affect employment and the efficiency of resource allocation through the incentives they provide to exports as against import substitution. On the whole, developing countries have a comparative ad- vantage in labor-intensive sectors, so that the protection of capital-intensive sectors will give rise to losses in employment and in allocative efficiency [2: 10361. TI'hese considerations indicate the interdependence of distortions in fac- tor and in product markets. In turn, simultaneously removing distortions in factor and in product markets will reinforce the effects of each, taken sepa- rately. For example, the favorable impact of trade liberalization will be enhanced if capital markets are liberalized so that capital can flow to the sectors in which the country has a comparative advantage. Reducing distortions in factor and in product markets would have budgetary repercussions, however. While the proposed changes in regard to labor and capital tend to be mutually offsetting, as taxes would be reduced on labor and increased in capital, lowering protection would decrease fiscal Social Policy: The Case of Developing Countries 55 revenues. The resulting loss in revenues would need to be offset by taxes that minimize distortions, such as a value-added tax. Summary and Conclusions This paper has examined the progress made in health and education in developing countries during the last two decades. It has further indicated that a more rational allocation of expenditures would bring further improve- ments !ri the future. At the same time, investment in human capital in the form of improvements in health and education has been shown to contrib- ute to economic growth. I The paper has further considered the employment and the efficiency effects of social policies. It appears that social security schemes, minimum wage legislation, wage determination in the public sector, labor legislation, and the taxation of labor incomes have increased the cost of labor in the formal sector of developing countries. At the same time, policy-imposed distortions in capital markets have reduced the cost of capital, thereby further raising wage/rental ratios. The rise of wage/rental ratios, in turn, has tended to discourage em- ployment in the formal sector and has created distortions in the allocation of resources. Employment has also been a(iversely affected by protection that has further reduced the cost of capital and has generally favored capital- intensive industries. At the same time, distortions in product and factor markets are interrelated, and removing these distortions simultaneously would reinforce the effects of each. Notes 1. The author is indebted to Peter HIeller, C.eorge Psacharopoulos, Richard Sabot, Vito Tanzi, and .Manuel Zymelman for helpful comments. However, the author alone is responsi- ble for the contents of the paper that should not be interpreted to reflect the views of the World Bank. 2. Following World Development Report, 1982, low-income countries have been defined as countries having per capita income of $410 or less and middle-income countries as having per capita income in the $420-$4500 range in 1980 [40: 110].-The averages have been calculated weighting individual country observations by population. In view, of its size, the results for India, that would otherwise be included in the IVw income group, are shown separatelv in Table 1. For comparability, the table also provides information on industrial market economies and on industrial non-market (socialist) economies. It excludes China, for which 1960 data in most instances are not available. 56 BELA BALASSA References 1. 1alassa, Bela, The Theory of Fconomic Integration, Homewood, Ill. Richard D. Irwin, 1961. 2. Balassa, Bela, "I)isequilibrium Analysis in Developing Economies: An Overview," World Development, 10, I)ecember 1982: 1027-38. 