metadata: authors: 0: author: Rutkowski,Jan Jerzy
count: Croatia
docna: 0: docna: Does strict employment protection discourage
            job creation? Evidence from Croatia
docty: Policy Research Working Paper
subtopic: Labor Markets,Employment and Unemployment,Rural Labor Markets
teratopic: International Economics and Trade
abstracts: cdata!: Employment protection legislation in
            Croatia is among the most strict in Europe. Firing is
            difficult and costly, and flexible forms of employment are
            limited. Is this apparent rigidity reflected-as one would
            expect based on standard economic theory-in low labor market
            dynamics? Is job creation low and hiring limited? Is the job
            security of insiders achieved at the cost of outsiders not
            being able to enter the labor market? The author attempts to
            answer these questions by examining job flows. If the
            employment protection legislation is binding, then job and
            worker turnover should be low. He shows that this is indeed
            the case. Hiring is limited and the average job tenure is
            very long in Croatia. Job destruction is low, however job
            creation is still lower. The result is accumulation of
            unemployment, in large part due to new labor market entrants
            not being able to find a job. The high degree of job
            protection also seems to strengthen the bargaining position
            of insiders and results in relatively high wages. So, wages
            in Croatia are higher than among its competitors, even after
            adjusting for productivity. These high labor costs are
            likely to contribute to limited job creation in existing
            firms, but also are likely to discourage the entry of-and
            thus job creation in-new firms. The author presents evidence
            that firm growth has been indeed limited in Croatia,
            contributing to the low employment level. The author
            examines other potential causes of high unemployment in
            Croatia (the unemployment benefit system, labor taxation,
            the wage structure, and skill and spatial mismatches). He
            argues that they do not play a substantial part in
            accounting for poor labor market outcomes in Croatia. The
            author concludes that the stringent employment protection
            legislation is the key labor market institution behind low
            job creation and high unemployment. Based on this he
            recommends specific measures aimed at liberalizing the labor
            market to foster job creation and employment.
geo_reg_key: 517208,517190,517191
repnme: repnme: Does strict employment protection
            discourage job creation? Evidence from Croatia
display_title: Does strict employment protection
            discourage job creation Evidence from Croatia
listing_relative_url: /research/2003/08/2487581/strict-employment-protection-discourage-job-creation-evidence-croatia
topicv3: Job Creation and Job Opportunities
            m1326483 1170,Labor Markets m1326488 855,Jobs m1503931 2670,Unemployment m1504051 2747,Jobs Strategies m1504080 2769
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Human Development Sector Unit (ECSHD)
no_of_pages: 76
author_keys: 0: author_key: 99825
model_extractions: I POLICY **RESEARCH WORKING**<sup>**PAPER**3104</sup>

# **Abstract**

Employment protection legislation<sup>inCroatiais among</sup> the most strict in Europe. Firing<sup>isdifficult and costly,</sup> and flexible forms of employment<sup>are limited.Is this</sup> apparent rigidity reflected-as<sup>one would expectbased</sup> on standard economic theory-in<sup>low labormarket</sup> dynamics? Is job creation low<sup>andhiringlimited?Is the</sup> job security of insiders achieved<sup>at thecostof outsiders</sup> not being able to enter the labor<sup>market?Rutkowski</sup> attempts to answer these questions<sup>byexamining job</sup> flows. If the employment protection<sup>legislationis</sup> binding, then job and worker turnover<sup>shouldbelow.</sup> He shows that this is indeed the<sup>case.Hiring islimited</sup> and the average job tenure is very<sup>longin Croatia. Job</sup> destruction is low, however job<sup>creationis stilllower.</sup> The result is accumulation of<sup>unemployment,in large</sup> part due to new labor market entrants<sup>notbeing ableto</sup> find a job.

The high degree of job protection<sup>alsoseemsto</sup> strengthen the bargaining position<sup>of insidersandresults</sup> in relatively high wages. So, wages<sup>inCroatiaarehigher</sup> than among its competitors, even<sup>after adjustingfor</sup> productivity. These high labor<sup>costs arelikely to</sup> contribute to limited job creation<sup>in existingfirms,but</sup> also are likely to discourage<sup>theentry of-andthus job</sup> creation in-new firms. The author<sup>presentsevidence</sup> that firm growth has been indeed<sup>limitedinCroatia,</sup> contributing to the low employment<sup>level.</sup> Rutkowski examines other potential<sup>causesof high</sup> unemployment in Croatia (the unemployment<sup>benefit</sup> system, labor taxation, the wage<sup>structure,andskilland</sup> spatial mismatches). He argues<sup>that they donot playa</sup> substantial part in accounting for poor<sup>labor market</sup> outcomes in Croatia. The author<sup>concludesthatthe</sup> stringent employment protection<sup>legislationisthe key</sup> labor market institution behind<sup>lowjob creationand</sup> high unemployment. Based on<sup>thishe recommends</sup> specific measures aimed at liberalizing<sup>thelabor market</sup> to foster job creation and employment.

This paper-a product of the<sup>HumanDevelopmentSector Unit,Europe and Central Asia Region-ispart of a larger effort</sup> in the reg'ton to examine labor market<sup>performance and its contributionto economic growth and poverty reduction. Copies</sup> of the'paper are available free<sup>fromtheWorldBank,1818HStreetNW,Washington,DC 20433.PleasecontactJan</sup> Rutkowski, room H7-170, telephone<sup>202-458-4569,fax 202-477-3387,email address jrutkowski@worldbank.org.Policy</sup> Research Working Papers are<sup>alsopostedonthe Webat http://econ.worldbank.org.August2003.(63pages)</sup> _The Policy Research Working Paper_<sup>_Series disseminates the findingsofworkin progress toencourage theexchange of ideas about_</sup> _development issues. An objective of_<sup>_the series is to get the findings out quickly, even if the presentations are less than fully polished. The_</sup> _papers carry the names of the authors_<sup>_and should be cited accordingly. The findings, interpretations, and conclusions expressed inthis_</sup> _paper are entirely those of the authors._<sup>_They do not necessarily represent the viewof the World Bank,its Executive Directors, or the_</sup> _countries they represent._ Produced by Partnerships, Capacity<sup>Building,andOutreach</sup>
## Does Strict Employment Protection<sup>Discourage</sup> **Job** Creation?

## Evidence **from** Croatia

# Jan Rutkowski

This paper was prepared for the Croatia<sup>Country EconomicMemorandum, which wasled</sup> by Helena Tang and Daniel Oks.
# Table of Contents

|I.LaborMarketPerformance<sup>inCroatia.</sup><br>**..............................................**<br>**1**|
|---|
|II.AStagnantLaborMarket:<sup>theChallengeof JobCreation</sup><sup>**...............**12</sup>|
|**Firmformation..........................................................**<br>13<br>|
|Jobcreationandjobdestruction<sup>.......................................................</sup><br>16<br> <br>|
|Jobturnoverbyfirmownership<sup>and size..........................................</sup><br>.............19<br> <br>|
|Jobtumoverbyindustry.......................................................<br>21<br> <br>|
|Jobturnoverbyregion<br>................................................<br>26|
|Determinantsofjob creation<br>**...........................................**<br>28<br>|
|Stagnantlabormarket:job<sup>stabilitybutnohiring</sup><br>**.............................**<br>37|
|III.WhyistheLaborMarket<sup>Stagnant?</sup><br>**.**<br>**.**<br>**......................39**|
|Stringentemploymentprotection<sup>legislation</sup><sup>**......................................................**</sup><br>40<br>Highlaborcosts**.......................................................**<br>44<br> <br>4|
|Compressedwagestructure<sup>**.......................................................**</sup><br>8<br> <br>|
|Skillandspatialmismatches<sup>**.......................................................**</sup><br>52<br>|
|IV.ConclusionsandRecommendations:<sup>BarrierstoJobCreationandhow</sup>|
|toremovethem<br>**............................**<br>54|
|References<br>..<br>**............................**<br>56|
|Annex1<br>.<br>.<br>.<br>**...........................**58<br>|
|Annex2<br>.<br>.<br>.<br>**.........................**<br>60|
# **Tables**

|Table1Keylaborforcendicators...................................................<br>**2**<br>|
|---|
|Table2LaborforceindicatorsinCroatia<sup>andinOECD countries...................................................... 4</sup><br>|
|Table3Selected indicatorsoflabor<sup>marketdynamics,1995-2001.........................</sup><br>5<br>|
|Table4Jobseekersbypreviouslabor<sup>marketstatus,2001....................................................</sup><br>6<br>|
|Table5Registeredunemployment,<sup>1992-2002...................................................</sup><br>10<br>|
|Table6Firm growthbyfirmsize,1993-2000<sup>...................................................</sup><br>14<br>|
|Table7Employmentbyfirmsize,<sup>2001...................................................</sup><br>16<br>|
|Table8Jobcreationandjobdestruction:<sup>Croatia against selectedcountries.................................15</sup><br>|
|Table9Jobcreationandjobdestruction<sup>bysector,2001...................................................</sup><br>17|
|Table10Jobturnoverby industry,<sup>2001</sup>...................................................<br>19<br>|
|A.Top10industries withhighestrates<sup>ofgrossjobcreation...................................................</sup><br>25<br>|
|B.Top10industrieswith highestrates<sup>ofgrossjobdestruction...................................................</sup><br>25<br>|
|C.Top10industrieswithhighestemployment<sup>growth...................................................</sup><br>25<br>|
|D.Top10industries withlargest employment<sup>decline...................................................</sup><br>25<br>|
|E.Top10industries with highestrate<sup>of jobreallocation...................................................</sup><br>26|
|Table11OLSestimationoftheemployment<sup>equation...................................................</sup><br>33|
|Table12Changesinemployment byfirm<sup>category,2000-2001...................................................</sup><br>37<br>|
|Table13Distributionofemploymentby<sup>jobtenure:Croatiaagainst selected countries..................40</sup><br>|
|Table14Employment Protection<sup>LegislationStrictnessforCroatiaand Central and</sup><br>|
|EastEuropeanEUaccession countries<sup>(CEEEUAC)...........................................................</sup><br>43<br>|
|Table15Grossmonthlywagesinmanufacturing,<sup>2000...........................................................</sup><br>47|
|Table16Thestructureoflaborcosts<sup>...........................................................</sup><br>49|
|Table17Summaryofearnings<sup>a)</sup>distribution,<sup>2001..................................</sup><br>51|
|Table18Thestructureofthelaborforce<sup>byeducationalattainment,2001...............55</sup><br>|
|TableAlSamplestructurebysize,<sup>ownershipandsector..................................................</sup><br>61<br>|
|TableA2Samplestructurebysize,<sup>ownershipandsector,2001..................................................</sup><br>63|
|**Figures**|
|---|
|Figure1Theevolutionofregistered<sup>unemployment,1992- 2002.................</sup><br>.............2<br>Figure2Job flows byregion...........<br>.......29|
|Boxes|
|Box1Unemployment:theLabor Force<sup>Surveyvs.administrativedata................ 1 I</sup><br>Box2UnemploymentBenefitSystem<sup>inCroatia..........................................14</sup><br>Box3JobTumoveranditsComponents.................................................<br>19|
## INTRODUCTION

Employment protection<sup>legislationinCroatiaisamong themoststrictin</sup> Europe. Termination<sup>isdifficultand costly, and flexibleformsof employmentare</sup> limited. At the same time long-term<sup>unemploymentishighwhile employmentis</sup> declining. This paper tries to determine<sup>ifthesetwofacts arelinked.</sup> Does the stringent protection legislation<sup>contributetohighunemployment?</sup> To answer this question the paper analyzes<sup>labor market dynamicsinCroatia,particularlyjob flows.</sup> If employment protection<sup>regulationisbinding,then jobturnoverisexpectedtobe</sup> low. Job destruction will be<sup>low becauseitiscostly fortheemployertoclosean</sup> unproductive job. Job creation<sup>will belowbecause employerswillavoid hiringnew</sup> workers in order not to<sup>incurfuturedismissalcosts.</sup> The paper finds that this<sup>is</sup> indeed the case. Job destruction<sup>in Croatiais low byinternationalstandards,and job</sup> creation is still lower. The result is falling<sup>employmentandaccumulationof</sup> unemployment, in large<sup>partdueto new labor market entrantsnot beingabletofinda</sup> job.

The paper examines other<sup>potentialcausesof highunemploymentinCroatia</sup> (the unemployment benefit<sup>system, labor taxation,thewage structure, and skilland</sup> spatial mismatches). It<sup>arguesthat theydonot playasubstantialpart inaccounting</sup> for poor labor market<sup>outcomesinCroatia.</sup> Thus, the paper concludes<sup>thatthe</sup> stringent employment protection<sup>legislationis the key labormarket institutioncausing</sup> high unemployment. Low job creation seems<sup>thepricetobepaidfor highjob</sup> protection.

The paper is organized as<sup>follows.The firstsectionpresentskey labormarket</sup> outcomes in Croatia. The<sup>secondsectionanalyses labormarketdynamics, focusing</sup> on job flows.- The third<sup>section examinespotentialfactorsthat explainthe stagnant,</sup> low turnover nature of the<sup>Croatianlabormarket.Thefinalsection concludesand</sup> recommends reforms to<sup>foster job creation.</sup>

# I. LABOR MARKET PERFORMANCE<sup>INCROATIA</sup>

The labor market does not<sup>performwell inCroatia.Theunemploymentrate</sup> hovers around 16 percent<sup>(Table1).</sup> The gradual increase<sup>inthe(registered)</sup>
unemployment stock has started in 1996,<sup>when inflowinto hasbeguntoexceed</sup> outflow from unemployment, and has accelerated<sup>after1998(Figure1).1Majorityof</sup> the unemployed (55 percent) are jobless<sup>for overoneyear,i.e.arelong-term</sup> unemployed. High unemployment combined<sup>with a lowlabor force participationrate</sup> (about 50 percent) implies low employment-to-population<sup>ratio.Only42 percent of</sup> persons of working age (aged 15 or more) are<sup>employedin Croatia.This entailsa low</sup> level of the utilization of labor resources<sup>andtranslatesinthelower levelof output</sup> and, eventually, lower economic welfare.

**Table 1 Key labor force indicators**

<!-- Start of picture text --> 2000.1 2000.11 2001.1 2001.11<br>Labor force participation rate 50.4 51.1 49.0 50.3<br>Employment rate 42.8 42.4 41.5 42.1<br>Unemployment rate 15.1 17.0 15.3. 16.3<br>Share of LTU 52.1 53.6 56.9 55.3<br>Notes:<br>Labor force participation rate = (Employed + Unemployed)/Population aged 15+<br>Employment rate = Employed/Population aged 15+<br>Unemployment rate = Unemployment/Labor force<br>Source: Labour Force Force in the Republic of of Croatia, Second Half-year of 2001, of 2001, 2001, Central Bureau of Statistics.of Statistics.Statistics.<br>Figure 1 The evolution of registered unemployment, 1992 - 2002<br>450<br>400 ._ _ _-- . - L - ,<br>350<br>300 .- -- -<br>o 250 - ~ v -- . {. -Unemployment<br>° 200- ~-7.. ;- nfo<br>250 15 - <-- . . Outflow<br>100 - - . . --, C<br>am a) a)C0) 0C 0) 0 ) 0 0 0<br>0) 0) 0 0) 0) 0) 0) 0) 0 0 0<br>_ _- _ - _- _- _ _ Ca N N<br>Source: Croatian Employment Service.<br><!-- End of picture text --> Source: Labour Force Force in the Republic of of<sup>Croatia,SecondHalf-year of 2001, of 2001, 2001,CentralBureau of Statistics.of Statistics.Statistics.</sup> Data used to calculate the unemployment rate (shown<sup>in Table1) come from the Labor Force</sup> Survey (LFS), which applies the standard ILO<sup>definitionof unemployment.Data on the dynamics of</sup> unemployment (show in Figure 1) come from<sup>theunemploymentregister and are not comparable with</sup> the LFS data. The description of both sources<sup>of unemploymentdata is providedin Box1.</sup> _-2-_
The low employment-to-population<sup>ratio-akeyindicatoroflabormarket</sup> performance - is a result<sup>ofthreefactorsthatdistinguishCroatiafromanaverage</sup> OECD country (Table 2).<sup>Theseare:</sup>

- Extremely high youth<sup>unemployment (over40percent)andlowlaborforce</sup> participation of young<sup>persons (aged15-24);</sup>

- Relatively low labor<sup>force participationof prime-agemen (aged25-49);</sup>

- Relatively low labor force<sup>participationof older persons (aged50 or more).</sup>

The overall low labor<sup>forceparticipationreflectspooravailabilityof job</sup> opportunities and is associated<sup>withtheso-called"discouragedworker"effect. This</sup> means that workers cease<sup>their jobsearcheffort becausetheir earlier attemptsto find</sup> work have proved futile<sup>and thusthey believethat no jobsare available.Highyouth</sup> unemployment is often<sup>indicativeof labor market rigiditiesand barriersto entry(such</sup> as high hiring and flring<sup>costs).Thesecharacteristicsof thelabor marketarequite</sup> typical of other transition economies with inflexible labor markets.

