metadata: authors: 0: author: Agenor,Pierre-Richard
count: World
docna: 0: docna: The mini-integrated macroeconomic model for
            poverty analysis : a framework for analyzing the
            unemployment and poverty effects of fiscal and labor market reforms
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Environmental Economics & Policies,Labor Policies,Banks & Banking Reform,Public Health Promotion,Health Economics & Finance,Inequality
teratopic: Health, Nutrition and Population,Finance and Financial Sector Development,Poverty Reduction,Environment,Social Protections and Labor,Macroeconomics and Economic Growth
abstracts: cdata!: The author describes a specialized and
            less data-intensive version of the Integrated Macroeconomic
            Model for Poverty Analysis (IMMPA) developed by Ag�or,
            Izquierdo, and Fofack (2003) and Ag�or, Fernandes, Haddad,
            and van der Mensbrugghe (2002). The mini-IMMPA focuses only
            on the "real" side but it offers a more detailed
            treatment of the labor market (by accounting, for instance,
            for public education, employment subsidies, and job security
            provisions) and the tax structure. Simulations of a cut in
            payroll taxes on unskilled labor show the importance of
            accounting for the fiscal implications of labor market
            reforms when assessing their effects on unemployment and poverty.
repnme: repnme: The mini-integrated macroeconomic model for
            poverty analysis : a framework for analyzing the
            unemployment and poverty effects of fiscal and labor market reforms
display_title: The mini-integrated macroeconomic
            model for poverty analysis : a framework for analyzing the
            unemployment and poverty effects of fiscal and labor market reforms
listing_relative_url: /research/2003/05/2378825/mini-integrated-macroeconomic-model-poverty-analysis-framework-analyzing-unemployment-poverty-effects-fiscal-labor-market-reforms
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Health, Nutrition and Population,Finance and Financial Sector Development,Poverty Reduction,Environment,Social Protections and Labor,Macroeconomics and Economic Growth
origu: World Bank Institute (WBI)
no_of_pages: 88
author_keys: 0: author_key: 177753
model_extractions: [ POLICY RESEARCH WORKING PAPER 3067 Ag6nor describes a specialized and less data-intensive version of the Integrated Macroeconomic Model for Poverty Analysis (IMMPA) developed by Agenor, Izquierdo, and Fofack (2003) and Agenor, Fernandes, Haddad, and van der Mensbrugghe (2002). The miniIMMPA focuses only on the "real" side but it offers a more detailed treatment of the labor market (by accounting, for instance, for public education, employment subsidies, and job security provisions) and the tax structure. Simulations of a cut **in** payroll taxes on unskilled labor show the importance of accounting for the fiscal implications of labor market reforms when assessing their effects on unemployment and poverty.

> This paper-a product of the Poverty Reduction and Economic Management Division, World Bank Institute-is part of a larger effort in the institute to analyze the interactions between micro and macro factors in the design of poverty reduction strategies. Copies of the paper are available free from the World Bank, 1818 H StreetNW, Washington, DC 20433. Please contact Maria Gosiengfiao, room J4-280, telephone 202-473-3363, fax 202-676-9810, email address mgostengfiao@worldbank.org. Policy Research Worlcing Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at pagenor@worldbank.org. May 2003. (82 pages)

_The Policy Research Working Paper Senes disseminates the findings of work in progress to encourage the cxchange of ideas about development issues. An objective of the senes_ **_is_** _to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and shozsld be cited accordingly. The_ **_findings,_** _interpretations, and conch!Siso;s expressed in this paper are entirely those of the authors. They do not necessarily represent the viewv of the World Bank,_ **_its_** _ErXccutive Directors, or the countries they represent._ Produced by Partnerships, Capacity Building, and Outreach
The lJni-Integrated Macroeconomic Model for Poverty Analysis A FRamework for Analyzing the Unemployment and Poverty Effects of Fiscal and Labor Market Reforms Pierre-Richard Agenor* The World Bank, Washington DC 20433 JEL **Classification Numbers:** C68, D58, 011

*This paper is part of my ongoing research program on micro-macro linkages for poverty analysis. I am grateful to Dennis Snower for drawing my attention to some of the recent work on firing costs, and to Nihal Bayraktar, Michael Grimm, and Henning Jensen for excellent technical advice and assistance.
|**Con**|**tents**|
|---|---|
|**1Int**|**roduction**<br>**3**|
|**2Str**|**uctureofMini-IMMPA**<br>5|
|2.1|Production<br>......................<br>.<br>5|
||2.1.1<br>RuralProduction.....................<br>5|
||2.1.2<br>UrbanInformalProduction.....<br>. . . . . . . . .<br>.<br>6|
||2.1.3<br>UrbanFormalPrivate Production.....<br>. . . . . .<br>.<br>7|
||2.1.4<br>Productionofthepublicgood.....<br>. . . . . . . .<br>.<br>8|
|2.2|TheLaborMarket<br>.......<br>.<br>.<br>.<br>9|
||2.2.1<br>RuralWagesandEmployment...... . . . . . . .<br>.<br>10|
||2.2.2<br>UrbanUnskilledWages,Employment,andUnemploy-|
||ment........<br>. . . . ..<br>. . . . .. . . . . . ..<br>.<br>12|
||2.2.3<br>UrbanSkilledWagesandEmployment ..... . . .<br>.<br>14|
||2.2.4<br>SkillsFormation. . . . . . . . . . . . . . . . . . . . . .<br>19|
|2.3|SupplyandDemand .......<br>.<br>.......<br>. . . . . . .<br>.<br>20|
|2.4|ExternalTrade.......<br>. . .<br>........<br>. . . . . . .<br>.<br>22|
|2.5|Prices.........<br>.<br>.<br>..............<br>..<br>. ..<br>.<br>22|
|2.6|ProfitsandIncome.......<br>. .<br>.......<br>. . . . . . .<br>.<br>26|
|2.7|PrivateConsumptionandSavings...<br>.<br>........<br>. . .<br>.<br>27|
|2.8|PrivateInvestment .......<br>. .<br>.......<br>. . . . . . .<br>.<br>28|
|2.9|PublicSector........<br>. . . . . . .. . . . . . . .. . .<br>.<br>30|
|2.10|Balance ofPayments......<br>. .<br>.......<br>. . . . . . .<br>.<br>31|
|2.11|PovertyandDistributionalEffects...<br>.<br>........<br>. . .<br>.<br>32|
|**3Poli**|**cyExperiments**<br>**34**|
|3.1|ReductionintheMinimumWage. . . . . . . . . . . . . . . .<br>35|
|3.2|Cutin Payrolltaxes onUnskilledLabor.....<br>. . . . . .<br>.<br>40|
||3.2.1<br>DomesticBorrowing....... . . . . . . . . . . .<br>.<br>40|
||3.2.2<br>Revenue-NeutralChange. . . . . . . . . . . . . . . . .<br>42|
|**4Con**|**clusions**<br>44|
|**Appen**|**dixA:EquationsofMini-IMMPA**<br>**47**|
|**Appen**|**dixB:VariableNamesand Definitions**<br>**53**|
|**Appen**|**dixC:CalibrationandSolution**<br>**59**|
# 1 Introduction

Fiscal and labor market reforms are at the forefront of the policy agenda in many developing countries, and assessing their effects on unemployment and poverty is a key issue in the design and sequencing of adjustment programs. In turn, assessing these effects requires understanding not only how the labor market operates, but also how fiscal variables (taxes and expenditure) interact with the labor market. Because most taxes have an effect on the functioning of the economy, they also affect the labor market, both directly and indirectly, through changes in the level and distribution of wages, labor supply decisions, and the level and composition of employment. For instance, taxing the profits of small firms (which tend to be more labor intensive) may affect their ability to create jobs, whereas income taxation and the existence of an unemployment benefit system may affect the propensity of the unemployed to seek employment. Payroll taxes (such as employers' social security contributions) raise the effective cost of labor over and above the wage paid, thereby affecting the demand for labor, whereas income taxes and employees' social security contributions reduce the return to being employed, thereby affecting the decision to enter (or remain in) the labor force and possibly to invest in the acquisition of skills.' In addition to influencing the decision to enter into (or exit from) the labor force, changes in taxation may also affect the decision to engage in part-time work. Similarly, taxes on goods and services may affect the purchasing power of wages, and thus the decision to seek formal employment. High tax rates on income and activities in the formal economy may also drive firms underground, thereby impeding an efficient allocation of resources, with adverse effects on employment and poverty. Indeed, as shown in Figure 1, in developing economies the overall tax ratio (in proportion of GDP), as well as the direct income tax ratio, seem to be positively correlated with the size of the informal economy, and thus with "disguised" unemployment.<sup>2</sup> To the extent that the urban lAs is well known, changes in income taxes affect labor supply and leisure choices through both substitution and income effects. Because these effects tend generally to operate in opposite direction, the net effect of a change in the income tax on the supply of labor is a _priorz_ ambiguous.

> 2At a more formal level, Loayza (1996), Johnson, Kaufman, and Zoido-Lobaton (1998), Schneider and Enste (2000), Ihrig and Moe (2000) and Dessy and Pallage (2003), have also found that a higher tax burden tends to be correlated with a larger informal sector. By contrast, there does not appear to be a simple correlation between the overall tax ratio and open unemployment.

3
poor tend to be concentrated in the infermal sector (as illustratea- in Figure 2), taxation could be positively correlated with poverty. But of course, the taxation-poverty correlation could also be weak or non existent, because it also depends on the use of tax proceeds-namely, whether taxes serve to finance expenditure on the poor, public spending on infrastructuere (which indirectly affect the poor through a comrplementarity effect on private investment and thus labor demand), or are simply wasted on inefficient projects.

Labor market distortions, and the RiLks between taxation and the labor market, have received limited attention in quantitative, general equilibrium models that have often been used for development policy analyss. The pirpose of this paper is to present a quantitative framework that accourt for many of these distortions and linkages, and that modelers and pol'icy economists in developing countries can use to assess the effects of fiscal and labor market reforms on unemployment and poverty. TL his framework, called MiniTMIPA, is a specialized, and less-data intensive, version of the `:htegrated Macroeconomic Model for Poverty Analysis (¶MMPA) developed by Ag6nor, lzquierdo and Fofack (2003), and Ag6nor, Fernandes, Haddad arod van der Mensbrugghe (2003). Although Mini-IMMPA focuses only on -he "real" side, it offers a more detailed treatment of the labor market than __MMPA_ (by accounting for features such as bilateral wage bargaining, Eree public education, employment subsidies, and job security provisions) ard the tax structure. The resulting framework allows the user to analyze a variety of important policy issues, such as for instance the trade-offs involved in, shifting the tax burden away from unskilled labor in the formal sector ad toward other tax bases.