3. Balassa, Bela, et al., Turkey: Industrialization and Trade Strategy A World Bank Coun- try Study, Washington, D.C., World Bank, 1982. 4. Behrman, Jere B., "Country and Sectoral \Variations in Manufacturing Elasticities of Substitution Between Capital and Labor," chapter 4 in KRUEGER [16]: 159-92. 5. -orrea. lIector, "Sources of Economic Growth in Latin America," Southern E.conomic Journzal, 37, Julj 1970: 17-31. 6. D)ougherty, Christopher and Psacharopoulos, George, "Measuring the Cost of Misal- location of Investment in lEducation," Journal of'Human Resources, 12, Fall 1977, 446-59. 7. [)ougherty, Christopher and Selo. sky, Marcelo, "Measuring the Effects of the Misal- Ilocation of Labor," Review of Economics and Statistics, 55, August 1973: 386-90. 8. (iuisinger, Stephen, with the assistance of Irfan, Mohammad, "Trade Policies and Emplo\yment: The Case of Pakistan," chapter 7 in Krueger, Lary, Monson, and Akrasanee [15j: 291-340. 9. Hlavami, V ujiro and Ruttan, Vernon IN'., "Agricultural Productivity I)ifferences Among Countries," American Fconomic Review, 61), December, 1970: 895-911. 10. lIeller, Peter S. and Tait, Alan A., "Government Employment and Pav: Some International Comparisonis," International Monetary F und, Occasional Paper 24, October 1981. 11. I licks, N-ornian, "Economic Growth and Human Resources," World Bank Staff Working Paper No. 408, Washington, I).C., July 1980. 12. International Labour Office, 4Minimum W age Fixing and Economic Development, Geneva, 1968. 13. Johnson, William R., and Browvning, Edgar K., "'IThe D)istributional and Efficiencv Effects of Increasing the Minimum Wage: A Simulation," American Economic Review, 73, March 1983: 204-11. 14. Krueger, Anne O., "Factor Endowments and Per Capita Income Differences Among Countries,' EconomicJournal, 78, September 1968: 641-59. 1 5. Krueger, Anne O., Lary, FHal B., .Xlonson, Terry, and Akrasanee, Narongchai, Trade and Employment in Developing Countries 1. Individual Studies, Chicago, The University of Chicago Press, 1981. 16. Krueger, Anne O., Trade and Employment in Developing Countries 2. Factor Supply and Substitution, Chicago, University of Chicago Press, 1982. 17. 7Krueger, Anne 0., 7rade and Emplo'ment in Developing Countries 3. Svnthesis and Con- cluisions, Chicago, The University of Chicago Press, 1983. 18. 1Laidler, I)avid, "Entrepreneurship and Labour Market Mobility, " in Growzth and En- trepreneurship: Opportunities and Challenges in a ('hanging World, Paris, International Chamber of (Commerce, 1981: 73-88. 19. Lindauer, I)avid 1. and Sabot, Richard 11., "The Public/Private Wage Differential in a Poor Urbani Economy," Journal of Development Fconomics, 12, February-April 1983: 137-52. 20. Marris, Robin, "Economic Growth in Cross Section. Experiments with Real Product I)ata, Social Indicators, Model Selection Procedures, and Policv Benefit/Cost Analvsis," Wash- ington, D.C., World Bank, April 1982 (mimeo). 21 ..Melo, Jaime de, "I)istortions in the Factor Mlarket: Some General Equilibrium Esti- mates," Review of Fconomics and Statistics, 59, November 1977: 398-405. 22. \Iesa-L[ago, (armelo, Social Security in Latin America. Pressure Groups, Stratification and Inequality, Pittsburgh, Unixversity of Pittsburgh Press, 1978. 23. Mesa-Lago, (armelo, "Social Security and Extreme Poverty in Latin America,"Jour- nal of Development Economics, 12, February 1983: 1-28. Social Policy: I'he ('Cse of D)eveloping Couintries 57 24. Monson, JIerry, "'Itrade Strategies and Enmployment in the Ivorv Coast," chapter 6 in Krrueger, ILarN , Monson, andi Akrasanee [1 5]:2 39-9(J. 25. Psacharopoulos, George, "Education and Private versuis Public Sectir Pay," Labour and Society, 8, April-June 1983: 12 3-34. 26. Poacharopoulos, George, "'Fhe Contributirin of Edducation to Economic (irowth: In- ternatiunal Comparisons," in International Productivist Comparisons (J. Kendrick, ed.), *W'ashing- ton, D).