_-3-_
> **Table 2 Labor force indicators in Croatia and in** OECD **countries by gender and** age **categories**

|||All wor|kers|||Men|||Women||
|---|---|---|---|---|---|---|---|---|---|---|
||15to64|15to24|25to49|50to64|15to24|25to49|50to64|15to24|25to49|50to64|
|Croatia(2001.11)|||||||||||
|Unemploymentrate|16.8|41.9|14.2|8.3|41.8|11.5|<br>8.5|42.0|17.2|<br>8.1|
|Laborforceparticipation rate|62.2|41.9|82.4|40.9|43.3|88.2|54.0|40.4|77.0|<br>29.2|
|Employmentrate|51.8|24.3|70.7|<br>37.5|25.2|77.9|49.5|23.8|63.8|<br>27.1|
||15to64|15to24|25to54|55to64|15to24|25to54|55to64|15to24|25to54|55to64|
|OECD (1999)|||||||||||
|Unemploymentrate|6.4|11.8|5.4|5.2|11.7|4.9|<br>5.6|11.9|6.1|4.6|
|Laborforceparticipationrate|70.4|53.0|80.3|<br>51.6|57.8|93.0|64.5|48.0|67.8|<br>39.4|
|Employmentrate|65.9|46.7|75.9|<br>48.9|51.1|88.5|<br>60.8|42.3|63.6|<br>37.6|

# Source:

> Croatia: Labour Force in the Republic of Croatia, Second half-year of 2001, Central Bureau of Statistics; Author's calculations.

> OECD: Employment Outlook, 2000.

-4-
The low employment-to-population<sup>ratio in Croatiais,inter alia,the resultof a</sup> mode of labor market<sup>adjustmenttonumeroussupplyanddemand"shocks"</sup> associated with the economic<sup>transition. Asinmostothercountriesof Centraland</sup> Easter Europe (CEE),<sup>thebruntofadjustment hasbeen born byemployment rather</sup> than wages. Employment has declined<sup>while-</sup> once the growth of output<sup>has</sup> resumed -- wages have<sup>roughly followedproductivityincreases.</sup> Since 1995 employment has declined<sup>byafewpercent,while realwageshavegrownby about</sup> one third and productivity<sup>(in industry)has increasedeven more (Table3).2</sup>

**Table 3 Selected indicators**<sup>**of labor market dynamics,1995-2001**</sup>

||**1996**|**1997**|**1998**|**1999**|**2000**|**2001**|
|---|---|---|---|---|---|---|
||||_1995= 10_<br>|_0_<br>|1330|1318|
|Realgrosswages<br>|107.9<br>|117.2<br>|124.9<br>|132.1<br>4|.<br>943|.<br>963|
|Employment<br>|103.7<br>|96.1<br>|99.1<br>|97.<br>|.<br>|.<br>1608|
|Laborproductivity(industry)<br>|111.3|124.5|135.4|140.7|146.7|.|
|Memorandum:<br>||||13551|1605|158|
|LFSunemploymentrate,<sup>%</sup>|10.0|9.9|11.4|.|.|.|

# I indicates the break in<sup>time-series</sup>

Note: In 2000 the sample<sup>frame for theLaborForceSurvey(LFS)was changed andaccordingly,</sup> the results are 'not fully<sup>comparableover time.</sup> Source: Central Bureau<sup>of Statistics, the WorldBank database, Author'scalculations.</sup> The fall in employment<sup>coupledwithsignificantproductivitygains reflects</sup> what can be called a "productivity<sup>catch-up".Overmanningwascommoninsocially</sup> owned firms in Croatia,<sup>whichwasassociatedwithlowlaborproductivity.</sup> As the transition progressed<sup>enterprises havebeensubjecttoanintensifiedcompetitive</sup> pressure, coming from<sup>thedeveloping private sector aswellasfromforeign</sup> competitors, increasingly<sup>enteringthe Croatianmarket.</sup> This has forced firms to reduce costs, cut employment<sup>and improve productivity.For manyfirms,especially</sup> the privatized ones, downsizing<sup>hasbecomeaprerequisite forasurvivalinamore</sup> competitive environment.<sup>Toillustratethisprocess,anaveragefirmsizehasalmost</sup> halved during the transition<sup>in Croatia,decreasingfrom over22 employeesin1993to</sup> about 12 employees in<sup>2000.3</sup>

> 2 Data on employment levels<sup>can be inaccuratedue to problemswithadequate coverageof</sup> small private firms by the<sup>employmentsurvey.</sup> 3 Data refer to registered firms<sup>whichare legal persons (FINA/ZAPregister).</sup>

_-5-_
The resulting labor shedding has led to improved productivity and lower<sup>costs,</sup> but also - given limited job creation - has contributed to unemployment.<sup>Indeed,over</sup> 50 percent of the unemployed are persons who lost<sup>their job,of which20 percentin</sup> the public sector, and 30 percent in the private sector (Table<sup>4).Nonetheless,itis</sup> worth noting that this proportion of job losers in total<sup>unemployment issignificantly</sup> lower than in other intensively restructuring transition<sup>economies, (suchas Hungary</sup> or Poland) and OECD countries, where it varies around<sup>75percent.Thismeansthat</sup> new entrants account for a disproportionately large fraction of<sup>unemployment,which</sup> again points to labor market rigidities, preventing persons without<sup>previousjob</sup> experience to enter the labor market.

**Table 4 Job seekers by previous labor market status, 2001**

|Labor forcestatus beforethe startofjobsearch|Percentof<br>alljob<br>seekers<br>|
|---|---|
|**Employed**|**55.9**<br>|
|Workersinthepublicsector<br>|19.9<br>|
|Workersintheprivatesector<br>|25.9<br>|
|Self-employedandemployers(privatesector)|3.9<br>|
|Unpaidfamilyworkers<br>|1.4<br>|
|Temporaryworkersforpaymentinkind|4.9<br>|
|**Outofthelabor force**|**44.1**<br>|
|Students|26.1<br>|
|Housekeepers|7.7<br>|
|Pensioners|1.0<br>|
|Militaryservice|8.2<br>|
|Others|1.1|

Source: CBS, LFS second half-year 2001, Author's calculations.

Enterprise restructuring has given rise to accelerated inflows into unemployment, a process which begun in the mid 1990s in Croatia<sup>(Table5).This</sup> has been reflected in an increasing proportion of workers who<sup>werelaid-off among</sup> the unemployed and, correspondingly, in a decreasing proportion of<sup>workerswithout</sup> previous labor market experience (whose share in unemployment was disproportionately large at an early stage of the transition in Croatia).

At the same time oufflows from unemployment, including outflows to jobs, have slowed down, and presently fall short of inflows into<sup>unemployment.</sup> For example, in 2001 as much as 74 thousand persons newly registered<sup>atEmployment</sup>

-6-
Offices, while 70 thousand<sup>werederegistered,of whichonlylessthan40thousand</sup> reportedly found jobs<sup>(Table 5).Sincethe excess of inflows into unemploymentover</sup> outflows from unemployment<sup>haspersistedovera numberof years,the resulthas</sup> been a gradual build<sup>up of unemployment. Whileregistered unemploymentwas240</sup> thousand in 1995, in early<sup>2002it alreadyexceeded410 thousand.</sup> There is a discrepancy<sup>between unemploymentdatacomingfromthe</sup> unemployment register<sup>andfromthe Labor ForceSurvey(see Box1 for a description</sup> of the differences between<sup>bothsources).This isa common regularity,and Croatiais</sup> no exception, however<sup>thediscrepancyisquite dramatic.Over 40percentofall</sup> persons who are registered<sup>at EmploymentOfficesare</sup><sup>_not_unemployedaccordingto</sup> the ILO definition of<sup>unemployment! 4They either have a job (in theinformal sector),</sup> or are not actively looking<sup>forwork, or arenot availablefor work.</sup> The genuinely unemployed<sup>asa ruleregister at EmploymentOffices;only14</sup> percent of the job seekers<sup>do notregister,and thisgroupis likely toincludemainly</sup> persons whose unemployment<sup>is short-termor transient.The net effect is thus that the</sup> unemployment register<sup>datasignificantly-byalmost50percent -</sup> overestimate the level of unemployment.

4 Based on the Labor Force<sup>Survey data from the second half of 2001.</sup>

-7-
# **Box l Unemployment: the Labor Force Survey vs. administrative**<sup>**data**</sup>

In Croatia as in most other countries, there are two main<sup>sourcesof data on</sup> unemployment: the Labor Force Survey (which is carried out twice<sup>a year by the Croatian</sup> Bureau of Statistics) and the unemployment register, maintained by<sup>the Croatian Employment</sup> Service (CES).

Both data sets have its strengths and weaknesses. The administrative<sup>data collected</sup> by the CES it provide long time-series of monthly information on persons<sup>who registered as</sup> unemployed (their socio-demographic characteristics, reasons for unemployment,<sup>duration of</sup> job search, etc.). Thanks to the fact that administrative data are<sup>compiled and published</sup> monthly, they allow one to follow changes in unemployment on a regular<sup>basis.As such they</sup> provide an early signal on changes in labor market conditions. However,<sup>the data are affected</sup> by various incentives to register, such as eligibility to unemployment<sup>benefits, pension and</sup> health insurance, and social assistance benefits. As a result, some<sup>persons register in order to</sup> get access to these benefits, although they are not genuinely unemployed.<sup>They either have</sup> an informal sector job, are not looking for a job, or are not available<sup>for work. At the same</sup> time, persons who are genuinely unemployed, often do not register if<sup>they are not eligiblefor</sup> benefits associated with registration. The net effect is usually (although<sup>not necessarily</sup> always) that the unemployment register data overstate the actual magnitude<sup>of</sup> unemployment. In the case of Croatia this upward bias is quite substantial<sup>(see text).</sup> Moreover, changes in benefit regime and thus in incentives<sup>to registerimply that</sup> administrative data on unemployment are often not fully comparable over<sup>time.For example,</sup> the tightening of unemployment benefit eligibility conditions leads<sup>to the drop in registered</sup> unemployment, as does more aggressive application ofjob search/availability<sup>tests, despite</sup> the fact the underlying labor market conditions have not changed: In contrast, unemployment data coming from the Labor Force Survey (LFS)<sup>provide</sup> information on the labor force status which is not affected by administrative<sup>regulations and</sup> thus more correctly reflect actual labor market conditions. The<sup>LFSuses the standard</sup> Intemational Labor Office (ILO) definition of unemployment,<sup>whereby a persons is</sup> unemployed if he/she jointly meets three conditions: (a) does not have<sup>a job, (b) is actively</sup> looking for a job, and (c) is available for work. Thanks to this the LFS produces intemationally comparable data on unemployment. In principle, the<sup>LFSalso produces</sup> unemployment data that is consistent over time, although changes in the<sup>sampleframe,survey</sup> design, etc. may lead to a limited comparability of results over time.<sup>For example,the CBS</sup> changed the sample frame for the LFS in 2000, which affected comparability<sup>of data.The</sup> disadvantage of the LFS is that the survey is carried out with a relatively<sup>low frequencyand</sup> sometimes irregularly. In addition, processing of the results is time<sup>consuming,meaning that</sup> the results are disseminated with a substantial delay (about 3 months in<sup>Croatia).This makes</sup> the LFS less suitable for regular and "real time" monitoring of labor<sup>market conditions.</sup> However, given the large number of variables it provides, the LFS<sup>is an invaluablesource of</sup> information for the purposes of labor market research.

In this paper we relay mainly on the LFS and accordingly use the<sup>ILO unemployment</sup> rate and other labor force indicators. However, to illustrate the trend<sup>in unemployment,we</sup> use the administrative data on registered unemployment, as in this<sup>case a much longer time-</sup> series is available (the first wave of the LFS was conducted in Croatia<sup>only in November</sup> 1996).

_-8-_
Relatively few unemployed<sup>receiveunemployment benefit.</sup> The benefit coverage rate (percentage<sup>of unemployedwhoreceivebenefit)has been below20</sup> percent since the mid<sup>1990s,reflectingtwofactors:(a)alargeproportionof new</sup> entrants to the labor<sup>market,whodonothaveaninsurancerecordtoqualifyfor</sup> unemployment benefit,<sup>and(b)a largeproportionof longterm unemployed,who are</sup> no longer eligible for<sup>thebenefit(withsomeexceptions,unemploymentbenefit</sup> duration is capped at one<sup>year).Thebenefitreplacementrate (i.e.benefit/eamings</sup> ratio) is low, as unemployment<sup>benefitaccountsforonlyabout one-fourthof the</sup> average wage. (See<sup>Box2onthedetailsof theunemploymentbenefitssystemin</sup> Croatia _-9-_
Table 5 Registered unemployment, 1992-2002

|<br>|1992<br>|1993|1994|1995|1996|1997|1998|1999|2000|2001|2002.3|
|---|---|---|---|---|---|---|---|---|---|---|---|
|Unemployment('000)<br> <br>|266.6<br>2<br>|50.8<br>2|43.3<br>2|40.6<br>2<br>_Pe_|61<br>2<br>_rcentageo _|77.7<br>2<br>_funemploy_|87.8<br>3<br>_mentstock_|21.9<br>3|57.9<br>3|80.2<br>4|14.4|
|Women<br>|53.0<br>|55.2|53.6|51.6|49.7|49.4|51.9|52.5|52.7|53.5|53.8|
|Nolabormarketexperience<br>|29.8|32.0|34.2|35.1|33.6|32.2|31.4|29.4|28.2|27.4||
|RecipientsofUB<br>|22.1<br>|10.1|12.5|15.0|20.3|19.9|15.6|16.9|17.7|18.5||
|Inflow(newlyregistered)<br>|66.9|64.1|77.2|73.6|77.9|78.9|76.9|77.4|73.2|73.9|5.2|
|Outflow<br>|75.3<br>|71.3|76.6|73.0|70.2|72.5|71.5|65.2|62.9|69.5|5.0|
|tojobs<br>|30.0|29.1|35.2|31.5|35.7|36.7|38.0|32.8|33.0|38.8|3.2|
|removedfromregister<br>|45.3<br>|42.1|41.4|41.4|34.5|35.8|33.6|32.4|29.9|30.8|1.8|
|Unemployment-to-Vacanciesratio|2.0|1.8|1.6|1.9|2.1|2.2|2.2|2.4|2.4|1.9||

> Source: Monthly Statistics Bulletin 3/2002, Croatian Employment Service, Author's calculations.

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All these factors - the low replacement<sup>rate,relatively shortdurationof the</sup> benefit, and limited coverage - imply that<sup>laborsupplydisincentives are modestand</sup> thus the unemployment benefit system<sup>isunlikely to have much influenceon the level</sup> of unemployment in Croatia. Most importantly,<sup>low benefitcoverageimplies that the</sup> role of existing labor supply disincentives<sup>islimitedasfew peopleareaffectedby</sup> them.

# Box 2 **Unemployment Benefit System in Croatia**

**Eligibility condition:** work record of at<sup>least 9months in thelast 24 month.</sup>

**Benefit replacement rate:** 100 percent<sup>of averagesalary(net of social security</sup> contributions) in the last three month<sup>precedingunemployment, subject to the</sup> minimum of 20 percent of the national<sup>averagesalary,and the maximumdetermined</sup> by the Minister of Labor and approved<sup>by theMinister of Finance.Currentlythe</sup> maximum amount of unemployment<sup>benefit is Kn 900(compared to average wage of</sup> around Kn 3600). This means that<sup>in practiceunemploymentbenefit in Croatiais a</sup> _flat rate_ benefit, as the fixed amount of<sup>the benefit is much below the nationalaverage</sup> wage.

**Benefit duration:** The duration of unemployment<sup>benefit paymentis related to the</sup> length of service, with the minimum of<sup>78 days andthe maximum of 312days.</sup> However, workers with long years of<sup>service(35for menand 30 for women)are</sup> entitled to an open-ended unemployment<sup>benefit,i.e.until they find a new job or</sup> acquire retirement rights.

The specific schedule is as follows:

|**Durationofunemployment**<br>**benefit(days)**<br>|**Lengthofservice**<br>**(years)**<br>|
|---|---|
|78<br>|9months-2years<br>|
|104|2-3<br>|
|130<br>|3-4<br>|
|_156_<br>|4-5<br>|
|182<br>|_5-6_<br>|
|208<br>|6-7<br>|
|234<br>|7-8<br>|
|260<br>|8-9<br>|
|286<br>|9-10<br>|
|312|morethan10years<br>|
|unlimited|Men:morethan35years<br>|
||Women:more than30years|

Source: Law on Employment Mediation<sup>andEntitlementsduring Unemployment,</sup> 2002.
Surprisingly, the unemployment-to-vacancies _(UN)_<sup>ratio has somewhat</sup> improved over the recent period, and is quite<sup>favorableat1.9(meaningthatthereare</sup> less than two unemployed per one vacancy). The<sup>relatively large number of vacancies</sup> suggests a structural component of unemployment<sup>in Croatia.Forexample,unfilled</sup> job vacancies are likely to indicate that the unemployed<sup>have differentskillsthan</sup> those required in vacant jobs. However, better<sup>dataandfurther research are necessary</sup> to find out to what extent unemployment in Croatia<sup>hasstructural character.</sup> To conclude, labor market outcomes in Croatia<sup>havebeenandstillare</sup> unsatisfactory. Employment has declined and unemployment has<sup>increasedduring</sup> the transition. This has led to the fall in labor force<sup>participationand,consequently,to</sup> the low employment-to-population ratio. Relatively<sup>fewpersonsof workingagein</sup> Croatia have jobs. This low utilization of<sup>laborresources implies highsocialcostand</sup> a loss in social welfare. An increase in labor<sup>forceutilizationiscriticalfor Croatia's</sup> economic growth and increase in the standards of<sup>living.</sup> Seemingly, the reason behind declining employment<sup>and rising unemployment</sup> is enterprise restructuring associated with<sup>laborsheddingandresultingproductivity</sup> growth. However, further analysis will prove that<sup>this isonly a part -not the most</sup> important one - of the story. At a deeper level<sup>the mainreason for unfavorablelabor</sup> market outcomes is insufficient job creation. In<sup>fact,the jobcreation ratein Croatiais</sup> among the lowest among transition economies of<sup>CEE.</sup> Experience shows that enterprise restructuring and rising productivity do<sup>not havetoentail job lossesas long</sup> as the economy is able to generates a sufficient<sup>numberof new jobs.Inanefficient</sup> economy with a flexible labor market job creation<sup>goeshandinhandwithjob</sup> destruction, with new expanding firms<sup>absorbinglaborreleasedintheoldand</sup> declining finns. Hence, the relevant question is<sup>whatlimits the jobcreation potential</sup> of the Croatian economy? Why the Croatian economy<sup>doesnot generateasufficient</sup> number of jobs to offset the negative impact of<sup>enterpriserestructuring?</sup> This question is addressed in the next two sections.