The remainder of the paper is organized as follows. The next section describes in detail the structure of Mini-IIMMPA, considering in turn the production structure, the labor market, supply and demand of coxmmodities, external trade, prices, profits and income, private consumption and savings, private investment, the public sC-ctor, and the balance of payments. The description of the labor is particularly detailed, given the _,_portaance of government-induced labor market distortions in developing countries. 7 account, in particular, for the existence of firing costs in the forreal sector. Such costs tend to benefit the employed (or "insiders") by lowering their probability of losing their job and increasing their bargaining power in wage determination, and to make firms reluctant to both hire and fre workers, thereby raising the duration (if not the level) of unemployment (lindbeck and Snower (2001)). Section II1 presents and discusses the results of two 4
policy simulations: a cut in the minimum wage, and a reduction<sup>inpayroll</sup> taxes on unskilled labor (assuming both neutral and non-neutral revenue effects). The payroll tax experiment is of particular interest in light<sup>of the</sup> previous discussion emphasizing the links between fiscal and labor market reforms. As it turns out, the unemployment and poverty effects of this policy change depend importantly on whether or not it is offset by other changes in sources of revenue, and what the precise nature of that source is. The last section summarizes the main results of the analysis and suggests<sup>various</sup> extensions. Appendices A, B and C provide a summary list of the model's equations, variable names and parameters, as well as a description<sup>of the</sup> calibration procedure.

# **2** Structure **of** Mini-IMMPA

The building blocks of the "structural" components of mini-IMMPA consist of the production structure, the labor market, the supply and demand for goods and services, external trade, sectoral and aggregate prices, profits and income formation, private consumption and savings, private investment,<sup>the</sup> public sector, and the balance of payments. The link between the<sup>structural</sup> component and a (fictitious) household income and expenditure<sup>survey, which</sup> is necessary for poverty and distributional analysis, is also explained later on.

## **2.1 Production**

The basic distinction on the production side is that between rural and urban sectors. In the rural economy (or agriculture) firms produces one<sup>good</sup> (referred to as good 1), which is sold domestically or exported. The urban economy consists of both formal and informal components. The<sup>informal</sup> economy produces nontraded services (referred to as good 2). in the<sup>formal</sup> urban economy production consists of a private good (referred to<sup>asgood3)</sup> and a nontraded public good (referred to as good 4).

### 2.1.1 **Rural Production**

Land available for rural activities is assumed to be non marketed and in<sup>fixed</sup> supply. Gross output of the agricultural good, Xi, is the sum of value added, 5
_V1,_ and intermediate consumption: where the a,, are input-output coefficients measuring relative sales from sector i to sector j.

Value added is produced with a Cobb-Douglas finction of 1and and a composite factor, defined as a constant elasticity of substitution (CES) function of the number of unskilled workers employed in the sector, _Ul,_ and the economy-wide stock of public physical capital _(K 0 ,_ defined below). Normalizing the area of land allocated to production to unity yields where 0 _< 71X_ < 1, and the other parameters have the standard interpretation. Given the Cobb-Douglas specification, agricultural production exhibits decreasing returns to scale in the composite input. The presence of _KG_ in (2) is based on the view that a greater availability of public physical capital in the economy (roads, power plants, and the like) improves the productivity of all production units in the rural sector, because it facilitates not only trade but also production itself.

Firms in the rural sector allocate their output to exports, E1, or the domestic market, _D1 ,_ according to a constant elasticity of tran-foi0rmation (CET) function: with the ratio ratio _E 1/D 1_ depending, as shown below, on the relative prices of exported and domestic goods.

# **_So12_** oUJrba lEcnfirmal Rroluctnon

Gross production in the urban informal sector, _X 2 ,_ is given also as the sum of value added, V2, and intermediate consumption: 6
There is no physical capital in the informal sector, and production requires only unskilled labor. Assuming decreasing returns to scale, value added can thus be written solely as a function of the number of unskilled workers employed in the informal economy, U2: FRom (5), the demand for labor in the informal sector is given by where W2 = W 2/PV 2 is the product wage, with W2 the nominal wage and PV 2 the price of value added in the informal sector (defined below).

# **2.1.3 Urban Formal Private Production**

Gross production of the private formal urban sector, X 3, is once again taken to be given by the sum of value added, _V3,_ and intermediate consumption: Private formal production uses as inputs both skilled and unskilled labor, as well as physical capital. Skilled labor and private physical capital are assumed, in line with the evidence discussed in Agenor (2000) and Hamermesh (1993), to have a higher degree of complementarity-that is, a lower degree of substitution-than physical capital and unskilled labor. In order to account for these differences in the degree of substitutability among inputs, a nested CES production structure is adopted. Specifically, at the lowest level of factor combination, skilled labor, S3, and private physical capital, _K 3 ,_ are combined to form the composite input _JL,_ with a relatively low elasticity of substitution (as measured by **_CYX3 L_** = 1/(1 _+ PX3L))_ between them: At the second level, this composite input is used together with unskilled labor, _U3,_ to form the composite input **_JH:_**
The elasticity of substitution between **_JL_** and unskilled workers, zrneasured by<sup>**_0_**</sup> **_X3 H =_** _1/(l+Px3H),_ is taken to be Egher than between S3 and K3, that is The final layer combines **_JH_** and _KG_ (the stock of government capital) as production inputs, with public capital subject to congestion effects: where _URB_ is the size of the urban population (defined below), EaM _dc3_ **_> 0._** The presence of the term _KG/URB_ in this equation can be exulained<sup>as</sup> follows (see Ag6nor (2003b)). As in agriculture, public physical capital has a positive impact on the productivity of production factors in the ufcan private sector. However, this positive effect is now subject to _congestion_ effects. As long as _dc3 >_ **0,** the positive externality of public capital decreases<sup>as</sup> its usage by the urban population increases, that is, the larger the size of the urban population, the lower is the contribution of the public capital stock to private urban production.

Private firms in the urban formal sector allocate their output to exports, _E3,_ or the domestic market, _D3 ,_ according to a production possibility frontier, again defined by a CET function: As shown later, the ratio _E 3 /D 3_ depends on the relative prices or exported and domestic goods.

# **MO14d** Production of the pubRic good

Gross production of the public good, X 4, is given by the sum of value added, _V4,_ and intermediate consumption: 8=
Value added in the public sector is measured by the government wage bill, as in national accounts: where S4 and _U4_ (respectively WSG and WUG) denote employment levels (respectively wages) of skilled and unskilled workers in government. Employment levels are treated as predetermined policy variables, whereas wage formation is discussed below.

# **2.2 The Labor** Market

As noted earlier, there are two categories of workers in the economy, skilled and unskilled. Unskilled workers may be employed either in the rural economy or in the urban economy, whereas skilled workers are employed only in the urban economy. As discussed later, skilled workers have a high reservation wage and therefore do not seek employment in the informal economy, even when they are unable to find a job in the formal sector.

In addition to accounting for various sources of labor market segmentation (a pervasive feature of the labor market in developing countries), MiniIMMPA accounts for the existence of employment protection regulations, an important component of which being state-mandated firing costs. Indeed, in many of developing countries, severance payments tend to be a partial substitute to unemployment insurance benefits. An important issue is whether these costs contribute to a high level of unemployment and to its degree of persistence-perhaps by reducing employment variation over the business cycle, as argued by Bertola (1990).3 A general conclusion of the literature is that firing costs affect employment dynamics more than the average level of employment; unemployment tends to be more persistent in countries characterized by high job security provisions, because mandatory firing costs play a stabilizing effect on aggregate employment. On the one hand, firing costs

> 3 Bertola's analysis assumes that workers are risk-neutral. But as noted by Booth (1999), typically most workers derive their income from employment, and it is difficult for most of them to diversify across jobs; it seems therefore more plausible to assume that workers are risk averse. She also considers the case in which firms and workers bargain about both wages and the size of redundancy payments. However, these modifications do not change Bertola's main result, which is that firing costs tend to stabilize employment over the business cycle.

9
prevent workers from losing their jobs (thereby preventing the loss of firmspecific human capital if downturns are temporary); but on the other, they discourage new hires.<sup>4</sup> They also tend to increase the incidence of temporary employment contracts, as noted by Betcherman, Luinstra, and Ogawa (2001), Heckman and Pages (2000), and Lindauer (1999).5 In what follows the effect of firing costs on both employment and wage formation is captured under the assumption that workers (or the trade union that represents them) internalize, while bargaining with employers, the value of the severance payment that they would receive in the event of dismissal.

# **2.2.1** Rural Wages and Employment

The demand for labor in agriculture, Ul, is derived in standard fashion from the first-order condition for profit maximization and is given by where _w, = W 1/PV1_ is the product wage in agriculture, _W1_ the nominal wage, and _PV1_ the net output price (determined below).

The nominal wage in agriculture, _W 1,_ adjusts to clear the labor market. With _UR_ representing labor supply in agriculture, the equilibrium condition of the labor market is thus given by The supply of labor in the rural sector is predetermined at any given point in time, but grows over time at the exogenous rural population growth rate, _9R,_ net of worker migration to urban areas, _MIG:_

> 4'As shown by Gavin (1986), the impact of firing costs on labor demand depends not only on the size of the required severance payments and the wage elasticity of labor demand, but also on the variability and persistence of shocks to labor demand, and the firm's discount rate.

> 5For some evidence on the effects of job security regulations, see Fallon and Lucas (1993), Kugler (2000), Dabalen (2002), and Besley and Burgess (2002).

10
Following Harris and Todaro (1970), the incentives to migrate are taken to depend negatively on the ratio of the average expected _consumption_ wage in rural areas to that prevailing in urban areas. Unskilled workers in the urban economy may be employed either in the private formal sector, in which case they are paid a minimum wage, _WM,_ or they can enter the informal economy and receive the average income in that sector (before transfers), **ym** **_.6_** When rural workers make the decision to migrate to urban areas, they are uncertain as to which type of job they will be able to get, and therefore weigh wages in each sector by the probability of finding a job in that sector. These probabilities are approximated by prevailing employment ratios. Finally, potential migrants also consider what their expected purchasing power in rural and urban areas is likely to be, depending on whether they stay in the rural sector and consume the "typical" basket of goods of rural households, or migrate and consume the "typical" urban basket of goods.

