# **5.2 Drivers of Aggregate Productivity Growth**

## **5.2.1 Labor Regulation**

<mark>Aggregate productivity growth in Ecuador can be partially attributed to the distortionary impact of labor market policy. Labor regulations in Ecuador impose high mandated labor costs on firms. Ecuadorian firms’ labor costs encompass not only salaries but also various other expenses, such as mandatory employment</mark> allowances<sup>23</sup> , compulsory worker participation in firm dividends<sup>24</sup> , additional obligatory services like childcare for larger firms, and high firing compensation packages<sup>25</sup> . These mandated labor costs are an <mark>excessive burden for firms. For example, severance pay and firing costs in Ecuador are higher relative to</mark> most of its South American peers, as illustrated in Figure A 4.<sup>26</sup> Additionally, as estimated by Grosh et al. <mark>(2014), mandatory employment allowances can increase costs by up to 25 percent for firms. Minimum wage policy also places a burden on firms, with Ecuador's minimum wage-to-GDP per capita ratio higher</mark> than most South American countries (Figure A 5).<sup>27</sup> Hence, the combination of these distortionary labor <mark>regulations results in a highly inflexible labor market and significantly impacts allocative efficiency.</mark> Differences in labor costs by firm size, age, and productivity indicate why the contributions of the between component negatively impact aggregate productivity growth. The top-left panel of <mark>Figure 8</mark> illustrates that larger firms report higher total labor costs per worker.<sup>28</sup> The top right panel of <mark>Figure 8</mark> indicates that this relationship persists even when examining firms’ labor costs per worker net of wages, i.e., non-wage labor costs per worker.<sup>29</sup> After controlling for firm age and revenue productivity, large firms report total labor costs per worker and non-wage labor costs per worker that are 1.6 and 1.5 times higher than micro firms, respectively. Non-wage labor costs are expenses associated with Ecuadorian regulations that impose additional costs on firms, such as compulsory allowances and workers’ participation in firm dividends. One plausible explanation for these findings is that large firms are more likely to be under scrutiny by the government to comply with the costs arising from these labor regulations. Additionally, certain obligatory services are tied to workforce size, such as the requirement for firms with 50 or more workers to provide child daycare services.

The middle panels of <mark>Figure 8</mark> further reveal that total and non-wage labor costs per worker increase as firms age. In particular, older firms have total labor costs per worker that are 1.2 times higher than micro enterprises and non-wage labor costs per worker that are 1.1 times higher. This can be linked to distortionary labor frictions that discourage employee churning, resulting in an aging labor force within firms and higher costs associated with longer job tenure, as compulsory allowances directly increase with salary increments over a worker’s job tenure. Also, the right panel of Figure A 4 illustrates that severance payments increase with job tenure, suggesting that older firms with older labor forces would face higher severance costs if they were to lay off workers. In turn, this encourages older firms to retain their labor force despite being less productive. Furthermore, the bottom panels of <mark>Figure 8</mark> demonstrate that more productive firms face

> 23 Ecuadorian formal firms are legally obliged to pay three compulsory allowances for each worker. The “thirteenth salary” allowance is equal to a worker’s monthly salary and paid to all workers during Christmas time (December). The “fourteenth salary” allowance is equal to a minimum wage payment that is paid to all workers before the school year begins (August/September). Lastly, the “unemployment reserve funds” allowance is paid monthly to every worker and equals 8.3 percent of each worker’s salary.

> 24 According to Article 97 of Ecuador’s Employment Regulation, firms are obliged to share 15 percent of their profits with their labor force.

> 25 According to Article 188 of Ecuador’s Employment Regulation, a worker that is fired and has been employed less than three years will receive firing compensation equivalent to three months’ salary. A worker that is fired and has been employed more than three years will receive firing compensation equivalent to the number of years worked in the company times their monthly salary (up until 25 monthly salaries).

> 26 Bolivia and the República Bolivariana de Venezuela are excluded as data is not reported withing the World Bank’s _Employing Workers_ Database.

> 27 Chile and the República Bolivariana de Venezuela are excluded as data on minimum wages is not available in the ILO’s Global Wage Report 2020 – 2021.

> 28 For this estimation, firms’ total labor costs consist of wages plus social security contributions, severance pay costs, mandatory compulsory allowances (i.e., “thirteenth” salary, “fourteenth” salaries, unemployment reserve fund), compulsory worker participation in firms’ dividends, and other remunerations (i.e., transportation, commissions, bonuses, childcare).

> 29 For this estimation, firms’ non-wage labor costs include mandatory compulsory allowances (i.e., “thirteenth” salary, “fourteenth” salaries, unemployment reserve fund), compulsory worker participation in firms’ dividends, and other remunerations (i.e., transportation, commissions, bonuses, childcare). It is important to caveat that it is not possible to include firing costs into the non-wage labor cost measure as the data sources used do not allow for this.

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