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# **H.** A **STAGNANT LABOR MARKET:**<sup>**THE CHALLENGEOF JOB CREATION**</sup>

Declining employment and rising unemploymeii.mean<sup>that jobcreationin</sup> Croatia falls short of job destruction. The job creation'.potential of the<sup>Croatian</sup> economy is insufficient. Why is this<sup>the case?Why few jobs arebeingcreatedand</sup> unemployment is growing? There<sup>are</sup><sup>_two. prima facie_reasons. First,theremaybe</sup> barriers to _entry_ by new firms, limiting<sup>firm growth and density (numberof firms</sup> relative to population). Second, there may be barriers to _expansion,_<sup>encumbering</sup> employment growth in existing firms.<sup>Bel4indthese,tfiere'isanumberof specific</sup> factors that can inhibit firm entry<sup>andexpansion,andtherebyjobcreation.</sup> They include unfavorable investment climate'and<sup>poor businessenvironment,labormarket</sup> rigidities and high labor costs, an inflexible'wage<sup>structufe.Inaddition,new jobs that</sup> are being created are likely to differ<sup>insalientcharacteristicsfromold jobs thatare</sup> being destroyed. This may make the'transition<sup>fromnoldto new jobscostlyand may</sup> contribute to structural unemployment<sup>thro'ughskill andspatial mismatches.</sup> This section looks at the issues of firm<sup>entryand expansion,andanalyzesin</sup> more detail job creation and job<sup>destructionin Croatia.Thenextsectionexamines</sup> various factors behind the poor job<sup>creation recordof theCroatian economy.</sup>

# **Firm formation**

The growth in the number.of new<sup>firmsis criticalfor job creation.Business</sup> start-ups create about one-third of<sup>new jobsin the economy,aregularity observedin a</sup> number of transition economies, -such<sup>as Bulgaria,LithuaniaandPoland (Rutkowski</sup> 2001b, 2002a, 2002b). At the same<sup>timhe,firmdensityintransitioneconomiestends</sup> to be less than in mature market<sup>economies(BoeriandMartins,2000).Thus amajor</sup> challenge of the transition is to encourage<sup>firmnen'tryinorder to increasefirmdensity</sup> and thus the number of available<sup>jobs.Thisinvolvesanimportantstructuralchange:</sup> the transition from a relatively smialltnumber<sup>of large(publicly owned)firms towarda</sup> much larger number of smaller,<sup>privatefirms.</sup> This process of growing number of<sup>small privatefirmnsis already under way in</sup> Croatia. However, it is accompanied<sup>bytheclosures, of inefficientfirms,especially</sup> after 1997. As a result, the growth. in<sup>the oveiall riumberof firms has been wobbling.</sup> The number of firms is presently by<sup>abou.ttwo-thirdshigherthanitwasin1993</sup>
(Table 6).5 However, the number of<sup>firms in 2000 was below that in1995.Allin all,</sup> the rate of new enterprise growth<sup>wasinsufficientto offset theemployment reductions</sup> taking place in existing firms.

Table 6 **Firm** growth by firm<sup>**size,**1993-2000</sup> Index of growth, 1993=100

||**1994**|1995<br>|1996<br>|1997<br>|1998<br>|1999<br>|2000<br>|Avg.<br>**annuat**<br>growth<br>|
|---|---|---|---|---|---|---|---|---|
|Numberoffirms('000)<br>|139.7|168.3|174.5|182.0|174.3|168.5|165.1|7.4|
|Employment(1993=100)|||||||||
|Allfirms|97.5<br>|92.4<br>|92.3<br>|93.0<br>|92.2<br>|89.7<br>|92.9<br>|-1.0<br>|
|251+|93.3<br>|85.3<br>|81.5<br>|79.7<br>|76.4<br>|72.9<br>|72.0<br>|-4.6<br>|
|51- 250|89.5<br>|80.7<br>|81.7<br>|83.0<br>|82.7<br>|76.2<br>|75.9<br>|-3.9<br>|
|-50|119.5|127.9<br>|136.6<br>|143.5<br>|148.9<br>|155.0<br>|174.4<br>|8.3<br>|
|Stateowned|61.0<br>|48.1<br>|45.7<br>|46.0<br>|46.6<br>|37.9<br>|39.6<br>|-12.4<br>|
|Mixed|114.2<br>|110.1<br>|104.1<br>|96.2<br>|84.7<br>|84.8<br>|78.3<br>|-3.4<br>|
|Private|145.3|155.2|166.7|178.2|187.5|192.8|210.4|11.2|

Note: Data refer to registered<sup>legalpersons.</sup> Source: FINA, Author's calculations.

_5_ Data refer to enterprises which are<sup>registered as legalpersons.Since a substantial proportion</sup> of all enterprises are natural persons,<sup>the data presented may not be representativeof all enterprises.</sup> Moreover, there is likely to be a discrepancy<sup>betweenthe number of registered enterprisesand the</sup> number of actually active enterprises,<sup>the latter often being substantiallysmaller(EUROSTAT, 2000).</sup> _-14-_
In some other transition economies the<sup>processof newfirmsformation has</sup> been much more dynamic than in Croatia.<sup>For examplein Poland the numberof firms</sup> increased by some 80 percent over the<sup>period1995-2000,implyingan averageannual</sup> rate of growth of almost 13 percent,<sup>whichismuch higherthaninCroatia.6</sup> The example of Poland shows that fast<sup>firmgrowthdoesnotprotectfromhigh</sup> unemployment. However, the unemployment problem<sup>wouldhavebeenfar more</sup> serious if the firm growth had been<sup>slower.</sup> A likely reason for the insufficient pace of<sup>newfirm formationis high costsof</sup> entry in Croatia, one of the highest<sup>amongtransition economiesof CEE.Forexample</sup> Djankov et al. (2000) report that<sup>the numberof procedures for entryis14in Croatia</sup> (7 in Latvia, 9 in Slovenia), time for<sup>entryis58days(26 days in Poland,35in</sup> Slovenia), and monetary cost is 34<sup>percent of GDP per capita (7% in Slovenia,17%in</sup> Bulgaria). These high costs are bound<sup>tosignificantlyslowdowntherateof new</sup> enterprise growth, with a detrimental<sup>effecton employment.Consequently,lowering</sup> the costs of firm entry is a condition for<sup>faster job creation.</sup> As expected, the structure of employment<sup>byfirmsizehaschanged.</sup> Employment in large firms fell by<sup>almost 5 percentduring1993-2000.It alsofellin</sup> medium-sized firms, although less<sup>precipitously(byabout4percent).Atthesame</sup> time, employment in small firms increased<sup>byover8percent.</sup> Looking from a different angle, employment is state<sup>ownedfirm decreasedby over12percentwhile</sup> in private firms increased by 11 percent.<sup>Thus theoldsector,consistingof largestate</sup> owned enterprises has been shrinking<sup>whereasthenewsector,consistingof small</sup> private firms is expanding. However,<sup>these changes,althoughsignificant,havebeen</sup> rather modest in comparison with<sup>leadingreformers(suchastheCzechRepublic,</sup> Hungary, or Lithuania).<sup>7</sup> Although small enterprises' share of employment<sup>has risen in Croatia,it is still</sup> relatively low. Small enterprises (employing fewer<sup>than50workers),whicharea</sup>

> 6 It should be borne in mind that cross-country comparability<sup>of data onthe numberof firmsis</sup> limited. For example in some countries (Poland is<sup>anexample)therehavebeen incentivesto switch</sup> from dependent employment to self-employment,<sup>whichhas inflated the number of firms.</sup> 7 Recent comparable data on employment<sup>by private/public sectoror firmsize arenot available.</sup> However, using the private sector share in<sup>GDP as a proxy,one sees that privatefirmsplay a lesserrole</sup> in Croatia than in more advanced transition economies.<sup>Forexample,in1999 the private sector share</sup> in GDP in Croatia was somewhat above 60<sup>percent,while it was around80percent in the Czech</sup> Republic or Hungary or Estonia or Lithuania<sup>(World Bank, 2002).</sup>

_-15-_
proxy for the "new sector" account for<sup>about46 percentof totalemployment(Table</sup> 7). This means that the new sector is<sup>still underdevelopedin Croatia,withimportant</sup> implications for economic and employment<sup>growth.Asnotedin World Bank(2002),</sup> "[...] there appears to be a threshold<sup>-</sup> of<sup>around40percentforthesharesof small</sup> enterprises in employment and value<sup>added-below which economiesdo not takeoff</sup> in terms of growth." (p. 40). Croatia<sup>hasbarely passed thisthreshold,andis lagging</sup> behind leading reformers where the<sup>shareof employmentinsmallenterprisesis over</sup> 50 percent. This means that the new<sup>sector-comprisedof smallprivatefirms--</sup> needs to grow further and faster in order<sup>to enhancethe jobcreation potentialof the</sup> Croatian economy. As it will be shown<sup>later,itissmallprivatefirmswhoarethe</sup> engine of job creation in Croatia,<sup>similarlyasinother transitionandmarket</sup> economies.

**Table 7 Employment by firm size,**<sup>**2001**</sup>

|Firmsize<br>(numberofemployees)|Shareintotalemployment,<br>%|
|---|---|
|1- 9|23.4<br>|
|10-19|9.4<br>|
|20-49|12.8<br>|
|50-99|10.5<br>|
|100-199|11.0<br>|
|200-499|12.4|
|500+a)|20.4|

a) Including respondents who did not<sup>know thesize of their firm(2.1%).</sup> Source: Labor Force Survey, 2001.2,<sup>CBS;Authorscalculations.</sup> _-16-_
To conclude, insufficient growth of the new sector, consisting largely of small. private firms, is one cause of the limited job creation potential of the- Croatian economy. If the average firm size goes down - as it does in Croatia due to restructuring - then the only way to increase the overall number of jobs is through having more firms.<sup>8</sup> Entry of new firms and the faster rate of new enterprise growth is thus critical for the increase in employment and the reduction in unemployment.

# **Job creation and job destruction**

High job destruction is _not_ the source of the employment problem in Croatia. It is low job creation. After all, the rate of job destruction in Croatia is much lower than in other transition economies, and even lower than in mature market economies, such s Germany and France. Despite the very low rate of job destruction employment decreased in Croatia because the rate of job creation is still lower. Thus the key to reduce unemployment is not to protect old jobs, but to foster the creation of new jobs, which entails removing barriers to enterprise expansion (definitions of job creation and destruction are provided in Box 3).

Table 8 documents the stagnant nature of the Croatian labor market. The job creation rate in Croatia is only 3.5 percent, compared with almost 10 percent in Lithuania or 7 percent in Bulgaria. This means that Croatia creates less than half as many jobs (relative to its employment) as more dynamic transition economies. . In other words, Croatia needs to. at least double its rate of job creation to achieve a degree of restructuring similar to that in other transition, and 'Market economies.

> 8 This is by virtue of a simple identity: employment-to-population ratio = average firm size * firm density. If average firms size goes down then firm density must go up proportionately to maintain the given level of employment.

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# **Box 3 Job Turnover and its Components**

The gross job creation rate (JC)<sup>is defined as the sum of all employmentgains in</sup> expanding firms in a given<sup>year,expressedasa proportionof total employment at</sup> the beginning of the year.

The gross **job destruction** rate<sup>(JD)is defined asasum of allemployment losses</sup> in contracting firms in a given<sup>year,expressedasa proportionof total employment</sup> at the beginning of the year.

The **job turnover** rate (JT)<sup>is defined as the sum of the absolutevalue of the</sup> change in employment in each<sup>finn,expressedas proportionof total employment.</sup> Put differently, job tumover is the<sup>sumof the job creationand job destructionrates</sup> (i.e. JT = JC + JD).

The difference between JC and<sup>JDgives the rate of</sup><sup>**employmentgrowth**(EG),or</sup> the net job creation rate (i.e.<sup>EG = JC - JD).</sup> The **job reallocation** rate (JR),<sup>also called"excess" job reallocation, is the job</sup> tumover rate beyond that necessary<sup>toaccommodatethenet changein</sup> employment. Thus JR is the<sup>differencebetween JT andtheabsolute valueof EG.</sup> Alternatively, JR equals to twice<sup>the JC or JD, whicheveris smaller(i.e.JR = 2*</sup> min{JC, JD).

The job reallocation rate is often<sup>used as an indicatorof enterpriserestructuring.</sup> Restructuring is assumed to be<sup>the moreintensive,the more jobs aremoved away</sup> from contracting firms toward<sup>expandingfirms.For example,a job reallocation</sup> rate of 20% means that 10%<sup>(20/2)of all jobs were shiftedfrom contractingfirms</sup> to expanding firms. Notice that<sup>that the degreeof job reallocationis deternined</sup> by the lower of the rates of job<sup>creationand job destruction.</sup> The concept of job tumover is often<sup>confusedwith that of labor turnover.The rate</sup> of labor turnover is the sum of<sup>hires and separations.However,not every hiring</sup> means that a job was created,<sup>andnot everyseparation means thata job was</sup> destroyed. A new job was created<sup>onlyif a hiring was not preceded by a</sup> separation. And a job was destroyed<sup>onlyif aseparation was not followedby</sup> hiring. Thus, labor turnover encompasses<sup>job turnover.The conceptof labor</sup> turnover refers to the movements<sup>of persons,that of job turnoveris limited to</sup> movements of jobs.
**Table 8 Job creation and job destruction: Croatia against**<sup>**selectedcountries**</sup> **(as percent of total employment)**

||Croatia|Bulgaria<br>|Lithuania|Poland|France<br>|Germany|
|---|---|---|---|---|---|---|
||2001|2000|1998-99|1998-99|1984-91|1983-90|
|Jobcreation|3.5|6.8|9.7|5.3|6.6|6.5|
|Jobdestruction|4.9|10.8|10.7|10.1|6.3|5.6|
|Employmentgrowtha)|-1.4|-4.1|-0.9|-4.8|0.3|0.9|
|Jobturnover|8.4|17.6|20.4|15.4|12.9|12.1|
|Jobreallocation|7.0|13.5|19.4|10.5|12.6|11.2|

Note: Continuing establishment only (i.e. business start-ups<sup>andclosures are not included).</sup> Definitions: a) The employment growth rate refers to the sample<sup>(whichis limited tolegalpersons)</sup> and is not necessarily consistent with the overall change<sup>in employment.</sup>

# Sources:

Croatia: Central Bureau of Statistics, Author's<sup>calculations.</sup> Bulgaria: Rutkowski (2002b) Lithuania: Rutkowski (2002a) Poland: Rutkowski (2001) OECD countries: OECD (1996) The low rate of job creation is associated with a low rate of<sup>jobdestruction.</sup> Croatian firms yearly close 4.9 percent of all jobs,<sup>comparedwiththe job destruction</sup> rate of 10-11 percent in the restructuring transition economies<sup>and around6 percentin</sup> mature market economies. At the first sight the low job destruction<sup>ratemayseem a</sup> positive phenomenon, preventing larger employment declines.<sup>Thisisnotthecase</sup> however. The reason is that the low rate of job<sup>destructiontranslates into alowrate</sup> of job creation. This is because the creation of new jobs necessitates<sup>destructionof</sup> old jobs (World Bank, 2002).9 Or alternatively, hiring is bound<sup>tobelimited if firing</sup> is difficult and costly, as employers avoid hiring to minimize<sup>thefuturecostsof</sup> employment adjustment during the downturn.

Economic costs of low job flows (turnover) can be substantial.<sup>Limitedjob</sup> turnover implies that there are limited efficiency gains associated<sup>with reallocationof</sup> jobs away from less productive toward more productive<sup>uses. In other words,low job</sup> turnover entails less enterprise restructuring and less<sup>associated productivity</sup>

> 9 This is because resources (including labor) locked in old jobs need<sup>to be releasedto become</sup> available for newjobs. This argument assumes that either the pool of<sup>unemployedis small(whichis</sup> not the case in Croatia), or that unemployment is structural,<sup>i.e.that theskillrequired (and/orlocation</sup> of) by new jobs differ from the skills possessed (or location of)<sup>by theunemployed.</sup>

_-19-_
improvements.'<sup>0</sup> Thus eventually low<sup>jobturnovercantranslateintolowerrateof</sup> economic growth.