The expected, unskilled urban real wage, wl, is thus a weighted average of the minimum wage in the formal sector and the going wage in the informal sector, deflated by the urban consumption price index for unskilled workers, Puu (defined below): where Ou is the probability of finding a job in the urban formal sector, measured by the proportion of unskilled workers in the private formal sector, relative to the total number of unskilled urban workers (net of government employment) looking for a job, _UF - U4,_ in the previous period: A similar reasoning is used to calculate the expected rural consumption real wage, _wA._ Here the employment probability is equal to unity, because workers can always find a job at the going wage. Assuming a one-period lag yields 6As discussed below, there is no job turnover for either category of workers in the public sector. Given that, as discussed below, households in the informal sector receive all profits from production, average income is a better measure of expected income in that sector than the going wage.
where _PR_ is the rural consumption price index (defined below). The migration function is therefore specified as where _am_ > 0 measures the elasticity of (relative) migration flows with respect to expected wages. Note that the evidence suggests that there are several factors, in addition to wage differentials, that affect rural-to-urban migration. The family, in particular, appears to play a particula-ly important role in explaining migration by individuals (Lucas (1997)) as well as cash-seeking behavior, which trarslates into a positive impact of the _composition_ or rural income, in addition to its level (Velenchik (1994)). Moreover, if workers are risk averse, they may reouire a greater wage premJi-m for urban employment than the one implied by the observed wage dife:ential, to compensate them for the risk of being unemployed. However, some of these considerations are difficult to integrate in the type of models considered here.

# 2.2.2 UJrban Unskilled Wages9 =Royrxeznt, and Unez2syrnent

Both the government and private firms in the formal and informal urban sectors use unskilled labor in production. The public sector hires an exogenous level of unskilled workers, _U4,_ at the nominal wage _TWUG,_ whereas the demand for unskilled labor by the formal private sector is deterzcine- ( by firms' profit maximization subject to t'he giver minimrm wage, _WM._<sup>_7_</sup> 3oth _WVUG_ and _WM_ are assumed to be indexed on tae price of the consumption basket for urban unskilled households, Puu (defined below): where _w1_ is the real wage and 0 < _idx, <_ J tshe indexation parameter. In order to avoid corner solutions, the wage rate paid to unskilled labor in the formal urban sector is assumed to be systematicaUy greater than the wage rate paid in the informal sector. Consequently, unskilled workers in the urban area will always seek employment in the porivate formal sector first.

> 7 The assumption that the minimum wage is binding in the formal sectoz is actually a source of debate; see for instance Dabalen (2000) for a review of the evidence<sup>for sub-</sup> Saharan Africa. However, what is needed is that the distribution of unskIilled wages shifts as a result of a change in the minimium wage.

12
Firms also pay a payroll tax, at the rate 0 _< ptxu <_ 1 for unskilled workers, which is proportional to the wage bill, _WMU3;_ and they receive a nominal employment subsidy on unskilled labor of _ESu < WM_ per worker. Using (9), unskilled labor demand by the private sector is thus given by In addition, mobility of the unskilled labor force between the formal and the informal sectors is assumed to be imperfect and determined by expected income opportunities. Specifically, the total supply of unskilled workers in the formal sector (including public sector workers), _UF,_ is taken to change over time as a function of the expected wage differential across sectors. Wage and employment prospects are formed on the basis of prevailing conditions in the labor market. Because there is no job turnover in the public sector, the expected real wage in the formal economy, _we,_ is equal to the real minimum wage (measured in terms of the price of the consumption basket for unskilled workers) weighted by the probability of being hired in the private sector. Assuming that hiring in that sector is random, this probability can be approximated by the ratio of employed workers to those seeking employment. Assuming a one-period lag, The expected real wage in the informal economy is simply the average real income in that sector (measured again in terms of the relevant consumption price index), because there are no barriers to entry in that sector. Assuming again a one-period lag, The flow supply of unskilled workers in the formal sector thus evolves over time according to 13
where _oF_ denotes the elasticity of labor flows with respect to the (expected) wage ratio. The rate of unskilled unemp.-oyment in the formal sector, _UNEU,_ is thus given by where U3 + U4 is total unskilled formal employment. The supply of labor in the informal economy, U2, is given by The informal labor market clears continuously, so that U2 = _U2._ rom this condition and equation (6), the equilibrium nominal wage is thus given by where y2j is average income (before trarsfers) in the informal economy.

The supply of unskilled labor in the urban sector, _Ut,_ grows as a result of "natural" urban population growth and nigration of unskilled labor from the rural economy, as discussed earlier. Moreover, some urban unskiled workers, _SKL,_ acquire skills and leave the unskilled labor force to augment the supply of qualified labor. All individuals are born unskilled, and thus naeLural urban population growth (not resulting from migration or skills acquisition factors) is represented by urban unskilled population growth only, at the exogenous rate _gu._ Thus, the urban unskilled labor supply evolves according to 2.2.3 Urban SkiRned Wages and Empoymet As noted earlier, the employment levels of both skilled and unskil.ed workers in the public (urban) sector are taken as exogenous; the lack of tuznover is in part due to the fact that working for the government provides a nonpecuniary benefit, which takes the form of greater job security. The real wage rate that skilled workers receive in the public sector, _WSG,_ is also taken as g;ven. With _WSG_ denoting the nominal wage, and _Pus_ the consumption price index for urban skilled workers (defined below), full indexation therefore implies that 14
From (8), the demand for skilled labor is, noting that _PX3 LX3L =1 O'X3L:_ Two alternative specifications are used for determining wages for skilled labor in the private sector, Ws. The first approach is based on the "monopoly union" framework, and is derived as follows (see, for instance, Agenor (1999), Devarajan, Ghanem, and Thierfelder (1997), and Thierfelder and Shiells (1997)). Let _w'_ denote the _consumption_ real wage, that is, the nominal wage earned by skilled workers deflated by the cost-of-living index that these workers face in the urban sector, _Pus._ A centralized labor union sets wl with the objective to maximize a utility function that depends on deviations of both employment and the consumption wage from their target levels, subject to the firm's labor demand schedule.<sup>8</sup> Specifically, the union's utility function is given by where _S3_ is given by equation (28). The quantities _w'T_ and _S3T_ measure the union's wage and employment targets, respectively, and are both assumed predetermined with respect to _wc._ The parameter v reflects the relative importance that the union attaches to wage deviations from target, as opposed to employment deviations. The union's problem is thus maxU = _(wM - wAT)v(sd _ ST)l-V._

> 8Alternatively, one could assume that firms and the union bargain over wages (through a generalized Nash bargaining process), with either firms determining employment (the so-called "right to manage" approach) or that firms and the union bargain over _both_ wages and employment. In the former case, the firm and the union would determine _ws_ by maximization of the product of each party's gains from reaching a bargain, weighted by their respective bargaining strengths, and once wages are set, employment would be determined by the firm. As shown by Creedy and McDonald (1991), for wage determination, it does not make much difference whether bargaining is over wages only, or over wages and employment. However, as is well known (see for instance Booth (1995)), the equilibrium outcome in the case of bargaining over both wages and employment is such that firms would not in general be on their labor demand schedule.

15
Using (28), the first-order condition is given by

> or equivalently

Solving this condition yields

> which indicates that percentage deviations of the optimal wage from its target value are linearly related to percentage differences of employment from its target level.

The union's target real wage, _wT,_ is assumed to be related pcsitively to skilled wages in the public sector (meast,red in terms of the relevant price index), _WSG,_ and negatively to the skilled unemployment rabe, _UiVEs,_ and the real firing cost per skilled worker, _fs,_ measured in terxns of the price of valued added in the private formal sector, _PV3_ (defined below). Wage-setting in the public sector is assumed to play a signaling role for wage setters in the rest of the economy. When unemployment is high, the probability of finding a job (at any given wage) is low. Consequently, the hig;her the une=ploymnent rate, the greater the incentive for tahe uion to moderate its wage deman6s in order to induce firms to increase employment. As noted earlier, firing costs do prevent excessive job losses in bad times (thereby preventing the loss of firmspecific human capital if downturns are temporary) but they also discourage new hires-namely because reversing mismatches is costly if workers prove to be inadequate matches with their job requirements. The union katernalizes the disincentive effect of severance payments on labor demand. As a result, the higher the firing cost, the greater the incentive for the -Lmion to -reduce its wage demands, in order to encourage fErrs **to** hire. Normalizing tI-e target level of employment to zero _(S3T_ = 0) the above expression ca7 thus be rewritten as 16
where _UNEs_ is defined below and the 0, coefficients are all positive. This equation implies, in particular, that a higher level of unemployment lowers the _level_ of wages, as predicted by various efficiency wage theories.' The second approach to determining skilled wages assumes direct bargaining, in each period, between producers and workers over the product wage, WS5 _= Ws/PL._ If a bargain is reached, each worker receives ws = _WS/PJL,_ whereas the producer receives ms - _ws,_ where _ms_ = _&JL(S3, K 3)/0S3_ is the marginal product of the worker, given by (using equation (8)): The worker's "fallback" position is denoted _Qs,_ which may represent an unemployment benefit (if one exists). The firm's fallback position is assumed to depend on firing costs in the following way (see Coe and Snower (1997)). In case of bargaining disagreement, the worker engages in industrial action that is costly to the firm (but not to himself). The greater is the level of industrial action, the lower will be the producer's fallback position and thus the higher will be the wage that the worker can achieve, up to a limit, beyond which the firm has an incentive to fire him. Producers face a firing cost of _fs_ per worker (measured now in terms of the price of the composite output _JL,_ that is, _PL),_ and for simplicity all workers become eligible for severance payments immediately upon hiring.'<sup>0</sup> If the cost of the industrial action to the firm exceeds the firing cost _fs,_ the worker will be replaced by another one. Consequently, the worker will set the level of industrial action so that its cost to the firm is exactly _fs,_ making the firm indifferent between retaining him and replacing him.