(., American Enterprise Institute for Public PolicN Research, 1983. 27. Rcynolds, .loyd G. and Gregory, Peter, l4'a,4es, Productivity and Industrialization in Puerto Rico, flomexood, 111. Richard 1). Irwin, 1965. 28. Schaafsnia, Joseph and WValsh, William D., " Emplovment andl Labor Supplv Effects of the -Minimum Wage: Some Pooled ]'ime-Series Estimates from Canadian Provincial Data," Canadian journal of Economics, 16. Februarv 1983: 86-97. 29. SchultZ, T. Paul, "Effectivc Protection and the l)istribution of Personal Income by Sector in Colombia," chapter 2 in Krrueger 11 11 S 3 -148. 30. Stiuire, Lvyn, E.mployment Policy in D)e'elopi,sg (jountries-. Survey of Issues and Evidence, A World Bank Research Publication, Newk Y'ork, Oxford Universitv Press, 1981. 31. Starr, (icrald, .Mlinimum Wlae Fixing, (Gcncva, International Labosur Office, 1981. 32. SyriqUin, Mloshe, "Fifficicnt Inpuit Frontiers for Manufacturing Sector in Mexico, 1965-1986," International Lconomic Review, 14, October 1)73: 657-7S. 33. Unitedi States )epartmcnt of I lealth and I lumani Services, Social Securitv Adinirrs- tration, Social SecurityPro)grams Throughout the llorhl 19YI, Research Report No. 58, Washing- ton, I).C. 1982. 34. Watanebe, Stisiniti, '\linintim \Wages in Ie)veloping Coountrics: XyNth andt Realitv," International labour Re- ie-, 113, May-June 1976: 345-57. 35. lWhecier, I)avid". Ihtimiani Resotirce )Declopment and Economic (rosth in )eselop- ing Coountries: A Simtiltaneoois Model," World B3anik Staff Working Paper No. 40)7, Washing- ton, D).C., July 1981). 36. Woodhur\, Stephen .\., "SubStitution bctwvcn W'age and Nonxwage Benefits," .lmerican Lconsmic Review, 7 3, March 1983: 166--82. 37. World Bank, Ilealth Sector PolicV Paper. W\ashington, D.C., Feblruary lJi80( 38. W\orld Bank, Education Sector Policy Paper, Washington, ).C ., pril 198(i. 39. World Bank, lW'orld ekvelopment Report, 199O. WN ashington, ).C., August 1980. 41). World Bank, lWorld Development Report, 1982, Washington, ).C. August 1982. Rjsitme (ct article ttucdic lcs progres accornplis au cours des deux dernieres decennies par les pays en cdveloppemrent dans les domaines dc la sante et de l'education. 11 exprime par ailleurs l'idee qu'une repartition plus rationnelle des d6penses conduirait a de nouveaux progr6s dans l'avcnir. En mcmc temps, il montrc qu'un investissement en capital humain, prenant la forme d'am6liorations dans Ies domaincs dc la santc et dc l'ducation, contribuc a la croissance economique. L'articlc examine aussi ]es effets de mesures sociales sur l'cmploi ct l'efficience de l'economie. 11 semble que les svstemes de securit6 sociale, la legislation sLir la salaire minimumn, la determination des traitements dans le secteur public, le droit diu travail ct la fiscalit6 des revenus tires du travail ont augmente le cout de la main d'oeuvre dans le secteur formel des econo- 58 BELA BALASSA mies en developpement. Simultanement, des distorsions dans les marches financiers, dues a la politique economique, ont diminue le couit du capital. En consequence, le rapport salaire/cout du capital a augmente. Cette hausse du rapport salaire/couit du capital a contribue a defavoriser l'emnploi dans le secteur formel et a cree des distorsions dans l'affectation des ressources. Le protectionnisme, qui a encore diminue le cout du capital et qui a g6neralement encourage les activites a forte intensite capitalistique, a egalement eu des effets defavorables sur 1'emploi. En outre, les distorsions sur les marches des produits et des facteurs se conjuguent, si bien qu'une suppression simultanee de ces distorsions ameliorerait I'efficacite de chacun de ces marches. THE WORLD BANK Headquaqrters 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. 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