Indeed, the Croatian<sup>economy-unlikeothertransition economies--does not</sup> seem- to. undergo<sup>aprocessofintensiveenterpriserestructuring.InCroatiaonly7</sup> percent of all-jobs<sup>areannually reallocatedfromcontractingfirms towardexpanding</sup> firms. This,is again<sup>muchless than inthe restructuringtransition economiesand less</sup> than in mature market<sup>economies.For example, in Lithuania the job reallocation rate</sup> accounts for'over l9'percent<sup>andinBulgariaforcloseto14percent.Thisclearly</sup> points to a stagnant<sup>nature of the Croatianlabor market.</sup> Low job'turnover seems<sup>to ruleoutinter-sectoralshiftsas an importantfactor</sup> accounting for unemployment<sup>in Croatia.Asrelativelyfew jobsare being eliminated</sup> and created in Croatia,<sup>theproblemof theskillorspatialmismatchbetweentheold</sup> and new jobs does not<sup>havemuch weight. Thereare relatively few worker transitions</sup> between the old and<sup>thenewsector.Thisisinstrongcontrasttotherestructuring</sup> transition economies,<sup>where frictionsassociatedwithmovementsfromoldtonew</sup> jobs, characteristic of<sup>structuralchanges, significantly contributeto unemployment.'</sup> To summarize, job<sup>destructionislowinCroatia,butsois,andnot</sup> independently, job<sup>creation.Ina way, the limitedcreationof new jobsis a pricefor</sup> the slow destruction<sup>ofold jobs.</sup> Low job turnover<sup>implies slow reallocationof</sup> resources, including<sup>labor, awayfromlessproductiveusestowardmore productive</sup> uses. The cost of the<sup>delayedrestructuringislower than otherwisepossible</sup> productivity and long-term<sup>output growth.</sup>

**_Job turnover byfirin_**<sup>**_ownershipand_**</sup><sup>_size_</sup>

Although the overall<sup>job turnover rate is lowin Croatia,therearesome sectors</sup> of'the economy which<sup>aremore dynamicthanothers.Notably, smallandprivate</sup> firms create - as well<sup>as destroy-more jobsthan largerand stateownedfirms (Table</sup> 9). The job creation<sup>rate inthe privatesector at about6 percent is nearly threetimes</sup>

> **10** We focus here on the<sup>aspect restructuring consistingin reallocationof resourcesacross units</sup> improvements (i.e. on<sup>allocativeefficiency)andassociatedproductivity gains.We leave aside the</sup> issue of restructuring<sup>within firm consisting in productivity improvementsdue to technologicaland</sup> organi2ational changes,<sup>whichnot necessarilyentail labor shedding.</sup> "1 This does not rule out<sup>that unemployment in Croatiahas an importantstructural component, as</sup> the unemployed may<sup>lack the skillsnecessary to successfully competefor available jobs.</sup>

_-20-_
as high as in the SOE sector. However, the job destruction rate in the private<sup>sector is</sup> also much higher than in the public sector (7 and 2 percent, respectively).

**Table 9 Job creation and job destruction by sector, 2001** (as percent of total employment)

|Sector|Job<br>creation|Job<br>destruction|Job<br>turnover|Employment<br>growth|Job<br>reallocation|Shamreplen<br>employment|
|---|---|---|---|---|---|---|
|Ownership|||||||
|Public|||||||
|Firms|2.2|<br>1.9|4.1|.0.2|3.8|27.5|
|Institutions|3.1|4.5|7.6|<br>-1.4|6.2|25.9|
|Private|6.2|<br>7.1|13.3|<br>-0.9|12.4|22.1|
|Mixed|3.0|<br>6.7|9.7|<br>-3.7|5.9|24.5|
|Size(employment)|||||||
|-50|6.9|<br>6.0|13.0|<br>0.9|12.1|13.7|
|51- 250|3.8|<br>5.7|9.5|<br>-1.8|7.7|38.0|
|251+|2.2|<br>4.0|6.2|<br>-1.7|4.5|48.3|
|Activity|||||||
|Agriculture|2.4|<br>6.0|8.4|<br>-3.6|4.8|3.8|
|<br>Non-agricultural business sector|4.1|6.0|10.1|-1.9|8.2|67.8|
|<br>Non-businesssector|2.2|<br>2.1|4.3|<br>0.1|4.2|28.4|
|Firmstatusa)|||||||
|Businessstart-ups|1.7|<br>na|na|<br>na|na|na|
|<br>Continuingfirms|8.1|5.2|13.2|<br>18.4|31.7|na|
|Closures|na|<br>0.5|na|<br>na|na|na|

na = not applicable Notes: Data refer to establishments defined by economic activity, rather than<sup>firms. Continuing firmsonly.</sup> a) Data on firm status come from a different source than the other data and<sup>are not directlycomparable.</sup> Source: Central Bureau of Statistics, FINA, Authores calculations.

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Equally pronounced<sup>arethedifferencesinjobturnoverbetweensmalland</sup> large firms. In small firms (up<sup>to50workers) thejobcreationrateisalmost7</sup> with<sup>slightlyover2percentinlargefirms(over250workers).</sup> percent, compared Small firms close 6<sup>percentof their jobs peryear,whilelargefirms4percent.This</sup> implies that that the _net_<sup>jobcreation (employmentgrowth )ispositiveinthesmall</sup> finn sector and negative<sup>inthe large firm sector.</sup> The above data provide<sup>anexemplificationoftheclaimnthat higherjob</sup> creation goes hand in<sup>handwithhigherjobdestruction.</sup> In other words, high job creation sectors tend<sup>tobehighjobturnoversectors.Putstilldifferently,old jobs</sup> need to be eliminated<sup>for new jobs to be created.</sup> Although some sectors<sup>aremoredynamicthan theothersin Croatia,itshould</sup> be emphasized that<sup>eventhe relatively more dynamic sectorsarecharacterizedby low</sup> job turnover. In particular, job<sup>turnover issmallprivate firmsinCroatiais</sup> substantially less than<sup>inmore dynamictransitioneconomies.Forexample,thejob</sup> reallocation rate in small<sup>firms(employing lessthan50workers)in Croatiais12</sup> percent, while in Bulgaria<sup>and Lithuania isabouttwiceashigh(24%and26%,</sup> respectively). Similarly,<sup>the job reallocationratein theCroatianprivatesector is half</sup> of that in Bulgaria. This<sup>is indeeda dramatic differences,clearly demonstratingthat</sup> labor market rigidities<sup>affect theCroatian economyat large,ratherthan onlytheSOE</sup> sector.

To conclude, there are<sup>visibleinter-sectoraldifferencesinjobturnoverin</sup> Croatia. In particular, as one<sup>wouldhave expected,smallprivatefirmsaremore</sup> dynamic than large SOEs.<sup>What is startling however,is that even these more dynamic</sup> segments of the economy<sup>look rather unimpressive whencomparedtosimilarsectors</sup> in more dynamic transition<sup>economies.</sup> This means that institutional<sup>barriersto job</sup> creation are pervasive,<sup>andnotlimited toparticularsegmentsof the economy(e.g. to</sup> the SOE sector). While the governance<sup>factorcancontributeto theslowpaceof</sup> restructuring in SOEs,<sup>it seemsthat it ismainly institutionsand regulationsthat hinder</sup> restructuring in the private<sup>sector.Given the privatesector's dynamic potential,the</sup> best way to foster job<sup>creationisthustoremoveinstitutional andregulatory</sup> constraints on its development.

_-22-_
_Job turnover by industry_ Industrial restructuring, which is under way in Croatia, involves the decline of some old industries and a simultaneous expansion of other industries, where Croatia has comparative advantage. At the same time, international evidence shows that restructuring largely occurs _within_ industries, that is resources (including labor) are reallocated away from contracting toward expanding firms within an industry. Which industries create jobs and which eliminate them? Which industries are restructuring the fastest in Croatia?

Table 10, Panel A shows ten industries with highest rates of gross job creation. These include wholesale trade, manufacturing of transport equipment, so called other business activities, manufacturing of metal products and car sale.<sup>12</sup> These are the industries which provide best job opportunities for persons looking for work, even though in some cases (e.g. wholesale trade) they not only create but also destroy a large number of jobs. Nonetheless such high job turnover is beneficial for the unemployed as entails more hiring and thus better chances to escape unemployment.

The top 10 industries in job destruction include manufacturing of RTV and communication equipment, manufacturing of basic metals, manufacturing of petrol products, manufacturing of textile and leather products (Table 10, Panel B). These are the industries where the risk of job loss is the largest, although in some cases it may coincide - due to high job turnover - with good hiring prospects.

The relation between gross job creation and gross job destruction determines whether an industry is expanding, i.e. creates jobs on a net basis, or is shrinking, i.e. eliminates jobs on a net basis. The fastest growing industries in Croatia include manufacturing of transport equipment, car sale, other business activities, and manufacturing of metal products (Table 10, Panel C). The industries which are shrinking include manufacturing of RTV and communication equipment, manufacturing of petrol products, manufacturing of textiles, hotels and restaurants, and manufacturing of wood and paper products (Table 10, Panel D). This is an interesting combination, as it contradicts the popular view that the manufacturing sector is shrinking during the transition, and the service sector is expanding. After all, some manufacturing industries (e.g. manufacturing of transport equipment) do expand, while some service

> **12** The category "other business activities" includes legal services, accounting, business counseling, marketing, personnel recruitment, etc.

_-23-_
industries contract<sup>(e.g.hotelsand restaurants).Obviously,theseexceptions,however</sup> important, do not contravene<sup>the overalltrend towarda highershareof servicesin the</sup> Croatian economy.<sup>Thisgeneraltrendhasi;mportantlabormarket implications,asit</sup> calls for the change<sup>in theskiilstructureof the Croatianworkforce,a gradualmove</sup> away from manual skills,<sup>essenfialin the manufacturing basedeconomy,towardnew</sup> skills (such as communication,<sup>language,computerskills)essentialintheservice</sup> based economy.

_-24-_
Table 10 Job turnover by industry, 2001 A. Top 10 industries with highest rates of gross job creation

|Industry|JobJo<br>creation<br>rate|Sharein<br>employment|
|---|---|---|
|Wholesale|||
|trade|10.5|<br>2.8|
|Transport|||
|equipment|9.4|2.2|
|Other business|||
|activities|8.9|2.2|
|Metalproducts|7.5|1.4|
|<br>Car<br>sale<br>&|||
|repair|7.3|1.0|
|Machinery|7.3|1.2|
|Basic metals|6.4|0.7|
|Rubber<br>and|||
|plastics|5.8|0.7|
|Construction|5.8|5.5|
|Leather|5.7|1.2|

B. Top 10 industries with highest rates of gross job destruction

|Industry|Jnuty<br>detutob<br>Sh<br>destructionempl|arein<br>oyment|
|---|---|---|
|RTV<br>&|||
|communication|12.3|0.5|
|Basicmetals|11.0|0.7|
|Petrolproducts|9.9|0.7|
|Textiles|9.5|1.1|
|Leather|9.5|1.2|
|Wholesale|||
|trade|9.3|2.8|
|Retailtrade|8.8|5.1|
|Wood|8.8|1.3|
|Machinery<br>Electric|8.5|1.2|
|equipment|8.0|1.4|

C. Top 10 industries with highest employment growth D. Top 10 industries with largest employment decline

|Industry|Employme<br>Sharein<br>ntgrowthemploymen<br>rate<br>t|Emp<br>Industry<br>t<br>rate|loymenShare<br>growthempl|<br>in<br>oyment|
|---|---|---|---|---|
|Transport||RTV<br>&|||
|<br>equipment|8.1<br>2.2|communication|-11.4|0.5|
|Car<br>sale<br>&|||||
|repair|3.5<br>1.0|Petrolproducts|-9.7|0.7|
|Otherbusiness<br>activities<br>|2.7<br>2.2<br>|Textiles<br>|-6.4|1.1|
|Met<br>Public|a prouct 1.61.4Hotels<br>1.6<br>1.4|&<br>restaurants|-6.1|3.8|
|administration|1.3<br>6.1|Wood|-5.7|1.3|
|Wholesale<br>trade|1.2<br>2.8|Paper|-5.6|0.6|
|Education|1.2<br>9.9|Electricity<br>&|||
|Post&telecom<br> <br>|0.8<br>3.1<br>|Financial|||
|Rubber<br>&<br>plastic|Fiacl<br>0.7<br>0.7|intermediation|-4.9|2.7|
|Petrol||Furniture|-4.7|1.6|
|extraction|0.4<br>0.7|Basic metals|-4.6|0.7|

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E. **Top 10 industries**<sup>**with highestrate of job**</sup> reallocation

|Industry<br>re|Job<br>Sh<br>allocatioemp<br>nrate|arein<br>loymen<br>t|
|---|---|---|
|Wholesale<br>||28|
|trade<br>|18.7<br>|.<br>|
|Machinery<br>|14.6<br>|1.2<br>|
|Basicmetals<br>|12.8|0.7|
|Otherbusiness<br>||22|
|activities<br>|12.5<br>|.<br>|
|Metalproducts<br>|11.8<br>|1.4<br>|
|Construction<br>|11.5<br>|5.5<br>|
|Leather<br>|11.4<br>|1.2<br>|
|Retailtrade<br> <br>|11.3|5.1|
|Rubber<br>&<br>||07|
|plastic<br>|10.2|.|
|Electric<br>|81|14|
|equipment|.|.|

Note: The raking<sup>isbasedonindustrieswhosesharein</sup> total employment<sup>isat least 0.5%.</sup> Source: Central Bureau<sup>of Statistics;Authorscalculations.</sup> Apart form the<sup>changeintheindustrystructure, aless visiblebutequally</sup> important change of<sup>the job structureis under way inCroatia.Within industrieslower</sup> productivity jobs<sup>arebeingdestroyedandsimultaneouslypresumablehigher</sup> Such productivity jobs,<sup>oftenrequiringdifferent,higherskills,arebeingcreated.</sup> of industries<sup>includewholesaletrade, manufacturing</sup> dynamic, restructuring machinery, manufacturing<sup>of basicmetals,andotherbusinessactivities(Table10,</sup> Panel E). Again, it is noteworthy,<sup>the restructuringsectors includeboth</sup> manufacturing and<sup>serviceindustries.</sup> The presumption<sup>thatjobreallocationinvolvestheeliminationofless</sup> productive jobs<sup>andthesimultaneous creationof moreproductivejobscannotbe</sup> However, substantiated directly<sup>for Croatia, as necessaryinformationis lacking.</sup> international evidence<sup>providesstrongsupportto thehypothesisthat job reallocation</sup> tends to bring about<sup>substantialproductivitygains.For example,Fosteret al.(2002)</sup> argue that "a substantial<sup>fractionof aggregateproductivity growth is associatedwith</sup> the reallocation of<sup>outputsandinputsfromlessproductivetomoreproductive</sup> individual microeconomic<sup>units."(p.2)Forexample,"intheU.S.,roughlythirty</sup> percent of productivity<sup>growth(measuredaseithermultifactor or labor productivity)</sup> over a ten-year horizon<sup>isaccountedfor by moreproductiveentering plants displacing</sup> _-26-_
less productive exiting plans."<sup>(p.2).</sup> This connection between reallocation<sup>and</sup> productivity dynamics holds<sup>forbothmanufacturingandservicesectors.Thelink</sup> between job reallocation and<sup>productivitygrowthisalsodemonstrated inasummary</sup> article by Bartelsman and Doms<sup>(2000).</sup> There is no reasons to assume<sup>thatthe</sup> connection between reallocation<sup>andproductivity observed in other countriesdoes not</sup> hold in Croatia. Accordingly,<sup>those sectors in which job reallocationis relatively high</sup> in Croatia are a likely to be<sup>themaincontributors totheaggregateproductivity</sup> growth.