Thus, the worker's bargaining surplus is _ws - Qs,_ whereas the firm's bargaining surplus is _ms - (ws + fs)._ The Nash bargaining problem can be formulated as max(ws _- Qs)rms - (ws + fs)]l-v, 0 <_ v _<_ 1, **_Ws_**

> 9 Note that, in general, on would expect the optimal wage to be also be an increasing function of union density. Here, it is implicitly assumed that all skilled workers are members of the union. In addition, note that the target wage could also be specified as increasing in the income tax rate, _itxs,_ implying that the union would demand higher wages to compensate for a decrease in after-tax income.

> 0I In practice, redundancy payments are only made to workers with some minimum period of continuous service with the firm.

17
where v measures the bargaining strength of the worker relative to the IE£m. The first-order condition is given by that is, RFom this equation, the equilibrium negotiated wage can be de:ived as Suppose that there is no unemployment benefit, so that _Qs_ = 0, and that the bargaining strength of a skilled worker, v, varies inverse;.y with the rate of skilled unemployment, _UNE3 ._ 7he wage-setting equatior can thus be written as" which implies again that the level of wages and the rate of unemployment are inversely related, and that an increase in the firing cost reduces the skilled wage.

The skilled open unemployment rate, _UNEs,_ is given by **the** ratio of skilled workers who are not employed e.ther oy the private or the public sector, divided by the total popuiation of skilled workers: where _SG_ is the _total_ number of skilled worlkers in the lpublic serctc, engaged in both the production of public services, S4, and education, _SQ (s5e_ below): Skilled workers who are unable to find a Job in the formal economy opt to remain openly unemployed, instead of enering the informa, eco2aoy (ir, contrast to unskilled workers), as a result oF eitther a reservation wage that systematically exceeds the informal sectcr wage, or concerns about adverse "lWith an unemployment benefit proportional to the wage, so that _3_<sup>_2_</sup> _s_ - _U,J_ the coefficient v in the negotiated wage should be replaced by **_vl/[l_** _-_ (I _- )t._
signaling effects to potential future employers, as argued in a different setting by McCormick (1990) and Gottfries and McCormick (1995).

The evolution of the skilled labor force depends on the rate at which unskilled workers acquire skills: where 0 <<sup>_6_</sup> _s_ < 1 is the rate of depreciation, or "de-skilling", of the skilled labor force. The size of the urban population, _URB,_ is thus that is, using (26) and (34):

# **2.2.4** Skills **Formation**

The acquisition of skills by unskilled workers takes place through an education system operated (free of charge) by the public sector. Specifically, the flow of unskilled workers who become skilled, _SKL,_ is taken to be a CES function of the "effective" number of teachers in the public sector, _SGE,_ and the government stock of capital in education, _KE_ (defined below): where o measures the productivity of public workers engaged in providing education. _fo_ is assumed to depend on the relative wage of skilled workers in the public sector, _WSG,_ relative to the expected wage for that same category of labor in the private sector, which (in the absence of unemployment benefits) is given by one minus the unemployment rate, 1 _- UNEs,_ times the going wage, _Ws.'_<sup>_2_</sup> Assuming a simple logistic form (as for instance in Maechler and Roland-Holst (1997, p. 492)), and a one-period lag, this function can be written as1<sup>3</sup>

> 1<sup>2</sup> For simplicity, it is assumed that all skilled workers in the public sector earn the same nominal wage.

> 1<sup>3</sup> Wages in equations (37) and (38) are specified in nominal terms, because they are assumed to be both deflated by the same price index-the price of the consumption basket for skilled workers in the urban sector.

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This equation shows that the higher the public sector wage relative to its opportunity cost, the greater the level of effort by teachers in the public sector, and thus the greater the nrumber of slilled workers produced by the system. Alternatively, the effort :Eiction derived by Ag6nor and Aizenman (1999) could also be used: and where 0 **_<Pm_** < 1 denotes the "min3 mum" level of effort.

# _2.3 $UPPRy_ am _Demad_

Both the informal and public sector goods aye nontradables, and both markets clear continuously. In each sector, total supply is thus equal to gross production, that is, _X 2 =_ Q2 and X 4 = _Q4._ Rural and private formal urban goods, by contrast, compete with imported goods. The supply of the composite good for each of these sectors, **_Qs_** and Q3, consists of a CES combination of imports and domestically produced goods: Aggregate demand in each sector consists of intermediate and final consumption, government spending, and investment demand: where _INT,_ is defined as total demand (by al productions sectors) for intermediate consumption of good j: 20
For the agricultural, public and informal sector goods, aggregate demand consists of intermediate consumption and private final consumption _(C1 , C2 ,_ and _C4 )._ Aggregate demand for the private formal good consists of intermediate consumption, final consumption by households and the public sector, C3 and G3 , and private investment, Z3.

Other current government spending on goods, Gc, and public investment expenditure, _ZG_ (that is, total government expenditure minus salaries, transfers, subsidies and interest payments) is spent only on the private formal sector good, so that G3 is equal to where _X1h_ is real autonomous consumption of good i by household _h,_ the coefficients _CCth_ are the marginal budget shares of good i in total consumption expenditure by household _h, Ch,_ and _PC,_ is the actual sales price of good i (defined below). These shares satisfy the standard restrictions Maximization of the utility function Uh subject to household h's budget constraint E4= 1 _Ch - COh =_ 0 yields the familiar demand functions Total final private consumption for each production sector i, _C1,_ is the summation across all categories of households of consumption of good i: Total private investment, Zp, consists of purchases of urban private sector goods: 21
where _PK_ is the price of capital goods.

# 2.4 xterna aade

As indicated earlier, firms in agricultu-re allocate their output tc exports or the domestic market according to the PI?F specified in equation (3) and the relative price of exports, _PE1 ,_ vis-a-vis domestic goods, _PD1_<sup>_._</sup> Efficiency conditions require that firms equate this relative price to the portaity cost in production. This yields: Similarly, using the PPF specified in equation (11), the allocation of output between exports and domestic sales by Rrms in the private formal sector is given by where _PE 3 /PD3_ is the price of exports relative to the price of domestic goods.

l[mports compete with domestic goods in agriculture as wel& as in the urban formal private sector. Making use of Armington functions for the demand for imported vs. domestic goods and xrelative prices, import demand for both sectors _(Ml_ and _M 3)_ car be written as: These equations show that the rat;o of imports to both categories of domestic goods depends on the relative prices of these goods and the elasticity of substitution, _oQ1_ and **_UQ3,_** between these goods.

## **2o5 EDr** ces

By definition, the net value of output (that is, gross output adjusted for indirect taxes) in sector i must be equal to value added plus s-lending on 22
intermediate inputs (purchased at composite prices): where PXi is the gross price of output, and atx, the indirect tax rate (or a subsidy rate, if negative) on output in sector i, with atX2 _=_ 0 (there is no indirect taxation of informal sector production). From this equation, the net or value added price of output can be derived as The world prices of imported and exported goods are taken to be exogenously given. The domestic currency price of these goods is obtained by adjusting the world price by the exchange rate, with import prices also adjusted by the tariff rate, itm: Because the transformation function between exports and domestic sales of agricultural goods is linear homogeneous, the gross output price, PX1 , is derived from the expenditure identity: Similarly, the gross output price in the urban formal private sector, _PX3 ,_ is given by The price of domestic sales in agriculture, _PD1,_ adjusts to equilibrate supply and demand.'<sup>4</sup> For the price of domestic sales by firms in the urban

> **141n** solving the model, equation (50) is used to solve for _PD1,_ and, because Q' = **_Qd_** (41) is used to solve for the equilibrium value of Ql. The composite good CES equation (39) is then inverted to solve for Ml and the CET function (3) is inverted to solve for **_Dl._** This procedure ensures that the composite price (and thus indirectly the price of domestic sales) adjusts to equilibrate supply and demand.

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formal private sector, _PD3 ,_ two options are considered. In the first case, _PD3_ is assumed to be fully fiexiole and determined in a manne- similar to _PD1 ._ In the second, _PD3_ is assumed _'Lo_ be set as a markup over variable costs. Because both private and public stocks of physical capit1 are taken as given, total variable costs (involving labor and intermediate c-sumption) associated with private urban production, _TVC3,_ are given by The average variable cost, _AVC3 ,_ is thus and the price of domestic sales, _PD3 ,_ is therefore given by where mk is the constant markup rate. Given this specificat on, and to maintain market equilibrium, the actual quantity of domestic goods must be assumed to be determined by the demand side, and the production function can be inverted to solve for the demand of one of the labor categories. Firms would thus typically be "off' their optimal labor demand curve.

For the agricultural sector and the urban formal. private sector, the substitution function between imports and domestic goods is also lUnearly homogeneous, and the composite price for eacha sector, _PQi,_ is determined accordingly by the expenditu-e identity: The actual sales price for the agricultural and formal private sector goods, _PC,_ differs from the composite price as a result of a sales tax, levied at the rate _stx,:_ _PC, = (1 + stxi)PQ,,_ for i = _i,_ 3.

For the informal and public sectors (both of which do not export), the composite price is equal to the domestic market price. In turn, because these 24
sectors do not compete with imports, the domestic price, _PD,,_ is simply equal to the gross output price, PX1: where _stx, =_ 0, for i = 2, 4.

The nested CES production function of private formal urban goods is also linearly homogeneous; prices of the composite inputs are therefore derived in similar fashion: where _PR 3_ is (before tax) profits by private firms in the formal urban sector, which is here viewed as the (gross) return to physical capital.

The price of capital is constructed by using the identity defining investment expenditure, equation (47), which involves only the urban private sector good: because _Z3 = ZP._ The consumption price index for the rural sector is given by where 0 < **OR** < 1 denotes the relative weight of good i in the index, with OR = 1. Similarly, the consumption price indexes for urban unskilled and skilled workers are given by where the _OSu_ and Os are relative weights that reflect the composition of spending by each group in a base period, with Ei = >r O< = 1. As noted below, these indexes are used to update the rural and urban poverty lines in simulation experiments.

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Firms' profits are defined as revenue minus total labor costs. 12 the case of the agricultural sector firms, and urban informal sector firms, profits are simply given by Profits of urban private sector firms account for both working capital costs and salaries paid to both categories of workers, as well as payroll taxes and firing costs, _FC,_ for both categories of workers:<sup>15</sup> where total firing costs are given by with _fs, fu_ denoting the fixed fring cost per worlker (skilled and uskilled, respectively).