What is the impact of job flows<sup>andrestructuringonemploymentgrowth</sup> within industry? This is an empirical<sup>question becauseaswehave just seen,high job</sup> destruction does not necessarily<sup>imply a fallin employment,as high job creationdoes</sup> not necessarily imply a growth<sup>in employment. It is only theinteractions, joint impact</sup> of job creation and destruction<sup>thatdetermineschanges inindustryemployment.It</sup> turns out that in Croatia<sup>employment growthwithin industryismore strongly</sup> negatively correlated with job<sup>destruction(r=-0.62), thanpositively correlatedwith</sup> job creation (r=-0.56). This<sup>isaratheruntypicalpattern,asin othercountries(e.g.</sup> Lithuania, Poland) employment<sup>growthisstronglycorrelatedwithjobcreation and</sup> only weakly with job destruction. In other words, in Croatia employment<sup>changes</sup> depend mainly on the pace of job<sup>destruction, while in othertransition economies they</sup> depend mainly on the pace of job<sup>creation.The pattern prevailingin Croatiamaygive</sup> rise to an misleading interpretation<sup>that forestallingjobdestructionisthewayto</sup> prevent employment decline. However, the experience from<sup>otherrestructuring</sup> transition economies points in<sup>exactlytheoppositedirection:fosteringjobcreation</sup> rather than preventing job<sup>destructionisthebestmeanstopromoteemployment</sup> growth. The job destruction<sup>rateis already very lowinCroatia,and thustherehardly</sup> is room to lower it still further.<sup>Accordingly,theonlypossiblewaytoreversethe</sup> negative employment trend is<sup>toincrease job creation.13</sup> Croatia is also untypical in<sup>thatthereisnocorrelationbetween industry</sup> employment growth and enterprise<sup>restructuring.</sup> In contrast, in other transition economies (Lithuania, Poland)<sup>thereisapositive, albeitnotverystrong,correlation</sup> between the rate of job reallocation<sup>and therate of employmentgrowth,meaningthat</sup> those industries where enterprise<sup>restructuringis moreintensive tend to growthfaster.</sup> One possible explanation is that<sup>the magnitudeof job reallocationinCroatia-which</sup> 13 Of course, a high job creation rate<sup>by itself does not ensurethat employmentgrowthis</sup> positive, as it can be outbalanced by<sup>a high job destruction rate.However, given the job destruction</sup> rate, the higher the job creation<sup>rate,thefasteris employmentgrowth.</sup> _-27-_
is significantly smaller than in<sup>therestructuringtransition economies--isnot</sup> sufficient to spur visible employment changes.<sup>If so,thisis yetanother argument for</sup> making the Croatian labor market more<sup>fluid.</sup> It is noteworthy, that job creation is correlated<sup>with jobdestructioninCroatia,</sup> which means that industries which<sup>destroy more jobs(relativetotheiremployment)</sup> also tend to create more jobs. Although the correlation is weak (r=0.30),<sup>itis</sup> statistically significant. This again implies that job destruction<sup>byitselfisnota</sup> negative phenomenon. High job destruction can go hand<sup>in handwithhighjob</sup> creation. For example, in the wholesale<sup>tradesectorthe jobdestructionrateis high</sup> (over 9 percent), but the job creation<sup>rateisstillhigher (over10percent).</sup> The problem arises only when high<sup>jobdestructionisnot accompaniedbyhigh job</sup> creation. Unfortunately, this is often the case<sup>inCroatia, whereinmajorityof</sup> industries (36 out of 54) job creation falls<sup>shortof job destruction.</sup> To summarize, while the overall level of job<sup>turnoverisvery low inCroatia,</sup> there are some industries which exhibit<sup>more dynamismandwhere enterprise</sup> restructuring is more advanced. However,<sup>unlikeothertransition economies,these</sup> restructuring industries do not grow faster<sup>thannon-restructuringones.</sup> Presently the industry employment growth<sup>inCroatiais mainlyinfluencedby</sup> the rate of job destruction. This is<sup>incontrasttorestructuringtransitioneconomies,</sup> where employment growth is largely determined<sup>by the rateof job creation.Sincethe</sup> rate of job destruction is already very<sup>lowinCroatia,protecting unviable jobsinthe</sup> old sectors is not a sustainable strategy. Croatia's<sup>mainproblemisnot highjob</sup> destruction, but low job creation. Accordingly,<sup>the onlyway to increaseemployment</sup> is to foster job creation.

# _Job turnover by region_

Is the Croatian labor market stagnant across<sup>thecountry,or therearemore</sup> dynamic regions, where job flows and<sup>restructuringaremoreintensive?Itturnsout</sup> that job creation as well as job destruction<sup>ratesarelowthroughoutthecountry.</sup> There is no single region with a dynamic<sup>labormarketandhighjobturnover.</sup> Although the job creation and job<sup>destructionratesdo varybyregion,thevariability</sup> is limited, ranging from modest to very low<sup>values (Figure2).</sup> _-28-_
# Figure 2 Job flows by region

<!-- Start of picture text --> 'OQ 0, , , | | ' ' '0 " - 4.0<br>9.0<br>2.0<br>8.0 I' '<br>i6.0 U fliI<br>11other tejb hihuemlyen aca onty- raio ae soeEmployment .groth<br>4.0 -/<br>-4.0<br>3.0<br>2 0<br>-6.0<br>0.0 - 8.0<br>Vukovarsko-rijemska an Vrzinsk coutis thJob creationraeiunr6<br><!-- End of picture text -->

In the most depressed regions virtually no new jobs are beingscreated. For 5.0 h aoiy(1 u f2)o rota ein o detrcto 2.0e exc deedulo example, in the Li6ko-senjska and Sisacko-moslavacka counties the job creation rate is less than 2 pecent. For comparison, in the most depressed regions of Bulgaria - another high unemployment Balcan country -- the job creation rate is o ver two times higher! -However, even in the regions with highest job creation rates, which include Vukovarsko-srijemska and Vara2dinska counties, the job creation rate is under 6 percent. Again this is humble in comparison with Bulgaria, where in the most dynamic.-regions the job creation rate (in continuing firms) exceeds 8 percent. Thus, job opportunities are limited across the country, but in the most depressed regions they hardly exist.

~In the majority (1 7 out of 22) of Croatian regions job destruction rates exceed job creatiQn rates, implying declining employment levels. However, job destruction rates are not, high in absolute termns. In the most depressed regions, such as Lifkosenjska and Sisa6ko-moslava6ka counties, the job destruction rate does not exceed 9 percent. In comparison, in Bulgaria job destruciton rates in regions most affected by restructuring approach 15 percent. In most Croatian regions the job destruciton rates vary around 4-6 percent, which is not much. This is additional evidence that the _-29-_
problem faced by the Croatian economy is<sup>thatof lowjobcreation,</sup><sup>_not_highjob</sup> destruction.

Regions with low job creation tend<sup>tohavehighjobdestruction.</sup> More generally, there is a _negative_ correlation<sup>between the jobcreationand job destruction</sup> rates across regions. This implies that regions<sup>differlittlein termsof jobflows,but</sup> they differ quite substantially in terms of employment<sup>growth.Therearedepressed</sup> regions, where job destruction is high and<sup>jobcreationlow(Licko-senjska and</sup> Sisacko-moslavacka counties) , and there<sup>arethriving regions (suchasVukovarsko-</sup> srijemska and Varazdinska counties) where job<sup>destruction islowand jobcreationis</sup> relatively high. However, in both depressed<sup>and thrivingregions job turnoverisata</sup> similar level, meaning that Croatian regions<sup>do</sup><sup>_not_differsignificantly in termsof</sup> labor market dynamics, although they differ<sup>in termsof economic prosperity. Thisis</sup> in contrast to the pattern observed in Bulgaria,<sup>where the correlationbetweenjob</sup> creation and job destruction is _positive,_<sup>i.e.highjobdestructiontendstobe</sup> accompanied by high job creation. The pattern<sup>prevailingin Croatia,wherehigh job</sup> destruction is accompanied by low job<sup>creationclearly pointstoinadequatejob</sup> creation as a main source of poor labor market<sup>outcomes.</sup> Regional employment growth in Croatia<sup>isstronglyinfluencedbyboththe</sup> pace of job creation and job destruction.<sup>14</sup> As there is not much scope to lower already low job destruction rates, the only<sup>way tofoster regionalemploymentgrowth</sup> is through encouraging faster job creation.

To summarize, regional analysis has<sup>provedthat thelabormarketis stagnant</sup> across the country in Croatia, that there are<sup>noregionswithhigh jobturnoverand</sup> large job reallocation. Our analysis has also shown<sup>that the principalproblemis that</sup> of insufficient job creation, which is low<sup>across thecountry,notthatof highjob</sup> destruction. Thus the main challenge and policy<sup>imperativeistoraisethe pacejob</sup> creation. It may involve an increase, not<sup>adecrease,in the paceof jobdestruction,to</sup> support reallocation of jobs from unprofitable<sup>to profitablefirms.</sup>

# Determinants of job creation

In the previous section we established<sup>thatsmallprivate firmhaveahigher</sup> rate of job creation than large publicly<sup>ownedenterprises.More generally,one can</sup> ask what explains job creation. What<sup>firmcharacteristicsthatareconducivefor job</sup> 14 This is in contrast to industry employment growth,<sup>which was mainly influencedby the pace</sup> of job destruction. _-30-_
creation? What kind of firms<sup>increase employment?</sup> This section shows<sup>that</sup> employment tends to<sup>increasemost infirms whichhavehigh laborproductivity and</sup> low unit labor costs,<sup>and in firmswhich are capital intensive and investing.</sup> We examine three<sup>groupsof factorsrelatedto jobcreation.Thefirst group</sup> consists of factors<sup>thatmaybeassociated withjobcreationbutbyitselfdonot</sup> influence it. An example<sup>isfirm size.Smallfirmsizedoesnot by andof itself cause</sup> employment growth,<sup>butsmallfirmstendto createonaveragemore jobsthanlarge</sup> firms.

The second group<sup>consistsof factors,whichinfluence jobcreation,butat the</sup> same time are themselves<sup>influenced bychangesinemployment.Examplesinclude</sup> profitability, productivity<sup>orlaborcost,whicharelikelytohavean impacton</sup> There is employment, but simultaneously<sup>theyvarywithchangesin employment.</sup> "reverse causality"<sup>hereandsuch factorsarecalled endogenous.</sup> The third group comprises<sup>true determinantsof job creation,that is factorsthat</sup> influence employment<sup>but are independentof it.Examplesincludeaccess tocredit, or</sup> export orientation.<sup>Firms, which haveaccess tocredit,ortoforeignmarkets,may</sup> find it easier to expand<sup>and thus increase employment.Thesefactorsarereferredto</sup> as exogenous.

The analysis of the<sup>impactof thesefactorson firmemploymentiscarriedout</sup> in two stages. First regression analysis<sup>isperformedinorderdeterminean</sup> independent or net<sup>impactof variousfirmcharacteristicson firmemployment.By</sup> using the regression<sup>analysisonecanseparatetheeffectof aparticularvariableon</sup> employment from that<sup>of all other variables,whichare heldconstant.Second, data on</sup> bivariate associations<sup>betweenselectedfirmcharacteristics andemploymentchanges</sup> are presented to illustrate<sup>the most importantrelationships.</sup> Main The results of the<sup>regressionanalysis arepresentedinTable11.15</sup> findings of the analysis<sup>can be summarized as follows.</sup> Productivity improvements<sup>coupledwithwagemoderationare keyfactors</sup> faster<sup>employmentgrowth.All elsebeingequal, higherproductivity</sup> contributing for firms tend to create<sup>morejobs.'6</sup> A ten percent higher<sup>productivityimpliesalmost</sup>

> is The analysis of determinants<sup>of job creation wasdone using adifferent dataset from that used</sup> to calculate the job creation<sup>and job destructionrates.See Annex## for the datasetdescription.</sup> **16** To reduce the endogeneity<sup>bias we use laggedvaluesof independentvariables. Specifically,</sup> employment change is<sup>measuredfrom 2000 to 2001while, theproductivitylevel,say,relates to the</sup> year 2000.

_-31-_
half a percentage point faster annual employment<sup>growth.</sup> This contradicts the popular view that productivity improvements imply<sup>employmentloses.</sup> To the contrary, productivity gains **turn** out to be beneficial<sup>for</sup> job<sup>creation.It isnoteworthy</sup> that a similar result was obtained for Lithuania, proving<sup>thatapositive impactof</sup> higher productivity on job creation is not country<sup>specific (Rutkowski,2002).</sup> It is important, however, that the gains of higher<sup>productivityarenot</sup> "consumed" in the form of proportionately higher<sup>wages.</sup> This is because the beneficial employment effect of higher labor productivity<sup>realizesitself through lower</sup> unit labor costs. If unit labor costs increase - as a result<sup>of wages rising in excessof</sup> productivity - then employment decreases. According to the model, other things held constant, a 10 percent increase in unit labor costs<sup>wouldresultsin a3.6 percent</sup> fall in the firm employment level. Firms which lower<sup>unit laborcosts tend to expand,</sup> those who do not often contract. The lowering of<sup>unit labor costs -mainly through</sup> higher productivity - is thus critical for employment<sup>growthbothatthefirmand</sup> aggregate level.

_-32-_
Table 11 OLS estimation<sup>of the employmentequation</sup>

|Explanatoryvariables|(1)|Regressi<br>(2)|onmo|dels<br>(3)||(4)|
|---|---|---|---|---|---|---|
|emplOO|0.946<br>_223.80_|0.939<br>_211.28_||0.941<br>_213.54_||0.950<br>_209.84_|
|_Ownership(public)_<br>||||||0005|
|private|-0.016<br>|0.003<br>||-0.010<br>033||.<br>_018_|
||_0.64_<br>|_0.11_<br>||.<br>||_._<br>|
|mixed|0.035<br>|0.040<br>||0.036<br>_090_||0.037<br>_084_|
||_0.93_<br>|_1.00_<br>||_._<br>||_._<br>|
|export|0.059<br>|0.036<br>||0.047<br> <br>_407_|***<br>_***_|0.041<br>_351_|
||_5.49_<br>|_3.12_<br>||_._<br>||_._<br>|
|credit|0.019<br>|-0.019<br>_163_||-0.019<br>_165_||0.000<br>_0_|
||_1.66_<br>|_._<br>||_._<br>|||
|invest|0.074***<br>|0.075<br>||0.073 <br>_1204_|***|0.072<br>_1084_|
||_11.88_|_12.15_<br>||_._<br>||_._<br>|
|ktol||0.020 <br>|**|0.025<br>_751_|***|0.035<br>_991_|
|||_6.17_<br>||_._||_._|
|wage||0.021<br>_1.69_|*||||
|productive||0.043<br>_8.59_|||||
|labcost||||-0.043<br>_8.57_|||
|profitab<br>||||||0.008<br>_2.24_<br>|
|industry|no|yes||yes||yes|
|constant|0.114|-0.613||-0.040||-0.090|
|No.ofobs.<br><sup>2</sup>|8961<br>7|8822<br>0911||8822<br>0910||6923<br>0917|
|R|0.90|.||.||.|

_Dependent variable:_ log of<sup>average employmentin 2001</sup> _Definitions of explanatory_<sup>_variables:_</sup> emplOO = log of average employment<sup>in 2000</sup> export = 1 if a firm sells<sup>its products aborad,0 otherwise</sup> credit = 1 if a firm has a debt<sup>towards financial institutions, 0 otherwise</sup> capform = log of the index<sup>of fixed-capital growthover one year.</sup> ktol = log of capital-to-labor<sup>ratio</sup> wage = log of average monthly<sup>wage</sup> labcost= log of labor costs<sup>as</sup> a<sup>share of sales</sup> productiv=log productivty<sup>(salesper employee).</sup> profitab log of the ratio of operating profit<sup>to sales</sup> industry = 2-digit NACE classification All explanatory variables<sup>referto 2000,i.e.are lagged one year.</sup> Absolute values of the t-statistics<sup>are in italics</sup> t-statistics were caluclated<sup>usingHuber-Whiterobust standarderrors.</sup>

- significant at the I percent<sup>level,** - significant at the 5 percent level,</sup>

* - signifcantat the 10 percent<sup>level.</sup>

_-33-_
Firms that are capital intensive, i.e. where<sup>thecapital-to-laborratiois high,</sup> expand employment faster than more labor intensive<sup>firms.Thisisnot an intuitive</sup> results and therefore it is worth emphasizing. Controlling for the impact of other variables, a 10 percent increase in the capital-to-labor ratio<sup>contributesaround 0.4of a</sup> percentage point to the firm's rate of annual employment<sup>growth.Again,similar</sup> result was obtained for Lithuania, supporting the relevance<sup>ofcapitalintensityfor</sup> employment generation. It should be stressed that apart<sup>fromthisdirectimpactof</sup> capital intensity on job creation, there is an indirect<sup>impact, ashighercapital-to-labor</sup> ratio usually leads to higher labor productivity, which<sup>wealreadyknowisconducive</sup> to job creation.

If capital intensity is beneficial for employment,<sup>thenso should be investment,</sup> which increases the stock of capital. The model shows<sup>that thisisindeed thecase.</sup> Other things being constant. a ten percent increase<sup>intheinvestmentrate(i.e.faster</sup> fixed capital formation) leads to employment growing faster<sup>byabout0.3percentage</sup> points, which is statistically highly significant.

It should be noted, that the direction of<sup>theemploymenteffect investment</sup> cannot be determined a priori. On the one hand,<sup>investmentcanentailmainlya</sup> switch toward a more capital-intensive technology with<sup>arelativelysmallincreasein</sup> output. In such a case capital is substituted for labor with<sup>aresultingfallin</sup> employment. On the other hand, investment can entail<sup>both an increasein the capital-</sup> to-labor ratio, and an increase in output large enough<sup>tobringaboutanincreasein</sup> employment. In the second case, capital and labor<sup>aregrosscomplements(despite</sup> being substitutes in production) because of the scale<sup>effect (i.e.,theincreasein output</sup> brought about by investment) dominates the substitution<sup>effect(i.e.,thefallin</sup> employment due to an increased use of capital).<sup>The regression results indicatethat in</sup> Croatia the scale effect of fixed capital formation<sup>dominatesthesubstitutioneffect,</sup> with a positive employment impact.