Household income is based on the return to labor (salaries), distributed profits, and government transfers. Households are defined according to the level of skills of its members and their sector of employment. There is one rural household, (indexed by a) comprising all workers employed in agriculture. In the urban sector there are two types of unskilled househoids (denoted by b and c), those working in the informal sector and those employed in the formal sector ((both public and private). The fourth household (denoted by d) consists of skilled workers employed in the formal urban economy (in both the private and public sectors). Finally, there is a capitalist-rentier household (denoted by e) whose income derives mainly from firms' net earnings in the urban private sector. Households in both agriculture and the infcrmal urban economy own the firms in which they are employed.

Encome of agricultural and informal sector households is given by, with _h_ = **_a,b_** and _i_ = 1,2: 1<sup>5</sup> Note that payroll taxes are assumed to be levied on the total wage _bil_ excluding interest payments, that is, _Wm_ **_U3_** instead of (1 + **_iL)WM_** _U3._ Note also that azing costs are assumed to be paid on the total reduction in the number of workers, thereby neglecting t"natural" attrition (retirement) and voluntary quits.

26
where _aYh_ is the portion of total government transfers _(TR)_ each group receives.

Income of the urban formal unskilled, and skilled households, depends on government transfers, salaries, and possibly redundancy payments; firms provide no source of income, because these groups do not own the production units in which they are employed: where _SG_ is the total number of skilled workers in the public sector, engaged in both the production of services and training (see (33)).

Firms in the private urban sector pay income taxes, and interest on their foreign borrowing, _FL3 ._ Their net (after-tax) profits, _NPR3 ,_ are thus where _itxf_ is the corporate income tax rate and i* is the interest rate paid on foreign loans, taken to be exogenous. A portion of these net profits, X, are retained for the purpose of financing investment; the remainder is transferred to the capitalist-rentier household. Thus, total income of that group is given by

# 2.7 Private Consumption and Savings

Each category of household _h =_ a, ... e saves a fixed fraction, 0 < _srh <_ 1, of its disposable income: where 0 < itxh _<_ 1 is the income tax rate applicable to household _h._ The portion of disposable income that is not saved is allocated to consumption: 27
2 0 g Private

# rnvestmat

Capital accumulation occurs only i' the urgan 6orTaal privato C.cr. To examine the decision to invest, defne Izrst- t'c after-tax rate ^l ,cW-on private physical capital, IK, as the ratio of net profits to th2e sto'COk f c apptal: The desired capital stock by firms ir the private cor.ai -: ban sxctor is determnined so as to equate the after'tax rate of returzn on. ca- taI plu.s the rate of capital gains due to changes iE the price of capi'c., and mnus depreciation (at the rate 63) to the opportunity cost of ingEcstTr-<.t, which (assuming the absence of "effective" restrictions to capital mobil _,y)_ is here taken to be the world interest rate, adjusted for the rate of cen:--.ation of the nominal exchange rate, e: where 0 _<_ 63 < I. One could also add to the marginal cost offor&gn caoitai on the right-hand side of this equation a risk premikim, to re..c_t 'type of imperfections that developing count:res face on wo-ld cakts _maar-kets._ Such a premium could be specified, for instance, as a convex f _Lr_ of the difference between the value of tbe private capital stoc!<, P'KK3, -rlative to firms' foreign borrowing, _ER * FL3 ,_ WhSci in the prese nt setting e-resents a measure of firms' net worth.

Using equation (76), and setting E _=_ 0, tais arbitrage condt:;'-.- y-Ilds<sup>1 6</sup> Actual investment in each period is determined by a paotial g .j-kStM ent process, and is given as a functioD of the ratio between t7ne &esirzA capital stock and last period's capital stock: 1<sup>6</sup> When checking for homogeneity **ok-** degree zero in prices (including the e.:chrnge rate, which is the numeraire here), the rate of deoreciation must indeed be accc-.:-ted for in (78).

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where zo, _Yz_ > 0. This investment function is, of course, very simple and does not account for a variety of other factors that have been shown to be important for developing countries-such as inflation, macroeconomic volatility, public capital in infrastructure, and possibly foreign borrowing."<sup>7</sup> Some of these modifications can easily be introduced. Note also that, although there is no direct effect of the public capital stock in infrastructure, _KR,_ on private investment, _KR_ does affect the overall stock of public capital, _KG_ (defined below), which in turn affects the production process-and thus indirectly the desired capital stock, through profits.

The capital stock depends on the flow level of investment, Zp, and the depreciation rate: The net worth of private urban firms in nominal terms, _NW 3 ,_ is defined as the value of physical capital, net of foreign borrowing, _FL3 :_ which changes over time according to _NW3 = NW3,-1 + PKAK 3 - ER * AFL3 + APKK 3,-l_ The last term on the right-hand side of this expression represents capital gains associated with changes in the price of capital. Note that changes in _NW3_ have no feedback effects on the economy, unlike what happens in the "full" IMMIPA model of Agenor, Izquierdo and Fofack (2003), in which banks charge a risk premium on their loans that is inversely related to the borrower's net worth. In the present setting, a feedback effect could be introduced by adding a risk premium to the marginal cost of _foreign_ capital, as noted earlier.

The _ex post_ aggregate identity (or _ex ante_ equilibrium condition) between savings and investment is specified as follows. Total gross investment in physical capital measured in nominal terms, which is equal to _PK(ZP + ZG),_ is financed by firms' after-tax retained earnings, total after-tax household savings, "primary" government savings (that is, before investment), and foreign 1<sup>7</sup> See Agenor (2000, Chapter 1), Agenor and Montiel (Chapter 3), Agenor, Izquierdo, and Fofack (2003), Jimenez (1995), and recent studies by Sanchez-Robles (1998), Ahmed and Miller (2000), Ghura and Goodwin (2000), Hendricks (2000), and Wang (2992).

29
borrowing by firms and the govermnent. Given the definition of the _overall_ government fiscal balance given below in (84), _GBAL,_ this identity can therefore be written with private investment only on the left-hand side: where _FLg_ is foreign borrowing by the government. In the simulations reported below this equation is solved residually for the savings rate of rentiers and capitalists, sre. In thats sense, then, the basic model is "investsment driven", although of course other closure rules are possible. For instance, one could solve "backward" for the government budget balance and deternmine the level of current public expenditure that is consistent with (82). Alternatively, one could drop purely and simply the investment equatior (79) and solve (82) instead for Zp. ln that case, then, the model would be "savings driven" (see Dewatripont and Michel (1987)).

# **_2.O_** PubHc SeteO c r

Government expenditures consist of final consumption, which only has demandside effects, and public investment, which has both demand- and supply-side effects. Total public investment, _ZG,_ consists of investment in infrastructure, _IR,_ education, _IE,_ and health, IH,which are all considered exogenous policy variables:<sup>18</sup> _ZG =_ **_IR_** _+ IE +_ **_IH._** (83) Investment in infrastructure consists of the accumulation of public capital such as roads, power plants and railroads. Investment in educatio.. consists of the accumulation of assets such as school buildings and other infzastructure affecting the acquisition of skills (for instance, research institutions), out does not represent human capital. In a similar fashion, investment in health adds to the stock of public assets such as hospitals.

Rom (13), _PV4V4 - (WUGU4 + WSGS4) =_ 0, that is, all va2.e added generated by the production of public goods is distributed as wages. The '<sup>8</sup> See Jimenez (1995), Tanzi and Zee (1997), Sanz and VelAzquez (2001), and Webber (2002), for a discussion of the links between thle composition of public investment and growth. It should be noted that this treatment of public investment differs from standard data classification reported in national accounts; in many instances these investments are classified as current expenditures.

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government fiscal balance, _GBAL,_ is thus defined as _GBAL = TAX - TR- WSGSGE - ESUU3 - PC3 (Gc + ZG)_<sup>_-_</sup> _icER_<sup>_*_</sup> _FLG, 1_<sup>_._</sup> (84) where TAX denotes total tax revenues, _TR_ government transfers<sup>tohouse-</sup> holds, _WSGSGE_ the wage bill on school teachers, _ESuU3_<sup>totalemployment</sup> subsidies to firms in the private formal sector, Gc other<sup>realcurrentexpendi-</sup> tures on goods and services, _ZG_ real investment<sup>spending,and</sup><sup>_iaER- FLG,__</sup> is interest payments on foreign borrowing.

Total tax revenues consist of revenue generated<sup>byimporttariffs, sales</sup> taxes, income taxes, and payroll taxes on unskilled labor: with atxrr = 0.

Public investment in infrastructure, health, and education,<sup>determinesthe</sup> rate at which the stock of each type of public capital,<sup>_K_</sup> _3_<sup>_,_</sup> with<sup>j</sup><sup>_= E, H, R,_</sup> grows over time. Accumulation of each type of capital<sup>is thusdefinedas:</sup> where 0 < _63_ **_<_** 1 is a depreciation rate.

Infrastructure and health capital are combined through<sup>aCESfunction</sup> to produce the stock of public capital, _KG:_

# **2.10 Balance of Payments**

The external constraint implies that any current account<sup>surplus(or deficit)</sup> must be compensated by a net outflow (or inflow)<sup>offoreigncapital,given</sup> by the sum of changes in net foreign borrowing by the government,<sup>_AFLG,_</sup> and private firms, _A\FL 3 :_ _, (wpe,E,_ - _wpmzM1) + i*(FLG,_l + FL 3 ,_1 ) + L\FLG + AFL3 = 0._ (88) **_i=1,3_** _31_
In the simulations reported below, E assume that public foreign borrowing is exogenous, and that private foreign borrowing adjusts to ecq-Sribrate the balance of payments.

Figure 3 summarizes the structure of the labor market in nini-iMMPA, whereas Figure 4 captures overall linkages. Appendix A provides a complete list of equations, Appendix B varia70le definitions, and Appendix C discusses calibration and solution proceduzes, as well as parameter values.<sup>19</sup>

# **2O.L1** PrDety and1 E _]$,Z (COa_

The procedure followed in mini-IMMPA to assess the poverty a2d distributional effects of exogenous and policy shock6s is similar to the one in VMMPA, which is described at length in Ag6ncr, Lzqnierdo, and Fofack (2003) and evaluated against several alternatives by Ag6nor and Grimm (2003). This procedure assumes that initial rural and urban poverty lines are exogenously set in real terms and involves linking the "structural" component described earlier to a household income and expenditure survey, organized along the household structure described earlier. Specifically, the calculation of poverty indices-the poverty headcount index (the proportion of individuals earning less than the poverty line) and the poverty gap (the average shortfall of the income of the poor with respect to the poverty line, multiplied by the headcount index)-as well as distributional indicators (the Gini coefficient and the Theil inequality index) involves the following steps:

- Step 1. Classify the data in the household survey into the categories of households contained in the structural component of the model. Here, as noted earlier, there are .five categories of households-workers in the rural sector, those in the urban (unskilled) informal economy, urban unskilled workers in the formal sector, urban skilled wo:rkers in the formal sector, and capitalists-rentiers.

- Step 2. Following a policy or exogenous shock, generate real growth rates in per capita consumption and disposable income fo6 all 'ive cat-

19As implied by Walras' Law, one equilibrium condition may be droppe6 because it can be deducted from the other equilibrium conditions. Instead of dropping one equation, the computer program checks numerically for continuous equality between savings and investment, as given in equation (82), by ensuring that a residual variable is continuously equal to zero.

32
egories of households, up to the end of the simulation horizon (say, T periods) .

- Step **3.** Apply these growth rates separately to the per capita (disposable) income and consumption expenditure for each household in the survey. This gives a new vector of absolute income and consumption levels for each group, for periods 1,...T.

- Step 4. Calculate poverty and income distribution indicators, using the new absolute nominal levels of income and consumption for each individual and each group, and after updating the initial rural and urban poverty lines, using the prices indexes generated by the structural component of the model, to reflect changes in the price of the consumption basket and purchasing power of income.

- Step **5.** Using the rates of growth of employment generated by the structural component of the model, adjust the relative weights of each household group in the urban sector (as given in the survey) and calculate the reweighted poverty and distributional indicators for that sector as a whole.<sup>20</sup>

- Step 6. Compare the post-shock poverty and income distribution indicators with the baseline values to assess the impact of the shock on the poor and the degree of inequality for periods 1, ... T.

The household survey that I use to perform the policy experiments reported below is an artificial survey, constructed as follows. First, a sample of 5,000 observations was produced, with the share of each household group corresponding exactly to that in the structural component of the model.<sup>2</sup> ' Each observation was considered to represent one household. Second, using a random number generator and a log-normal distribution, values for disposable income and consumption expenditure were drawn for each household. As parameters for each group, the initial values for average disposable income and

> 20The same reweighting procedure would need to be applied to the rural sector if there was more than one category of households there.

2 These shares are 28.2 percent of workers in the rural sector, 45.3 percent of workers in the informal urban sector, 13.7 percent of unskilled workers in the formal urban sector, 9.9 percent of skilled workers in the formal urban sector, and 3 percent of capitalists and rentiers.

33
average consumption expenditure (which are taken from the caiTbrated database) are imposed as mean and as standard deviation. For skille-& workers in the formal urban sector and for capitalist and rentiers, a standard deviation of 0.8 times the mean is assumned. Figure 5 shows the distribtion **of** consumption in each group. Third, the incorne poverty line for the rural sector is set (somewhat arbitrarily) such that the percentage of rural houiseholds in poverty is 50 percent. The poverty line in urban areas is then assumed to be 15 percent higher. The rural and urban poverty lines for consumption expenditure are calculated in the same manner. This procedure produces an economy-wide, income-based headcount poverty index of 38.6 percent and an economy-wide consumption-based headcount index of 41.1 percent. For income distribution, the overall Gini index is 0.48 (consumption based) and 0.49 (income based).<sup>2 2</sup> The within-group Theil inequality decomposition is 78 percent (consumption based) and 73 percent (income based).

# 3 Nhcy Mxp'men(t

Mini-IMMPA can be used to analyze a variety of policy ana exogenous shocks. For illustrative purposes, the growth, unemployment and poverty effects of two types of labor market policies are examined in this section: a cut in the minimum wage and a reduction in the payroll tax rate on unskilled labor.<sup>23</sup> Both experiments relate to critical policy issues in developing countries. Economists have long debated the roie of minimnum wage legislation in labor market adjustment. Advocates have oLten viewed minimum wages as being beneficial in various ways-through its positive effect on- nutrition or productivity, or as an instrunent of income redistribution and social justice. By contrast, opponents argue that minimum wage legislation, bI preventing wages from adjusting downward to excess supply of labor, impos^-s an implicit tax on employers in the formal economy, leads to misallocation of labor (by preventing wages from adjusting downward to excess supply of **a** la nr) d creates unemployment (particularly for unskilled workers), induces .labor market

> 2 2 The income-based Gini coefficients are 0.45 for the rural sector, 0.48 for the urban sector, 0.44 for the informal sector households, 0.43 for urban unskilled households, 0.38 for urban skilled households, and 0.39 for capitalists and rentiers.

> 2 3 1n these simulations, **_PD3_** is assumed to be fully flexible, the skilled wage-setting equation (29) and the effort function (38) are used, and both the unskilled public sector wage and the minimum wage are taken to be fixed in nominal terms _(idxu_ **_idxM_** _=_ **0).**

34
segmentation, and depresses wages in the informal urban sector-which has an adverse effect on the poor. By increasing the relative cost of employing unskilled workers, a high minimum wage may also accelerate the substitution of capital for unskilled labor and reduce profits-and thus firms' capacity to invest. As a result of both factors, high minimum wages may restrain the expansion of labor demand over time. Thus, a government-mandated increase the minimum wage (assuming that it is binding) may not only reduce employment but also raise poverty, because the increase in the marginal cost of labor will lead firms to scale back hiring-forcing the unemployed to enter the informal sector and depressing wages there.<sup>24</sup> Thus, changes in the minimum wage are likely to have important distributional effects among (unskilled) workers, notably between those employed in the formal sector and those in the informal sector. Similarly, in both industrial and developing countries, a flat payroll tax is often imposed on employers to finance general government expenditure, or more specifically the pension system or the unemployment benefit scheme.<sup>25</sup> The conventional, partial equilibrium view suggests that the incidence of such a tax-its actual burden-depends on the elasticity of labor supply and the degree of wage rigidity. But it is also important to account for general equilibrium effects. The effect on wages depends on the structure of the labor market. For instance, an increase in employers' social security contributions may initially cause an increase in labor costs and lower employment; but the ensuing increase in unemployment may drive wages down over time, thereby offsetting the higher non-wage costs. In addition, the effect of a reduction in payroll taxation depends to a very significant extent on how the cut is financed; with a binding budget constraint, reducing the payroll tax requires shifting the tax burden to some other tax base. Thus, it is important to consider alternative financing rules in evaluating the effect of a cut in the payroll tax.

> 24If a binding minimum wage does not reduce employment among the poor, it will also reduce poverty if a large number of poor households consist of low-wage workers. However, in many poor households, no one may be employed in a formal sector job. If indeed lowpaid workers axe not in poor households, much of an income gain that may come from an increase in the minimum wage would benefit those that are not poor to begin with.

> 2 5 Financing of unemployment benefit schemes is in general usually shared between employers and employees-but the employers' contribution is usually substantially higher than employees' contribution.

35
# 3.1 Fldcto kU^Wa the Mfin=m A.af Wage^L

The simulation results associated with a permanent, 5 percent rcd-iiction in the minimum wage are illustrated in Tables 1 and 2, which display relative and absolute percentage changes from the baseline sol.ution, respcctively, for the first 10 periods after the shock. This time period is referred to below as the "adjustment period." The experiment assumes that the government borrows domestically to finance its deficit-implying therefore (as discussed earlier) an offsetting adjustment in the savings rate of capitJalists a.rd rentiers, in order to maintain the aggregate bala-ace between savings and 'nvestment (equation (82)).26 Table 1 provides data on national accounts, fiscal accounts, and the labor market, whereas Table 2 sHows changes in prices, consumption and income for each household group, and poverty and distributional indicators, both income- and consumption-based. Also shown in TLable 2 is the real exchange rate, defined as a weighted average of the domest c-currency price of exports and imports (with weights based on initial volumcs of trade), divided by a weighted average of the price of domestic sales of agricuJ.tural and private sector goods.

The impact effect of the reduction in thhe minimum wage is an increase in the demand for unskilled labor in the private sector of the ^rcder of 4.3 percent in the first year. The increase ir demand is met by the existing pool of unskilled workers seeking employment in the urban sector. As a result, the unskilled unemployment rate drops sigrificantly, by 2.8 percentage points in the first year.<sup>27</sup> The cut in the minimuum wage, by reducing the r_eiative cost of unskilled labor, leads to substitution among production factors not only on impact but also over time. Because unskilled labor has a relatively high elasticity of substitution with respect to the composite factor consisting of skilled labor and physical capital, the -lower cost of that categcry of labor gives private firms in the formal sector an incentive to substitute away from skilled labor and physical capital. In tmrn, the fall in the demand for that category of labor puts downward pressure on skilled wages, which drop by 1.6

> 26 How this "transfer" of private savings to the government takes place is not explicitly specified; one can think of a "pure" financial ;ntermediary operating in the background. Note that a more elaborate approach would involve accounting explicitly fe: the issuance of government bonds, and thus portfoiEo decisions on the part of savers.

> 27 Note that, from equation (23), the initial change in unskilled unemployment is given _by AUNEu,o =_ **_-AU3dO/U;._** It therefore depends on the initial number of workers seeking employment in the formal sector. Similarly, from _(32), AUNEs,O = -AS3,G/S._

36
percent in the first period. On impact, labor supply is fixed in agriculture and the informal economy, so the level of employment does not change in either sector-and neither does the level of activity (real value added in both sectors is constant). The rise in real disposable income (by 1.1 percent and 1.5 percent, respectively) and real consumption of rural and informal sector households leads to higher value added prices and higher wages in both sectors. But value added prices go up by slightly more than wages in the second and subsequent periods, implying a fall in the product wage in both sectors and a rise in employment.