Contrary to common perception, more profitable firms<sup>do not createmore jobs</sup> than less profitable ones. Although the relevant regression<sup>coefficientispositive and</sup> statistically significant, its value is very small. For example,<sup>a10 percentincreasein</sup> profitability in an average firm (employing 15 workers)<sup>wouldhave noobservable</sup> impact on the employment level. Thus firm profitability<sup>hardly hasan independent</sup> impact on employment growth. If more profitable firms<sup>employ more workers,this is</sup> _-34-_
due to higher productivity<sup>andlowerunit costs,which boost profitability,ratherthan</sup> due to higher profitability<sup>by and of itself.Improvinglabor productivityandlowering</sup> costs is the way<sup>toincreaseboth profitsandemployment.Againit isinterestingto</sup> note that the same<sup>results wasobtained for Lithuania.</sup> Firm which export<sup>their productstend tocreatemore jobs than firmswhichdo</sup> not. This is consistent<sup>withacommonviewthatanaccessto foreignmarkets</sup> facilitates firm expansion<sup>and employmentgrowth.Theemploymenteffectof export</sup> orientation is substantial:<sup>all elsebeingequal,exporting firmsincreasetheir</sup> For employment by<sup>around4percentagepoints fasterthannon-exportingfirms.</sup> example, if an average<sup>non-exportingfirmincreaseditsemploymentbysomewhat</sup> over 2 percent in<sup>2001overthe previous year,anaverageexportingfirmincreased</sup> employment by over<sup>6 percent.This suggeststhatan increasein Croatia'sexportsis</sup> likely to engender<sup>employmentgrowth,directlyaswellasindirectlythrough</sup> productivity improvements<sup>necessary for firmstoeffectivelycompete in theglobal</sup> economy. As with other variables,<sup>thestronglinkbetweenexport growthand</sup> employment growth<sup>hasalso beenobservedin Lithuania.</sup> Ceteris paribus,<sup>firms,which haveaccesstocredit,do not generatemore jobs</sup> than firm, which do<sup>not.Afterall,thedataindicatethatfirms whichreceivedcredit</sup> created _less_ jobs<sup>thanfirmswhichdidnot,although this negativeeffect isinsome</sup> is<sup>statisticallyinsignificant.This suggeststhatcreditdoesnotgoto</sup> specifications firms with growth<sup>potential,but insteadgoestoinefficientbut wellconnectedfinms.</sup> This sort of "soft<sup>lending" toa narrowgroupof privilegedfirmsimplies misallocation</sup> of resources and<sup>hinders rather thanfostersfirm expansionandemploymentgrowth.'7</sup> Given that credit<sup>canplayanimportantroleinsupporting firm expansionandjob</sup> creation, the observed<sup>negative relationshipbetween accessto credit and job creation</sup> should be of concern.<sup>Theissuewarrants further investigation,andif necessary,a</sup> corrective policy<sup>action.</sup>

> the<sup>effect of ownershiponemploymentvanishes onceotherfirm</sup> Interestingly, characteristics are<sup>controlled for.Otherthings being equal, privatefirmsdo not create</sup> 17 In the sample (which<sup>consists predominantlyof smallfirms),only one firm in five wasusing</sup> credit as a source of<sup>financing.At the same time, according to the WorldBusinessEnvironment</sup> Survey (2001), poor<sup>accessto creditis a major constraintto firmdevelopmentin Croatia.Asmuch as</sup> 55 percent of Croatian<sup>firms considered access to credit as an important obstacle, whichsignificantly is</sup> more than in most<sup>other countriesin theregion.For example,in Hungary,Poland or Slovenia only</sup> about one-third of firms<sup>citeaccess to creditas an importantobstaclefor expansion.</sup>

_-35-_
more jobs than public firms. However, in reality, other things are not being equal, and private firms differ in salient characteristics from public firms. These characteristics associated with private ownership cause private firms to create more jobs than public firms. Thus, although firm ownership has no independent impact, privatization still is the best way to improve firm performance, including employment growth.

Finally, all else equal, small firms tend to growth faster than larger ones. However, the faster rate of employment growth does not necessarily translate in a larger number of jobs created. To see this imagine, two firms, one employing 25 workers and the other 50 workers. Assume that the larger firm increases employment by 10 percent over one year, i.e. by 5 workers. Then our model implies that the smaller firm will increase employment by 12.8 percent, i.e. by 3.2 workers. The smaller firm will create more jobs relative to its initial employment, but less in absolute terms. But the difference in the number of jobs created is rather small. So, the net impact of firm size on employment generation should not be overstated.

Table 12 provides an additional illustration for the relationships between firm characteristics and employment performance. The positive impact of productivity on employment growth comes out very distinctly. While low productivity firms (bottom quintile) decreased employment by over 5 percent in 2001, high productivity firms (top quintile) increased it by over 11 percent. Similarly pronounced is the link between job creation and labor costs. Twenty percent of firms with the lowest unit labor cost increased their employment by 14 percent, while twenty percent of firms with the highest unit labor cost decreased employment by 3 percent.

-J6-
Table 12 Changes in employment by firm category, 2000-2001

|Firmcharacteristics(2000)|Numberof<br>firms<br> <br>(sample)")|Average<br> <br>employment<br>(2000)|Changeine<br>2000-<br>Absolute<br>(persons)|mployment,<br>2001<br>Relative<br>_(%)_|
|---|---|---|---|---|
|All firms|9576|14.9|0.4|2.4|
|_Size (employment)_|||||
|Micro(1-10)|8134|2.9|0.3|10.5|
|Small(11-50)|1071|21.0|0.4|2.0|
|Medium(51-100)|153|72.9|0.3|0.4|
|<br>Large (101+)|218|389.4|1.9|0.5|
|<br>_Ownership_|||||
|Public|127|254.2|0.0|0.0|
|Private|9184|8.6|0.4|4.3|
|Cooperative|59|16.9|-0.8|-4.5|
|Mixed|206|146.9|0.3|0.2|
|_Wage_|||||
|Verylow(1stquintile)|1905|6.2|-0.1|-0.9|
|Low(2ndquintile)|1905|9.6|0.2|1.9|
|Medium(3rdquintile)|1903|9.5|0.2|2.6|
|High(4thquintile)|1904|13.7|0.6|4.4|
|Veryhigh (5thquintile)|1904|35.7|0.8|2.3|
|_Productivity_|||||
|Verylow(1stquintile)|1891|9.5|-0.5|-5.2|
|Low(2quintile)|1890|13.6|0.0|0.0|
|Medium(3rdquintile)|1890|24.1|0.3|1.3|
|High(4tquintile)|1890|17.6|0.8|4.5|
|Veryhigh(5thquintile)|1890|10.3|1.2|11.3|
|_Unitlabor_costs|||||
|Verylow(1stquintile)|1881|8.3|1.2|14.0|
|<br>Low(2ndquintile)|1880|8.8|0.4|5.0|
|Medium(3rdquintile)|1880|18.8|0.5|2.5|
|<br>High(4thquintile)|1880|24.9|0.1|0.6|
|Veryhigh(5thquintile)|1880|14.7|-0.4|-3.0|
|_Capitalintensity(capital-to-laborratio)_|||||
|Verylow(1stquintile)|1835|6.3|0.0|0.1|
|<br>Low(2quintile)|1835|5.3|0.2|3.5|
|Medium(3rdquintile)|1835|6.2|0.3|4.9|
|High(4thquintile)|1835|14.1|0.5|3.6|
|<br>Veryhigh(5thquintile)|1835|45.1|0.8|1.8|
|_Net investment(%increaseinfixedass_|_ets)_||||
|Negativeorzero|5730|12.5|-0.2|-1.4|
|<br>Upto25%|1163|42.1|1.4|3.3|
|<br>Morethan25%|2068|9.7|1.4|14.1|
|_Profitability(Y.)_|||||
|Negativeorzero|2152|19.6|-0.4|-1.8|
|<br>10|5824|15.3|0.6|3.9|
|25|1107|7.7|0.5|6.4|
|Morethan25%|368|6.5|0.3|3.8|
|_Accesstocredit_|||||

_-37-_
|Firmcharacteristics(2000)|Numberof<br>firms<br>(sample)a)|<br>Average<br>employment<br>(2000)|Changeine<br>2000-2<br>Absolute<br>(persons)|mployment,<br>001<br>Relative<br>(%)|
|---|---|---|---|---|
|Yes|1878|50.3|0.6|1.2|
|No|7698|6.2|0.3|4.7|
|_Exportorientation_|||||
|Exportingfirms|1753|46.4|0.7|1.5|
|Non-exportingfirms|7823|7.8|0.3|3.6|

Definitions of variables:

# Access to credit = liabilities to credit institutions.

Net investment = increase in the value of fixed tangible assets over one year. Capital-to-labor ratio = value of fixed tangible assets over employment. Productivity = sales over employment. Unit labor costs = wages and social security contributions over sales. Profitability = operating profit over sales a) Active at both January and December 2001.

Source: FINA, Author's calculations.

In this context a seemingly positive association between job creation and the finn wage level may seem surprising. However, given the earlier results, the positive relationship between wages and employment growth reflects the fact that higher productivity firms are able to award their workers higher wages. This is consistent with the concept of "efficiency wages", whereby as long as higher wages lead to a more efficient use of labor they increase rather than decrease profit. This is also consistent with the theory of monopsonistic competition in labor markets, which claims that the employer offering higher wages can fill their vacancies more easily and employs more workers (Bhaskar et al., 2002). However, if wages are misaligned with productivity, which translates into high unit labor cost then firm employment is negatively affected. Thus, descriptive data strongly reinforce the earlier finding that productivity improvements coupled with wage moderation are key factors behind faster employment growth.

Investment in fixed capital evidently brings about job gains. Machines and equipment are not substituted for workers but instead enhance their productivity. Firms who do not invest often lay-off workers and close jobs. In contrast, firms which invest simultaneously create new jobs, on average 1.4 job per firm. This may seem a small number, but if aggregated across firms it translates into a much bigger _-38-_
one. Clearly, measures which<sup>wouldfacilitate investment,suchas betteraccessto</sup> credit, carry a potential to boost<sup>employment.</sup> To conclude, main factors<sup>contributingtofirmemploymentgrowth include</sup> high productivity and low unit<sup>laborcosts, high capitalintensityandinvestment, and</sup> export orientation. Access<sup>to credit does not contributeto job creation,likely because</sup> credit is directed to ineffective<sup>firmsrather thanfirmswith growth potential. To the</sup> extent this is the case,<sup>inefficientallocationofresourcestranslates intolessjob</sup> creation than otherwise would<sup>bepossible.</sup> These findings have straightforward policy implications. Employment<sup>growthwillbefosteredbypoliciesthatpromote</sup> competitions and thereby force<sup>firmstoimproveproductivity,policies whichhelp</sup> firms to lower costs (e.g. through<sup>lower taxation),policieswhichimproveaccessto</sup> credit, facilitate investment<sup>and export.Inshort, a key for faster job creationis better</sup> investment climate.

Stagnant **labor market:**<sup>**job stability but no hiring**</sup> The stagnant nature of the<sup>Croatianlabor marketalsomanifestsitselfin</sup> limited hiring. In a low turnover labor market<sup>anunemployedperson haslittle</sup> chances of finding a job.<sup>Dataonemploymenttenure showanotheraspectof poor</sup> job opportunities in Croatia. A proportion of persons<sup>with shorttenureis16w,</sup> reflecting the unwillingness<sup>of employers to hire new workers.On theother hand,the</sup> proportion of workers with<sup>long jobtenureisveryhigh,reflectingthehigh levelof</sup> employment protection<sup>inCroatia.</sup> Poor chances of finding<sup>work for thejobless</sup> coexist with high job security<sup>of thosewhohavework.This pointstolabormarket</sup> duality. There are _insiders_<sup>withstable jobsand</sup><sup>_outsiders_with little chances to break</sup> into the formal labor market.<sup>Table13documents this division.</sup> _-39-_
**Table 13 Distribution of employment a) by job tenure: Croatia against selected countries;** percentages

||Under1<br>year|1and<br>under2<br>years|2and<br>under5 <br>years|5and<br>under10<br>years|10and<br>under20<br>years|20<br>years|Average<br>tenure<br>(years)|Median<br>tenure<br>(years)|
|---|---|---|---|---|---|---|---|---|
|Croatia(2001)|9.7|5.1|17.2|21.3|20.7|26.0|12.2|8.0|
|Privatesector|13.0|7.1|21.2|21.7|17.0|20.0|10.8|6.0|
|Publicsector|4.9|2.2|11.8|21.3|26.0|33.8|14.1|12.0|
|Underprivatization|2.1|0.5|6.6|12.4|30.9|47.5|17.3|19.0|
|**1-49**|15.3|7.8|23.7|21.9|14.5|16.7|9.2|5.4|
|**50-199**|6.7|3.1|13.8|19.9|24.5|31.9|14.3|13.3|
|200+|4.4|3.0|11.3|18.9|26.2|36.2|15.6|15.7|
|_Othertransitioneconom_|_ies_||||||||
|Bulgaria(2001)|14.0|9.5|25.2|20.8|19.8|10.8|8.1|5.5|
|Privatesector|20.6|13.0|32.0|18.5|10.6|5.9|5.6|3.5|
|Publicsector|7.3|5.7|17.6|23.2|30.0|16.2|10.8|8.5|
|CzechR.|19.2||36.6|12.0|14.8|17.4|9.0|2.0|
|Lithuania(2001)|15.4|8.9|21.6|25.4|16.8|11.9|8.3|5.0|
|Poland(1999)|14.5|11.7|19.0|17.7|20.3|16.7|9.6|6.2|
|_Marketeconomies_|||||||||
|Denmark|25.1|11.4|16.2|18.2|17.7|11.4,|7.9|4.4|
|France|15.0|8.0|17.7|17.4|23.3|18.7|10.7|7.7|
|Germany|16.1|9.4|22.0|17.2|18.4|17.0|9.7|10.7|
|Spain|35.5|4.9|11.1|14.4|17.7|16.5|8.9|4.6|
|UnitedKingdom<br>|19.6|10.7|19.5|23.5|17.3|9.4|7.8|5.0|
|UnitedStates|26.0|8.5|20.0|19.8|16.8|9.0|7.4|4.2|

> Note: data for the OECD countries refer to 1995.

> a) Wage and salary workers Sources:

> Croatia: Central Bureau of Statistics, Author's calculations. Bulgaria: LFS June 2001, Bank staff calculations.

> Lithuania and Poland: Rutkowski (2002)

> OECD countries - OECD Employment Outlook 1997

> The proportion of workers with job tenure less than one year (which is a

> common indicator of labor market dynamics) is much lower in Croatia than in both transition and market economies. In Croatia new hires account for less than 10

> percent of all employees. In the restructuring transition economies this proportion varies from 14 to 19 percent. But the most striking is the comparison with dynamic market economies characterized by low hiring and firing costs. In Denmark and the U.S. new hires account for some one-fourth of employment. In Spain, thanks to the

> liberalization of rules governing the use of fixed-term contract, new hires account for

> over one-third of total employment. This comparison clearly shows the extremely

_-40-_
low amount of hiring<sup>taking place inCroatia,and thusthe stagnant nature of its labor</sup> market. This is consistent<sup>with thelarge shareof newlabor market entrants (largely</sup> youth) among the unemployed<sup>and reflects barriersto labor market entry.</sup> These barriers are associated<sup>with thehigh levelof protectionof jobs held by</sup> insiders and the lack of<sup>job mobility.Over one-fourthof all workersin Croatia have</sup> held their jobs for 20<sup>yearsor more,an extremely high proportionunparalleledin any</sup> other country. For example,<sup>in Bulgaria and Lithuaniathe proportionof workerswith</sup> long employment tenure<sup>is11-12percent.</sup> In the U.K or U.S.<sup>it is lessthan10</sup> percent.

Extremely high job<sup>stabilityis particularlypronouncedin large public(as well</sup> as privatized) enterprises<sup>inCroatia.</sup> For example, large<sup>firmshavelessthan5</sup> percent of workers with<sup>shortjobtenure (lessthan12months)and asmuchas36</sup> percent of workers with<sup>long job tenure (20 years or more).</sup> Hiring is more frequent and job mobility larger<sup>insmall private firms,howevereveninthis"newsector"</sup> hiring is much lower<sup>thanindynamicmarketeconomies.Apparentlythenewsector</sup> in Croatia is not exempt<sup>from constraintsto job creationand hiring.</sup> To conclude, hiring<sup>isextremelylimitedinCroatia.Lowhiringisamirror</sup> image of low firing and<sup>considerablejobstabilityenjoyedbytheinsiders.Thehigh</sup> level of protection of<sup>theinterestsof those whohave jobssubstantially risesimplicit</sup> labor costs and, consequently,<sup>makesemployers reluctant tohire new workers.Those</sup> who pay the price are<sup>theoutsiders:new entrantsto thelabormarket(mainlyyouth)</sup> and job losers.

# **IH. WHY IS THE LABOR**<sup>**MARKETSTAGNANT?**</sup>

In the Why the job creation<sup>rateislowan hiringislimited inCroatia?</sup> previous section strict<sup>employmentprotection regulationswasidentifiedas alikely</sup> cause of the lack of job<sup>mobilityand labormarket stagnation.Thissectionexamines</sup> more closely employment<sup>protection legislationinCroatiaanditsimpacton labor</sup> market dynamics. Furthermore,<sup>it analyzesotherpotentialconstraintsto job creation,</sup> such as labor costs, wage<sup>flexibility,andskill mismatch.</sup> _-41-_
# **Stringent employment protection legislation**

Employment protection regulation in Croatia is among the strictest in Europe.'<sup>8</sup> Laying-off redundant workers is difficult and costly due to both high procedural and monetary costs of dismissals. This highly rigid nature of the<sup>Croatian</sup> labor market is reflected in a high value of a composite index of the strictness of employment protection legislation (EPL) developed by OECD.1<sup>9</sup> Table 14 documents that employment protection legislation is stricter in Croatia than in any transition economy accessing EU (which tend to have relatively rigid labor market), and<sup>in fact</sup> stricter than in virtually all EU and OECD economies. It is noteworthy that EPL<sup>in</sup> Croatia is much stricter than in countries characterized by low unemployment<sup>flexible</sup> labor markets, such as Hungary among the transition economies, and<sup>Denmark,</sup> Ireland, the Netherlands, and the U.K. among the mature market economies. For illustration, the summary EPL index amounts to 1.1 in Ireland or to 1.7 in Hungary, compared with 3.6 in Croatia. This indicates a truly dramatic difference in<sup>termsof</sup> constraints facing employers who need to adjust the size and composition of<sup>their</sup> workforce. Hence, strict employment protection, such as in Croatia, does not prevent high unemployment (resulting from the cumulative growth of the number of<sup>persons</sup> who cannot enter the labor market). Conversely liberal employment protection does not necessarily lead to high unemployment, to the contrary it tends to be associated with better labor market outcomes (anglo-saxon countries - U.S. and U.K. - provide the best example of relatively low level of employment protection associated with<sup>low</sup> unemployment).

**18** Labor laws and regulations in Croatia are discussed in more detail in Fuenzalida (2002).

> **'9** The index is a weighted average of 22 indicators of the strictness of employment protection legislation in three areas: (1) regular contracts (with the weight of 5/12, (2) temporary contracts (5/12), and (3) collective dismissals (2/12). Regular contract are divided into (a) procedural<sup>inconveniences</sup> (1/3), (b) notice and severance pay (1/3), and (c) difficulty of dismissal (1/3). Temporary contracts include (a) fixed term contracts (1/2) and (b) temporary work agency employment (1/2). The index for collective dismissals is directly computed by averaging four indicators relating to<sup>special requirements</sup> and costs associated with collective dismissals. The higher the value of the summary index,<sup>thestricter</sup> the employment protection legislation. The methodology of calculation of the index is described in OECD (1999).

_-42-_
**Table 14 Employment**<sup>**ProtectionLegislationStrictnessfor Croatia and Central**</sup> **and East European EU**<sup>**accessioncountries (CEEEUAC)**</sup>

|Contr|Reular|EPLstrict<br>Temporary|ness<br>Collective<br>umma|ryindex|
|---|---|---|---|---|
|uy|g<br>employment<br> <br>|<br>employment<br>|<br><br>dismissals<br>||
|Croatia<br>|2.8<br>|3.9<br>|5.0<br>|3.6<br>21|
|CzechRepublic|2.8<br>|0.5<br>|4.3<br>|.<br>26|
|Estonia|3.1<br>|1.4<br>|4.1<br>|.<br>|
|Hungary|2.1<br>|0.6<br>|3.4<br>|1.7<br>|
|Poland<br>|2.2<br>|1.0<br>|3.9<br>|2.0<br>24|
|SlovakRepublic|2.6<br>|1.4<br>|4.4<br>|.<br>|
|Slovenia|3.4|2.4|4.8|3.5|
|CEEEUACaverage|2.7<br>|1.2<br>|4.1<br>|2.4<br>|
|EUaverage|2.4<br>|2.1<br>|3.2<br>|2.4<br>|
|OECDaverage|2.0|1.7|2.9|2.0|
|CEEEUACminimum|2.1<br>|0.5<br>|3.4<br>|1.7<br>|
|EUminimum|0.8<br>|0.3<br>|2.1<br>|0.9<br>|
|OECDminimum|0.2|0.3|0.4|0.7|

Sources: OECD (1999),<sup>WorldBankestimatesforEstoniaandSlovenia,Biondicetal.</sup> (2002) for Croatia.

The overall high level of<sup>EPL in Croatiareflectregulatoryconstraintsin three</sup> basic areas: high procedural<sup>andmonetarycosts associated with individualdismissals,</sup> restrictions on temporary<sup>employment,and finallyhigh costsof collectivedismissals.</sup> In all three cases regulations<sup>inCroatiaaremorestringent thaninvastmajorityof</sup> transition economies, EU<sup>andOECD.However,collective dismissalsare byfar the</sup> most difficult and costly<sup>inCroatia acrossthewholeOECD.Thepertinentindex</sup> reaches the maximum<sup>valueof 5 in Croatia,comparedwith 3.4inHungaryand 2.1in</sup> Ireland. This means that<sup>thecostsof collectivedismissals-whichcanmeanas few</sup> as five workers - can in<sup>mancases beprohibitiveinCroatia.Below wepresent the</sup> most important legal provisions<sup>contributing to highdismissal costsin Croatia.</sup> _Individual dismissals_<sup>arecostlydue tothelongadvancednoticeperiodand</sup> high severance pay. In<sup>addition, expectedcostsareincreasedby highprobability of</sup> job readmission and generous monetary compensation ordered by courts. Specifically, advanced notice of dismissal<sup>forworkerswith20ormoreyearsof</sup> service is 6 months in<sup>Croatia,comparedwith3 monthsin Hungary or Polandand2</sup> _-43-_
months in Ireland or Slovakia.<sup>20</sup> Severance pay is determined as two weeks of salary per year of service, with no upper limit, which is very generous. For example, a Croatian worker with 20 years of service would be entitled to 10 monthly salaries in severance pay, while his/her Slovak, Irish and Hungarian colleagues would get 2, 2.2 and 5 monthly salaries, respectively. Imagine now that a Croatian workers is fired for, say, poor performance. As proving poor performance is difficult, courts - which traditionally have exhibited a pro labor bias - tend to order job readmission and compensation amounting to forgone earnings (with no upper limit). Given lengthy court procedures, expected hiring costs are high, effectively discouraging employers from laying worker off.

_Temporary (fixed-term) employment_ is way of circumventing high costs of terminating regular employment contracts. However, the law in Croatia restricts its use by requiring that temporary contracts are signed only on exceptional basis when there is a valid and important reason.<sup>21</sup> Furthermore, the total cumulative duration of temporary employment cannot exceed three years. While many countries impose some restrictions on the use of temporary employment contracts, in Croatia they are more strict than in other countries. For example, in Hungary or Estonia the total duration of temporary contracts can be five years. Accordingly, the incidence of temporary contracts - 11 percent -- is relatively low in Croatia. For comparison, in Spain, where temporary contracts were introduced specifically to improve flexibility and increase hiring, they account for about one-third of all contracts (Dolado et al., 2002). However, despite the restrictions, temporary contracts seem to be increasingly used by Croatian employers. After all, there is a perception that they are being abused, because reportedly the majority of new hires are offered fixed-term contracts. Using the recent Labor Force Survey (2001) data we estimate the incidence of temporary employment contracts among new hires at 55 percent. The proportion of newly concluded fixed-term contracts is high, indicting weak enforcement of the relevant provision of the Labor Law. The growing popularity of fixed term contracts among employers reflects high dismissal costs in the case of permanent employment contracts, and is a source of necessary employment flexibility for employers. As

> **20** As documented earlier in the paper, the proportion of workers with long job tenure, for whom dismissal costs are substantially higher, is very high in Croatia compared with other countries. **21** Valid reasons include seasonal work, replacement of a temporary absent employee, special business needs, etc.

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such, fixed term contracts contribute<sup>togreaterhiringandplayapositivefunction.</sup> The only efficient way to increase<sup>the uiseof permanentcontractsby employersis to</sup> significantly lower the firing<sup>costs associatedwith-ihem.</sup> If individual dismissals are difficult,<sup>_collective dismissals_are evenmore soin</sup> Croatia. Accordingly lay-offs<sup>forecohomic or technologicalreasonsareverycostly.</sup> One source of the problem<sup>is anoverlyinclusivedefinitionof collectiveredundancy</sup> in Croatia whereby special<sup>regulations applyfrom5 dismissalsoverthe periodof 6</sup> months upward. This is<sup>amuchbroaderdefinitionthatintheEU,where collective</sup> redundancy is defined as either<sup>10ormore workerslaidoffovertheperiodof1</sup> month, or 20 or more workers<sup>laid off over the periodof 3 months.22</sup> Another source of the high<sup>costsof collectivedismissalsarestrict procedural</sup> requirements. They include consultation with<sup>tradeunions onalternativesto</sup> redundancy, notification of<sup>localEmploymentOfficeandan obligationtopreparea</sup> Social Plan, to mitigate<sup>theeffectsof redundancy.</sup> These procedural requirements involve an additional delay<sup>of 90daysbefore'anoticeofdismissalcanbeissued.</sup> This is much longer than<sup>in othercountries wherethe additional delay usuallyisfour</sup> to six weeks. Altogether, collective<sup>disrmissalin* Croatia involvelengthyand</sup> cumbersome procedures, which<sup>translateintodirect financial costsof compensating</sup> redundant labor.

What are the implications of<sup>stringentemployment protection regulations and</sup> high firing costs in for<sup>labormarketpe'rformanceinCroatia?</sup> Basically, they contribute to and account for<sup>theobservedunfavorablelabormarketoutcomes,such</sup> as low job creation and<sup>hiring,longdurationofunemploymentspells,andthe</sup> concentration of unemployment<sup>among disadvantagedworker groups.23</sup> The mechanics of the impact<sup>of strictEPL onlabormarket outcomesare as</sup> follows. All but prohibitive<sup>dismissal costs in Croatia' explain theobservedlow firing</sup> and job destruction rates. At<sup>thesame time, theycontributetolowhiringandjob</sup> creation rates. This effect works<sup>through twochannels.First,stringent labor market</sup>

> 22 European Council Directive<sup>98i591EC.See Fuenzalida2002for the comparisonof</sup> employment protection in Croatia<sup>withEU nornms.</sup> 23 It has been extensively documrented<sup>that the costsof labormarket rigidities and poorlabor</sup> market performance are disproportionately<sup>borne by vulnerable, workergroups,suchas youth,women</sup> and older individuals. See Bertola<sup>et al.(2002)for most recentresearchonthe relationshipbetween</sup> labor market institutions and<sup>demographicemployment patterns.</sup>

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regulations discourage firm entry (Scarpetta, 2002). Second, high firing costs discourage hiring as employers limit staff recruitment in order to avoid future costs of employment adjustment to changes in product demand (OECD 1994). Accordingly, limited hiring is a mirror image of limited firing. By hindering both job destruction and job creation strict EPL limits job turnover. As a result, both employment and unemployment spells tend to be longer. The chances to escape unemployment, are thus less than in a dynamic, high turnover labor market. This, coupled with the discouraged worker effect, leads to lower employment-to-population ratio, especially among disadvantaged worker groups, such as youth, women and older workers, and thus to the underutilization of labor resources (OECD 1999).

Moreover, by inhibiting job turnover and raising the costs of enterprise restructuring, strict EPL in Croatia hinders productivity improvements and thereby lowers the rate of economic growth. Finally, strict EPL provides an incentive to firms to move to or remain in the informal sector in order to lower explicit<sup>andimplicit</sup> labor costs (Schneider and Enste, 2000).

Economic costs of overly strict EPL, in Croatia are thus enormous. Ultimately they boil down to lower employment and slower economic growth and thereby to lower welfare of the population. This is not a price worth paying for high job<sup>security</sup> of insiders, i.e. those workers who have protected jobs in the formal sector.

# **High labor costs**

Wages are high in Croatia, higher than virtually all other transition economies of Central and Eastem Europe (Table 15). An average manufacturing worker receives close to USD 500 in Croatia, which is from 50 to 100 percent higher than in Croatia's closest competitors such as the Czech Republic (USD 340), Hungary (USD<sup>310)or</sup> Slovakia (USD 260) and almost five times as much as in Bulgaria or Romania (USD 110).

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**Table 15 Gross monthly wages in manufacturing,**<sup>**2000**</sup>

||Gross<br>wages<br>|Labor<br>compensation <br>|GNIpercapita|Gross<br>wages<br> <br>|GIprcpt<br>GNIpercapita<br>|
|---|---|---|---|---|---|
|||$||Croat<br>|ia=100<br>|
|Bulgaria.|109<br>||1520<br>|22<br>|33<br>|
|Croatia|494|577.9<br>|4620<br>|100<br>|100<br>|
|CzechRepublic|341|503.5|5250<br>|69<br>|114<br>|
|Estonia|281<br>|373.3|3580<br>|57<br>|77<br>|
|Greece|1432<br>|..<br>|11960<br>|290<br>|259<br>|
|Hungary|312|449.7|4710<br>|63<br>|102<br>|
|Ireland|1804<br>|..|22660<br>|365<br>|490<br>|
|Latvia|225<br>|..|2920<br>|46<br>|63<br>|
|Lithuania|247<br>|..<br>|2930<br>|50<br>|63<br>|
|Poland|457|605.3|4190<br>|92<br>|91<br>|
|Portugal|679<br>|..|11120<br>|138<br>|241<br>|
|Romania|112<br>|..<br>|1670<br>|23<br>|36<br>|
|Slovakia|255|382.2<br>|3700<br>|52<br>|80<br>|
|Slovenia|793<br>|1093.9|10050<br>|160<br>|218<br>|
|Spain|1461|..|15080|296|326|

= Not available a) Gross wage plus payroll taxes.

# Sources:

Wages: Yearbook of Labor Statistics 2001, ILO Gross National Income: World<sup>Bank Atlas,2002</sup> Exchange rate: World Development Indicators,<sup>The WorldBank,2002.</sup> Do these wage differentials reflect productivity<sup>differentials? Theansweris</sup> no. Relatively high wages in Croatia are not<sup>justifiedbyproportionatelyhigher labor</sup> productivity. Using GNI per capita as a proxy<sup>forlabor productivity,it turnsout that</sup> wage differentials between Croatia and<sup>other transitioneconomiesarelarger than</sup> productivity differentials.<sup>2 4</sup> Croatia does not enjoy a productivity advantage<sup>which</sup> would warrant the existing level of wages. In other words, productivity adjusted wages are high in Croatia compared<sup>with othercountries.</sup> For example, manufacturing wages in Slovenia are about<sup>60 percenthigher thanCroatia,however</sup> -productivity is over twice as high, which<sup>impliesthat despite higher wages,unit labor</sup>

**24** Clearly, GNI per capita is a very rough proxy<sup>for manufacturingproductivity (outputper</sup> worker), and accordingly the results presented<sup>are grossapproximation.Nonetheless,given cross-</sup> country correlation between GNI per capita<sup>and productivity,the scope for large errors regarding the</sup> ranking of countries with respect unit labor<sup>costsseemslimited.</sup>

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costs are lower in Slovenia. Similarly, while labor productivity<sup>inHungary is ata</sup> similar level as in Croatia, Hungarian wages are on average by one-third<sup>lower.</sup> Labor costs comprise not only gross worker wage but also payroll taxes<sup>paid</sup> by the employer. The payroll tax rate, at around 17 percent, is lower<sup>inCroatiathan</sup> in other transition economies of CEE and in fact lower than in most<sup>EUcountries.By</sup> way of comparison, the payroll tax rate in EU accession countries<sup>ranges from33</sup> percent in Estonia to 50 percent in the Slovak Republic. The average<sup>payrolltaxrate</sup> in the EU is 23.5 percent (Ribaud et al., 2002). The low payroll<sup>tax rateinCroatiais</sup> a positive factor, as high payroll taxes negatively affect labor<sup>demand.Nonetheless,</sup> the relatively low payroll tax rate in Croatia does _not_ offset the<sup>relativelyhigh gross</sup> wages. Labor costs in Croatia are still higher than in most of its East<sup>European</sup> competitors. For example, labor costs in Croatia's manufacturing are about<sup>15</sup> percent higher than in the Czech Republic, 30 percent higher than<sup>in Hungary and50</sup> percent higher than in Slovakia.

As a digression, it should be noted that he sole focus on payroll<sup>taxesis</sup> misguided as contributions can be shifted from employers<sup>toemployeeswithout</sup> affecting the level of labor costs. That is exactly the case<sup>inCroatia:whilesocial</sup> security contributions paid by paid by employers are relatively<sup>low,thosepaid by</sup> employees are relatively high, accounting for the high gross wages.<sup>Whatmattersis</sup> thus the total tax wedge - the wedge between labor costs to<sup>theemployerandthe</sup> corresponding net take-home pay of the employee. Currently<sup>the tax wedgeaccounts</sup> for 41.1% of total labor costs in Croatia (Table 16), which is still<sup>relativelylow both</sup> by standards of EU and other transition economies of CEE. For<sup>example,inCEE the</sup> tax wedge ranged (in 2000) from 44.4 percent in the Slovak<sup>Republic to45.3 percent</sup> in Poland, to 56.3 percent in Hungary (OECD 2001). In the<sup>EUthetax wedgeranges</sup> from 39.4 percent in the U.K. to 67 percent in Belgium, with<sup>theaverage</sup> (unweighted) at 52.7 percent.<sup>25</sup> It should be stressed that the relatively<sup>low tax wedge</sup> is a results of a conscientious effort of the govemment of Croatia,<sup>who recognizing</sup> the importance of low labor costs for Croatia's competitiveness<sup>andemployment,</sup> reduced the tax wedge by a considerable 7 percentage points in<sup>thesecondhalf of he</sup> 1990s.