Over time, changes in wage differentials affect both rural-urban and formalinformal migration flows, and therefore the supply of labor in the various production sectors. The expected unskilled wage in the formal economy is constant on impact, as implied by (17) and (18). Despite the increase in unskilled employment in the private sector in the first period (and thus the increase in the probability of finding a job), the fall in the minimum wage is such that the urban expected wage falls. Moreover, because agricultural sector wages rise, the expected urban-rural wage differential (measured in proportion of the rural wage) falls by 8.7 percentage points in the second period, with this differential narrowing over time. As a result, the inflow of unskilled workers into the formal sector (measured in proportion of the total formal urban labor supply) falls by about 1.2 percent in periods 2 and 3. The reduction in the inflow of labor leads to an increase in informal sector wages throughout the adjustment period, by 2.6 percent in period 2, 1.6 percent in period 3, and so on. This increase in the informal sector wage, coupled with the reduction in the minimum wage (as well as the expected wage in the urban formal private sector, despite the higher employment probability) leads to a sharp fall in period 2 in the expected formal-informal wage differential. This tends therefore to reduce (by 1.2 percent in period 2, and about 2 percent over the entire adjustment period) the number of workers willing to queue for employment in the urban private sector. This, coupled with the sustained effect of the cut in the minimum wage on labor demand, explains the large effect on unemployment, which averages about 5 percent in the long run. Note also that throughout the adjustment period, despite significant fluctuations in the expected formal-informal wage differential and formal-informal migration flows, the supply of unskilled labor in the formal private sector remains systematically lower than its baseline value.

Although the behavior of nominal wages in agriculture reflects essentially changes in value added prices on impact (as noted earlier), over time it is 37
> also affected by changes in labor elemand -induced by changes in holuseholds' disposable income and expenditure-and migration flows. Aftef an initial increase in nominal wages, lower migration flows to urban areas begin to put downward pressure on rural wages, which end up faling (in nominal terms) by 1.6 percent in period 9 and 1.8 percent in the last period. As also indicated earlier, the reduction in the cost of unskilled labor induces a substitution away from skilled labor, which brings a sustained fall in skilled wages in nominal terms (by about 1.3 percent in the long run). Hlowever, the overall effect on labor demand is not large; skilled employment ir. the private formal sector falls in the long run by only about 0.1 percent. And because the supply of skilled labor remains roughly constant t-I^oughout (public investment in education and the number of school teachers are held

> constant at their baseline values), the skilled unemployment ra..e rises by

> about the same amount (in percentage points).<sup>28</sup> The reason fCr the small effect on skilled employment is that the direct substitution effect associated with the reduction in the minimum wage is offset by a fall in the skilled wage, resulting from general equilibrium effects-the drop in the nominal skilled wage is less than the fall in the value added price of the urban private formal

> sector, implying a rise in the product wage, and thus dampening tbae demand for labor. For instance, the nominal skilled wage drops by 1.6 percent in period 1, 2.4 percent in period 2, 1.4 percent in period 3, and 0.7 percent in period 4; at the same time, the price of value added in the private formal sector drops by 2.4 percent in period 1, 3.1 percent in period 2, 2.0 percent in period 3, and 1.4 percent in period 4.

The long-run effect on aggregate output (or real GDIP) is slightly positive, at about 0.3 percent.<sup>2 9</sup> Changes im real output (as measured by real value added) are also positive and small in the urban informal sector, b-ct between 0.7 to 1 percent in agriculture and the urban formal sector, which reflects here essentially changes in private activity. ,The impact on agricultural output tends to grow slightly over time, as a result of the gradual fall in agricultural wages, as noted earlier.

> 28As implied by equation (38), the level of e.Fort of skilled workers changes as a result of variations in the skilled unemployment rate. H1owever, given the magnitude of these

> variations, and the elasticity of the effort function with respect to relative wages, the impact on the supply of skilled labor is negligible relative to the baseline.

> 29Note that this analysis of the growth effects of a cut in the minimum wage does not account for the possible negative externality that may arise if such a cut reduces incentives

> for human capital accumulation, as emphasized by Cahuc and Michel (1095).

38
On the fiscal side, tax revenue falls by about 0.2 percentage points as a share of GDP during the adjustment period, mostly as a result of indirect taxes changing at a slower pace than nominal GDP. Because public investment falls by about 0.1 percentage points of GDP (reflecting a lower price of capital, that is, because _PK = PV 3,_ a fall in the value added price in the urban private formal sector), the increase in the overall deficit is about 0.1 percent of GDP. This deficit is financed by domestic borrowing. From the aggregate balance between investment and savings, and given the closure rule discussed earlier, this means that the savings rate of capitalists and rentiers has to increase to maintain equilibrium. Given the small size of that group (about 3 percent of the total number of households), this increase turns out to be quite large-between 5.8 and 6.6 percentage points in the long run.<sup>30</sup> Despite relatively large changes in real consumption and disposable income (mostly in urban areas), overall poverty indicators for the rural and urban sectors change relatively little during the adjustment period. This is, of course, related to the fact that the aggregate growth and income effects of the shock are fairly limited and involve essentially a re-allocation of resources across sectors. In addition, however, there are significant differences among household groups within the urban sector. In particular, although real consumption of the capitalists-rentiers group drops significantly, and the incidence of poverty (as measured by the consumption-based headcount index) increases slightly toward the end of the adjustment period, the _depth_ of poverty (as measured by the poverty gap) is barely affected in either the short or the long run. By contrast, income-based poverty indicators barely change. This difference in behavior of the two sets of indicators is, of course, related to the fact that the savings rate of capitalists and rentiers is endogenously determined, thereby affecting directly expenditure patterns, rather than the level of income (see (75)). For unskilled workers engaged in the informal and formal sectors, both measures of poverty indicate a slight improvement in the longer run, regardless of whether the consumption- or income-based measure is used. This is also the case in the short run for informal sector workers. However, for unskilled workers in the formal sector, poverty increases slightly on impact-by about 0.1 percentage points when the income-based headcount index is used-and so does the skilled poverty

> 30It is worth noting that, if instead a "classical closure" had been chosen (with private investment determined residually), the government deficit would have had a direct crowding out effect on private capital formation. See, for instance, the discussion by Agenor and El Aynaoui (2003) of the case of Morocco in a similar setting.

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rate in the longer run. There is therefore a potential _trade-off_ emerging between unemployment and poverty: although the reduction in the minimum wage raises unskilled employment in the formal sector, it also mncreases poverty (albeit slightly) in the short term for that category of households, whereas the poverty rate for skilled workers in the formal sector r.ses both in the short and the long run. Changes in the consumption-base& Gii coefficient indicate that income distribution is effected quite significantly by a cut in the minimum wage; the degree of inequality falls by more than one percentage point in the long run. This effect is directly related to the sharp reduction in consumption experienced by capitalists and rentiers, .elative to other household groups.

# 3.2 Out 2ln PayroHR tas an U k%lild1 laba:r

The simulation results associated with a permanent, 5 percentage-point reduction in the payroll tax rate on unskilled labor are illustrateed in Tables 3 to 8. The results correspond to three alternative budget financing rules: domestic borrowing (that is, an endogenous adjustment in the capitalistsrentiers savings rate, as in the previous case) with no offsetting t?x change; an offsetting, revenue-neutral increase in sales taxes on private forraal sector goods only; and a revenue-neutral increase in income taxes.<sup>31</sup>

## 3.2O . EDomestic E1orc>winng

Consider first the case of domestic borrowing (7ables 3 and 4). Tne impact effect of a reduction in the payroll tax rate is qualitatively similez to a cut in the minimum wage, as discussed earlier: by reducing the effectfve cost of unskilled labor, it tends to increase immediately the demand for that category of labor-in the present case by 3.4 percent in the first year, anc by about the same amount on average during the adjustment period. Thie unskilled unemployment rate drops by 2.2 percentage points in the first year as well, and in the long run by an average of 1.4 percent. And the reduction in the

> 31A potential problem with these simula-tions, as in othex studies along the same linesuch as Dreze et al. (1984)-is the failure to distinguish between changes in _average_ tax rates, and changes in _margznal_ tax rates. The effects could be very different. .Por instance, a reduction in the average payroll tax rate might reduce "wage-push" press-as, whereas a cut in marginal rates might reduce the unemployment cost of achieving a higher net income, thereby influencing trade unions' bargaining strategies.

40
"effective" cost of unskilled labor leads firms in the private formal urban sector to substitute away from skilled labor and physical capital, leading to a reduction in skilled wages in nominal terms (by 1.4 percent in period 1, 2.5 percent in period 2, 1.9 percent in period 3, and 1.1 percent in period 4) and a reduction in the price of capital (that is, the price of the private formal good) by about 1.2 percent on impact. In the present case, however, the skilled nominal wage falls by more than the price of value added in the private formal sector (which drops by 1.2 percent in period 1, 2.1 percent in period 2, 1.4 percent in period 3, and 0.7 percent in period 4), implying a fall in the skilled product wage and stimulating the demand for that category of labor. Thus, the adverse impact of the substitution effect induced by the reduction in the cost of unskilled labor on the demand for skilled labor is dampened. Overall, skilled employment falls by about 0.1 percent on impact and 0.2 percent in the longer run, bringing with it a concomitant increase in the skilled unemployment rate.

The behavior of the (expected) urban-rural wage differential follows a pattern qualitatively similar to the one described in the previous experiment, although the magnitude of the initial effects are not as large. The expected formal-informal wage differential, however, _increases_ now in the second period. The reason is that the minimum wage does not change this time around, and the increase in unskilled employment raises the probability of finding a job in the private sector, thereby increasing the expected formal sector wage. As a result, therefore, there is an increase in the number of unskilled job seekers in the formal economy (by 0.6 percent in period 2), which therefore mitigates the initial reduction in unemployment. In the subsequent period, however, because of the sharp increase in the informal sector wage (itself due to the reduction in labor supply in the informal economy), the formal-informal wage differential moves in the opposite direction and by about the same amount (1.8 percentage points)-thereby reducing the number of unskilled job seekers in the formal sector. These fluctuations in wage differentials, migration flows, and labor supply in the formal and informal sectors continue throughout the adjustment period.

The overall effect on aggregate real output is, again, fairly small-given that this is also a shock that fundamentally entails a change in relative prices as the initial impulse (in both cases, a change in the relative price of unskilled labor). An important feature of the long-run adjustment process, however, is a reduction in the size of the informal sector and an expansion of the private formal urban sector, which essentially results from the transfer of 41
unskilled labor across these two sectors. This result is therefore consistent with the. widely-held view (discussed in the introduction) that reducing the tax burden on the formal sector is essential to limit the growth of the informal sector, although in the present case the "disincentive' effects of taxation<sup>are</sup> indirect and captured at the level of firms, and do not account explicitly for the propensity to evade income taxes by individuals. The government budget is of course more significantly affected, with indirect tax revenue falling by about 0.4 percentage points of GDP. Despite the drop in the price of capital (which tends to raise the desired capital stock, as implied by<sup>(78)),</sup> the drop in profits-resulting from the reduction in private consumption<sup>by</sup> capitalists and rentiers, and to a lesser extent by skilled households in the formal sector-private investment drops significantly in the first 2-3 periods following the shock, recovering partly thereafter. Because the current account improves (by about 0.6 percentage points of GDP in the long run), private capital inflows fall. Despite the initially large reduction in private<sup>investment,</sup> borrowing by the government and the reduction in foreign savings<sup>lead toa</sup> fairly significaiit increase in the savings rate of capitalists-rentiers relative to its baseline value (about 8 percentage points during the adjustment period).

Poverty and distributional indicators are affected in the same direction as before. In particular, after increasing during the first part of the adjustment period, the consumption-based headcount index for capitalists and rentiers shows a slight increase toward the end of the adjustment period,<sup>whereasthe</sup> poverty gap barely changes. And because the drop in consumption for that category of households is larger than in the case of a cut in the minimum wage, the degree of inequality (as measured by the consumption-based Gini coefficient or the Theil index) falls by a larger amount. In addition, in the present case, the poverty rate for unskilled households in the formal sector drops on impact, with no significant long-run effect, whereas skilled poverty rates increase throughout the adjustment period.

# **3.2.2 Revenue-Neutral Change**

Consider now the case where the effect of the cut in payroll taxes on overall tax revenue is offset by either an increase in sales taxes on private formal sector goods (Tables 5 and 6) or an increase in income taxes (Tables 7 and 8). In the latter case, the increase in the tax rate is assumed to be proportional across all households-except of course for informal sector households, who are not subject to direct taxation to begin with. Put differently, the 42
offsetting effect in both cases implies a constant level of total tax revenue, after accounting for general equilibrium effects.

In both cases, the impact and longer-run effects of the shock are qualitatively similar to those described earlier, although their magnitude differs. In particular, movements in the informal sector wage are less pronounced, in part because changes in rural-urban migration flows are not as large. By contrast (or, rather, by implication), movements in the expected formalinformal wage differential during the first part of the adjustment period are larger, implying more pronounced movements in the number of job seekers in the formal sector. Compared to the case of private sector borrowing, the reduction in the unskilled unemployment rate is less pronounced with an offsetting change in the sales tax, and of about the same magnitude when the income tax is adjusted, with also similar effects on overall real GDP and private investment. When the sales tax is adjusted, the fall in total private consumption is more pronounced than in the case of domestic borrowing or with an offsetting adjustment in the income tax (see Table 5). The reason, of course, is that the increase in the sales price reduces the purchasing power of income (everything else equal) and tends to reduce demand, particularly in urban areas (see Table 6). In both cases, the offsetting changes in the budget imply that domestic borrowing by the government does not change as a result of the reduction in the payroll tax; thus, the increase in the savings rate of capitalists and rentiers is much less pronounced that in the case in which the government finances its deficit through the private sector.

In both cases, changes in the poverty and distributional effects (as measured by the consumption-based indicators) are also less pronounced initially than in the case of a non-neutral shock, although the income-based poverty gap for formal skilled workers displays slightly larger and more persistent fluctuations in the case of an offsetting income tax change (see Table 8). This is obviously what one would expect given that disposable income for this particular group falls by a much larger amount compared to the nonneutral case-by about 2 percent for skilled workers in the formal sector between periods 6 and 10 (see Table 8), compared to about 0.8 percent with a non-neutral policy shock (see Table 4). As a result, the income-based Gini coefficient falls by more (by about 0.4 percentage points in the long run, compared to 0.2 in the non-neutral case), despite the fact that changes in the consumption-based measures of inequality are less pronounced. Overall, the results indicate that there are some significant differences in economic and poverty outcomes, depending on the offsetting change in the budget that 43
accompanies the reduction in the payroll tax.

# 4 _(CaU$CS$_

The purpose of this paper has been to present the structure of fir.-7MPA, a specialized version of the Integrated Macroeconomic Model f.or Poverty Analysis developed by Ag6nor, Izquierdo and Fofack (2003), and Ag6nor, Fernandes, Haddad and van der Mensbrugghe (2003), w.hich is particularly suitable for users interested mainly in assessing the quantitative efects of fiscal and labor market reforms on unemployment and poverty. Although Mini-IMMPA focuses only on the "real"' side, it offers a more detailed treatment of the labor market than KMMPA. (by accounting for features such as public education, employment subsidies, and firing ccsts) &nd the tax structure. The first part of the paper described in detail the st7ucture of Mini-IMMPA. In the second part the model was used to analyze the growth, unemployment and poverty effects of two types of labor market policies: a cut in the minimum wage and a reduction in the payroll tax rate on unskilled labor. In particular, the results (which arc obviously highly dependent on the selected closure rule) indicated that a reduction in the mi-mmum wage may have a sizable impact on unskilled unemployment, and that the extent to which a reduction in payroll taxes on usllaed labor lower une.mployment for that category of labor depends on how they are financed. More generally, the foregoing analysis suggests th2at the fiscal implications of labor market reforms have to be carefully analyzed 'n order to assess the potential impact of these reforms on unemployment and poverty. Labor mairket rerorms may end up having a limited overall elfect on unemployment and poverty, depending on how they are financed.

Another important implication of tae roregoing analysis-which is discussed in more detail in Agenor (2C03a)-is thaSt labor rnark-et reKrms aimed at reducing unemployment may end up increasing poverty, if they are implemented in a context in which fiscal constraints impose offsetting changes in financing. Consider, again, a reduction i-a payroll taxation on unskilled labor. Despite stimulating employment for that category of labor (as mentioned earlier), this policy measure may also lead to higher poverty, depending on how it is financed. An offsetting, across-the-board reduction in transfers, for instance, would have an immediate adverse effect on the poor. Financing through an increase in consumption taxes may raise the price of the con44
sumption basket of the poor and reduce their real income to a level below the poverty line. Financing through higher income taxes may reduce disposable income and the ability to spend; it may also drive over time activity underground, leading to a fall in the overall tax ratio, which in turn could force cuts in expenditure (including transfers to the most needy). Financing through a tax on capital (usually a limited option for governments, due to concerns about capital flight) may lower private investment capital; as noted earlier this may reduce skilled employment and mitigate the overall, positive effect on total employment. Finally, financing through a cut in government spending on infrastructure may affect aversely the overall productivity of production factors in the private sector (including labor) and lead to a reduction in wage income; it may also have a negative impact on private investment. This, in turn, will have an adverse overall effect on the demand for labor (due to the negative effect of investment on growth) as well as an adverse effect on the demand for skilled labor through the complementarity relationship between human capital and physical capital. Thus, although the direct effect of the reduction in the payroll tax rate on the demand for unskilled labor may well be positive (both in the short and medium run), overall employment (and thus unemployment) may not change much, as an increase in the number of unskilled jobs is offset by lower employment of skilled labor. In all of those cases, again, unemployment may fall, but poverty may increase-because of adverse effects on income, due either to lower after-tax wages or lower public transfers. There may therefore be a trade-off between unemployment and poverty goals.

In addition, of course, labor market reforms may themselves be complementary, if labor market institutions are complementary as well. As emphasized by Coe and Snower (1997), this implies that partial or piecemeal labor market reforms are unlikely to achieve significant and persistent reductions in unemployment rates or poverty. For instance, active labor market policies (such as retraining schemes) may not be very effective in the presence of substantial passive policies (such as stringent job security provisions). Reform programs must be sufficiently broad (in the sense of covering a wide range of complementary policies) and deep (of substantial magnitude) to have much of an effect. In addition, these reforms may also need to be combined with measures that address more efficiently the distributional objectives of the pre-reform policies, such as the imposition of high minimum wages.

The Mini-IMMPA prototype developed here can be used to analyze a variety of additional labor market policies. First, it can be used to analyze a 45
reduction in union bargaining pawer. To the extent that this translates into lower wages for skilled workers, this may afect incentives to ac3iuire skills. As noted by Lindbeck and Snower (2001), firing costs can increase a union's bargaining power, and help to explain excessive real wages and resultant involuntary unemployment. Second, the model can be used to analyze changes in employment subsidies for unskilled labor. ln general, the employment effects of an increase in employment subsidies and reductions in payroll taxes are different, as can be inferred from the results of Pisauro (1909) and Rasmussen (1998). Third, one could study the impact of a reductica in public unskilled employment in the production of government services, coupled with a deficit-neutral increase in subsidies to u-nskilled employment in the private formal sector.<sup>3 2</sup> The prototype presented in this paper can also be extended in a variety of directions. First, to the extent thaat patL o47 the job problem is a shortage of skilled workers, the model can be extended to account for subsidies to skills acquisition and/or on-the-job training. Second, labor taxation and labor market regulations may encourage firms to go informal.<sup>3 3</sup> This is captured only indirectly in the present version of the model. But changes in income taxes may have a direct effect on the prope.-sity to go informal; accounting for this effect may lead to an inverted U-shape curve between taxation and the size of the informal sector, depending on the use of tax revenues. Suppose, for instance, that revenues are used to finance higher spending on infrastructure. An increase in inzome taxes may well have a ocsitive effect on growth initially (by stimulating private production), but a negative effect afterward, as further increases tend to drive activity underground and reduce overall revenue. Finally, the model caTn be extended to consider the impact of the introduction of social insurance on savings, labor supply, and unemployment.<sup>3 4</sup>

> 32Several of these shocks are analyz^d by Ag6nor, Nabli, Yusef, and Ecyniung (2003), in a variant of the present model. Note that a meaningful analysis of public employment and wage shocks requires the introduction of a oroduction function for pubL;c services, in order to break the equality between the wage bill and the production of value added.

> 33 See for instance Sarte (2000) or 'hi-ig and Moe (2001) for a model wit& transitional dynamics, and Schneider and Enste (2000) for a more general discussion. KXugler (2000) develops a model in which job security regulations provide incentives for nigh turnover firms to operate in the informal sector.

> 34 See Karni (1999) for a thorough discussion of analytical issues in the design of unemployment benefit schemes.

45