> **25** The tax wedge is calculated for a single individual at the income level of the average production worker.
|**Tab**<br>(gro|**le16Thestructureoflaborcosts**<br>sswage=100)<br>||**2000**|**2002**|
|---|---|---|---|---|
||Laborcostcomponents<br>|**1995**<br>|<br>||
|**1**|Employee grosswage|100|100|100|
|2|Employercontributions(payroll taxes)<sup>a)</sup><br>|21.78<br>|16.98<br>|17.92<br>|
|2.1|healthinsurance<br>|7<br>|7<br>|7<br>|
|2.2|professionaldisease<br>|0<br>|0<br>|0.47<br>|
|2.3|pensioninsurance<br>|12.75<br>|8.75<br>|8.75<br>|
|2.4|unemploymentinsurance<br>|0.85<br>|0.85<br>|1.7<br>|
|2.5|watercontribution<br>|0.8<br>|0<br>|0<br>|
|2.6|chamberofcommerce contribution|0.38|0.38|0<br>|
|3|Employee taxesandcontributions<sup>a)</sup><br>|37.00<br>|31.69<br>|30.55<br>|
|3.1<br>|healthinsurance<br>|7.0<br>|9.0<br>|9.0<br>|
|3.2<br>|pensioninsurance<br>|12.75<br>|10.75<br>|10.75<br>|
|3.3|child allowancecontribution<br>|2.2<br>|0<br>|0<br>|
|3.4|unemploymentinsurance<br>|0.85<br>|0.85<br>|0<br>|
|3.5|personalincometax(effective)<br>|14.2<br>|11.1<br>|10.8<br>|
|4|Net(take-home)wage(1) - (3)<br>|63.00<br>|68.31<br>|69.45<br>|
|5|Laborcosts(1)+(2)<br>|121.78<br>|116.98<br>|117.92<br>|
|6|Taxwedgeb)[(5)-(4)]/(5)*_100_|48.27|41.60|41.10|

a) as a percentage of employee gross wage b) as a percentage of labor cost Source: Ministry of Finance; Bank<sup>staff calculations.</sup> All in all, _unit_ labor costs in Croatia are high,<sup>higherthaninCroatia'smain</sup> competitors.<sup>26</sup> This has an important negative<sup>effect on labordemand.First,thereis</sup> a direct effect whereby higher labor costs<sup>implylower labor demand.Second,thereis</sup> an indirect effect whereby higher unit labor<sup>costsimplies lowerprofit marginwhich</sup> discourages investment by lowering resources<sup>availableforinvestmentandexpected</sup> returns on investment. Lower investment,<sup>in turntranslates into less jobs creation and</sup> lower employment.

Why are labor costs high in Croatia? Given<sup>that the taxwedgeis moderate,it</sup> is workers net pay that is the primary reason<sup>of highunitlaborcosts.Onepossible</sup> factor behind relatively high wages is wage<sup>pressureexertedbyinsiders, thatis</sup> workers with secure jobs who therefore<sup>haveastrongbargainingposition.</sup> In addition, the industry level bargaining,<sup>whichprevailsinCroatia, especiallyinlarge</sup>

> 26 Unit labor costs in Croatia is even higher if one<sup>uses the hourlywage rate insteadof average</sup> wage per worker. This is due to the relatively<sup>shortworkinghours in Croatia (effectively37.5hours</sup> per week), which is less than in most other countries<sup>in theregion,where theworking hoursare 40 per</sup> week.

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firms, and which is known to generate<sup>wagepressure,has likelycontributedto</sup> increase in labor costs (Calmfors and<sup>Driffil,1988).27</sup> Strong real wage growth, unparalleled in other transition economies,<sup>whichhasoccurredin Croatiasincemid</sup> 1990s, is consistent with both hypothesis. If<sup>so, thenhigh unitlaborcosts in Croatia</sup> result from the interaction between the<sup>strict EPL(whichgivesrisetoinsiders'</sup> bargaining power) and wage bargaining institutions,<sup>specificallythepredominanceof</sup> industry level bargaining.

To summarize, unit labor costs are high<sup>inCroatia,higherthaninmost of its</sup> close competitors, reflecting wages not aligned<sup>with productivity.This has anegative</sup> impact on hiring and employment level.<sup>In additionto limitingcurrent labor demand,</sup> high unit labor costs also discourage investment,<sup>thuslimitingfutureemployment.</sup> The likely cause of high labor costs<sup>inCroatiaarestrongbargainingpositionof</sup> insiders, stemming from strict employment<sup>protection, coupledwithindustrylevel</sup> bargaining, which generates wage pressures.<sup>Giventhatthetaxwedgeisrelatively</sup> low, the only way to lower unit labor costs<sup>(withoutloweringrealwages)isthrough</sup> productivity improvements, which necessitate<sup>intensive enterpriserestructuring.It is</sup> essential to reform wage bargaining institutions<sup>sothatthesegainsarenotfully</sup> consumed by the wage growth.

# **Compressed wage structure**

The wage structure is more compressed<sup>in Croatiathanin most other transition</sup> economies. The Gini coefficient - a summary measure of income inequality<sup>-</sup> amounts to 0.274 in Croatia, while in<sup>othertransitioneconomiesof CentralEuropeit</sup> is around 0.300 or higher (Rutkowski<sup>2001).</sup> Earnings dispersion is thus rather modest in Croatia. However, at closer inspection it turns out<sup>thatthe earnings</sup> structure in Croatia exhibits some peculiar<sup>features.</sup> The wage distribution is compressed at the upper tail, while having<sup>a relativelylongand heavy lower tail. This</sup> is in contrast to other transition economies,<sup>wherewagedistributionhaswidened</sup> mainly at the upper end, meaning that in the<sup>courseof transition high earningshave</sup> become more prevalent. In Croatia still the<sup>incidenceof high payseems tobelimited.</sup>

> 27 The structure of wage bargaining and its<sup>impacton wage pressure is a complexissue which</sup> requires further investigation. Here we just<sup>point to a potentialsourceof wagepressures observedin</sup> Croatia.

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At the same time the incidence of low pay is quite high, comparable<sup>tothatin higher</sup> inequality transition economies, such as Hungary.<sup>28</sup> Specifically, the bottom decile worker earns 54 percent of<sup>themedian earnings</sup> which indicates a fair amount of wage flexibility at the lower<sup>endoftheeamings</sup> distribution (Table 17). For comparison, in Slovenia the bottom<sup>decileworkerearns</sup> some 60 percent of the median, which is characteristic of<sup>amoreegalitarianwage</sup> structure. Simultaneously, over 20 percent of all wage<sup>andsalaryearnersinCroatia</sup> eam less than two-thirds of the median, which means that the incidence<sup>of lowpay is</sup> quite high.<sup>29</sup> For instance in the EU countries, where wage inequality tends to be limited, the incidence of low pay rarely exceeds 15 percent.

**Table 17 Summary of earnings** _a)_ distribution, 2001

||Mean|Bottom<br>decile|Median|Top<br>decile|P10<br>PO|P90<br>P0|Decile<br>ratio|Ginicoeff.|
|---|---|---|---|---|---|---|---|---|
||Kuna||||%||||
|Allworkers(CBS)|3397|1626|3008|5270|54.0|175.2|3.2|0.274|
|Allworkers(FINA)b|)3448|1850|3454|4943|53.6|143.1|2.7|0.206|
|_Sector_|||||||||
|Publicsector|3838|2824|3886|4661|72.7|119.9|1.7|0.117|
|Privatesector|3124|1685|2805|5103|60.1|182.0|3.0|0.240|

# Note:

P1O denotes the eamings of the bottom decile relative to the median, expressed<sup>as apercentage.</sup> The decile ratio is the ratio of the top decile to the bottom decile,<sup>i.e.P90/P10.</sup> a) Gross earnings.

b) Legal persons only; February 2002 Source: FINA and Struktura zaposlenih prema visni prosjecne isplacene neto place i po djelatnostima<sup>uozujku2001,CBS.</sup> Author's calculations.

At the other extreme, the top decile worker earns 75 percent<sup>morethanthe</sup> median worker. This represents a lower premium for high<sup>skillsthanin mostother</sup>

**28** In this sub-section the terms high and low pay have a _relative_ rather<sup>than</sup><sup>_absolute_meaning,</sup> i.e. refer to wage inequality rather than the level. This is in contrast to<sup>theprecedingsub-section,where</sup> the focus was on the absolute level of wages. To illustrate the difference<sup>between these two concepts</sup>

(of absolute and relative wages), the wages are high in Croatia relative to<sup>other transitioneconomies;at</sup> the same time there is a relatively large number of workers who are low paid<sup>comparedwith the</sup> median worker, and a relatively small number of workers who are highly paid<sup>compared with the</sup> median worker.

**29** This figure can be inflated, however, by employers underreporting<sup>wages inorderto lowerthe</sup> payment of social security contributions.

_-51 -_
transition economies, where top decile workers<sup>usuallyearnat least twiceasmuch as</sup> the median worker. Simultaneously, the<sup>incidenceof highpayislimited.Only17</sup> percent of workers earn more than 1.5<sup>timesthe medianinCroatia,compared with</sup> over 20 percent in countries such as<sup>Hungary,PolandorSlovenia.</sup> This is not a dramatic difference, nonetheless it is<sup>significantand indicativeof somerigiditiesin</sup> the wage setting process in Croatia (see<sup>below).Highly paid jobsarestill tocomein</sup> Croatia.

As in all other transition economies, wage<sup>inequalitiesaremuch higherin the</sup> private than in the public sector. For example,<sup>the decileratio -the ratio of topdecile</sup> to bottom decile earnings - is less than<sup>twoin thepublicsector and aboutthreein the</sup> private sector, which points to substantially<sup>differentwagesettingpracticesin both</sup> 30 sectors. In the public sector wages are still set<sup>ina veryegalitarianway,whichis</sup> not the case in the private sector, where<sup>wagesbetterreflect productivity differentials</sup> among workers.

It seems that the primary source of the<sup>limitedwagedispersioninCroatiais</sup> the still large employment share of publicly<sup>owned and privatizedfirmsandthe</sup> relatively low share of _de novo_ private<sup>firms. In the public sector wagesof different</sup> categories of workers are determined according<sup>toastandardwagegrid, i.e.asystem</sup> of coefficients meant to reflect skill requirements<sup>associatedwithdifferent jobs.The</sup> least skilled jobs are assigned the coefficient<sup>of one whilethemostskilled jobsare</sup> assigned the coefficient in the five to<sup>six range,dependingon thefirmorindustry</sup> level collective agreement. Such a system<sup>of wage determination, supportedbytrade</sup> unions, is an obvious source of wage<sup>compression,as it produces boththe wagefloor</sup> and the ceiling.

The wage ceiling is determined according<sup>toaperceptionof afairdegreeof</sup> wage dispersion. As to the wage floor,<sup>this roleis usuallyplayedbytheminimum</sup> wage. However, there is no statutory<sup>minimumwagein Croatia.Insteadthis roleis</sup> played by the minimum base for social<sup>securitycontribution (which presently</sup> accounts for about 50 percent of the average<sup>wage).This notional minimumwageis</sup> as a rule used in collective agreements<sup>as thefloor for thewage structure,althoughin</sup>

> 30 The data on the pubic/private sector wage<sup>structure come froma different source thandata on</sup> overall wage distribution and are not comparable.

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some industries, where trade unions bargaining position is stronger, this floor is set at a somewhat higher level.

What are the ramifications of the existing wage structure? The relatively high incidence of low-paid jobs implies two things. First, it contributes to income inequalities. On the other hand, however, it provides employment opportunities for low skilled and inexperienced workers. To the extent this is the case, wage inequality alleviates inequality that is more socially harmful, namely that in access to work. Thus, given the high level of unemployment in Croatia, wage flexibility at the lower end of the distribution should be viewed as a positive factor, on balance enhancing social welfare.

Second, the relatively low incidence of top paying jobs may imply relatively low premium for high and specialized skills and may thus discourage investment in such skills. A question which requires further investigation is whether there is a sufficient supply of high skills in Croatia and whether firms are able to recruit and retain highly skilled workers. This problem is most probably concentrated in public and privatized firms.

To summarize, the wage structure in Croatia is somewhat more compressed than in other transition economies. This reflects a still relatively large share of the public sector, where wage setting is more egalitarian, mainly due to the - active involvement of trade unions. Unlike other transition economies, the wage structure in Croatia is decompressed at the lower tail of the distribution and compressed at the upper tail. The decompressed lower end of the wage distribution is likely to reflect the lack of statutory minimum wage, whereas the compressed upper end is likely to reflect trade unions' perception of fair wage differentials.

Wage flexibility at the lower end of the distribution translates into a relatively high incidence of low-paid jobs. While this contributes to income inequalities, it also provides job opportunities for low productivity workers and thus alleviates the unemployment problem. The compressed earnings distribution at the upper end may limit the supply of highly specialized and rare skills. This is an empirical question which merits further investigation.

All in all, the wage structure does not seem to be a factor contributing to poor labor market performance in Croatia.

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# **Skill and spatial mismatches?**

Unemployment in transition economies<sup>isoftenof frictionalandstructural</sup> nature, reflecting accelerated restructuring<sup>and spatialand skill mismatchesoccurring</sup> in its course. These mismatches emerge<sup>becausenewjobsthatarebeingcreated</sup> differ in salient characteristics - such as the<sup>skill contentandlocation -- fromthe old</sup> jobs that are being eliminated. Accordingly,<sup>afaster paceof enterprise restructuring</sup> can be expected to lead to more pronounced<sup>labormarketmismatchesandhence</sup> higher unemployment.

Given the slow pace of enterprise restructuring<sup>in Croatiaandthuslimited</sup> inflows into unemployment one can conjecture<sup>that frictionalunemploymentdoes</sup><sup>_not_</sup> play a significant role. In order to gauge the<sup>extentof structuralunemploymentone</sup> needs to compare the skill and location structure<sup>of available jobs (vacancies) with the</sup> structure of unemployment. For example, the more the skills required<sup>by employers</sup> differ from the skills possessed by the<sup>unemployed,thelargerisstructural</sup> unemployment. Unfortunately, there is no<sup>goodmeasureof theskillcontent.Asa</sup> rough proxy one can use educational attainment,<sup>howeverinthiscaseimportant</sup> aspects - such as occupational, computer,<sup>communication, language, or managerial</sup> skills - are left out from the analysis.

With this caveat in mind, it is interesting<sup>to noticethattheeducational</sup> structure of existing jobs does not<sup>differsignificantlyfrom thestructureof</sup> unemployment in Croatia (Table 18). This is in contrast to most transition economies, where there is a visible discrepancy<sup>between thosetwostructures: the</sup> proportion of low skilled jobs is much<sup>lowerthan theproportionof low skilled</sup> unemployed. Accordingly, an index of<sup>skillmismatchislowerinCroatia thanin</sup> other transition economies. As noted, this<sup>is a far from perfectmeasureof the extent</sup> of the skill mismatch, but nonetheless it<sup>suggeststhat inadequate formaleducational</sup> attainment of the unemployed is _not_<sup>a</sup> primary<sup>causeofunemploymentinCroatia.</sup> This positive finding notwithstanding, it<sup>islikely thatsomeoftheunemployed,</sup> especially the long-term unemployed whose<sup>skills tendto erode,lack importantskills</sup> sought after by the employers, which limits<sup>their chancesto find a job.</sup> _-54-_
**Table 18 The structure of employment and unemployment by educational attainment, 2001**

|Education<br>Educatbon<br>|Sharein<br>Sharein<br>employment unemployment|"Excess<br>supply"|
|---|---|---|
|Lessthanprimary|5.6<br>3.3<br>|-2.3<br>|
|Primary|17.6<br>15.8|-1.8<br>|
|Vocationalschoola)|22.4<br>30.2<br>|7.8<br>|
|Secondarytechnicalb)|<br>32.9<br>35.5<br> <br>|2.6<br>|
|Secondarygeneral|3.5<br>4.9<br> <br>|1.4<br>|
|College|6.5<br>4<br>|-2.5<br>|
|University|11.5<br>6.3|-5.2|

a) 1 to 3 year courses b) 4 year courses Source: Labor Force Survey, CBS; Author's calculations.

As to the spatial mismatch, it is difficult to assess it degree due<sup>to the lackof</sup> relevant data.<sup>3</sup> 1 Other studies documented relatively strong regional<sup>variation of</sup> unemployment in Croatia, which may point to regional mismatches<sup>(Bisogno2000).</sup> Still, given relatively little variation in the job creation and job destruction<sup>ratesby</sup> region, these regional differences in labor market conditions are more<sup>likely to be of a</sup> historic nature rather than recent developments resulting from the differential<sup>rateof</sup> enterprise restructuring during the transition.

We can tentatively conclude that educational and spatial mismatches<sup>arising</sup> from industrial restructuring are not major factors behind high<sup>unemploymentin</sup> Croatia. Indirect evidence supporting this claim comes from slow pace of<sup>job</sup> reallocation in Croatia. As few jobs are being destroyed and created,<sup>thereis not</sup> much scope for mismatch between the old and new jobs. A more direct<sup>evidence</sup> comes from the comparison of the educational structure of employment<sup>and</sup> unemployment. Both are similar and there is no - common in other countries<sup>-</sup> disproportion between the fractions of low skilled jobs and low skilled<sup>unemployed.</sup> Nonetheless, there are reasons to believe that long term unemployment<sup>-whichis</sup> substantial in Croatia - is associated with inadequate skills.

3 1 The Central Bureau of Statistics does not publish data on unemployment by<sup>region.</sup> _-55-_
# **IV.** CONCLUSIONS AND RECOMMENDATIONS:<sup>BARRIERSTO JOB CREATION</sup><sup>**AND**</sup> HOW TO REMOVE THEM

This paper shows that a slow<sup>pdceof jobcreationis at theroot of poor labor</sup> market performance in Croatia. This slow pace of job creation<sup>iscausedby(a)</sup> barriers to entry by new<sup>_firms,_and(b)barrierstoexpansionbyexistingfirms.The</sup> paper focuses on, the latter<sup>issue and'findsthatthestrictemploymentprotection</sup> legislation in Croatia is a<sup>keyconstrainton jobcreationandhiring.Inaddition,and</sup> not independently, job creation<sup>issloweddown byhighunit laborcosts.Thesehigh</sup> unit labor costs are a result of<sup>thewage, pressureexertedby</sup><sup>_insiders,_that is workers</sup> with protected and secure jobs<sup>employedin astilllargeold sector,consistingof large</sup> state owned or privatized enterprises.<sup>Inadditionthe paperexaminesotherpossible</sup> causes of slow job creation<sup>andhigh unemployment,suchasthe unemployment</sup> benefit system, the wage structure,<sup>enterpriserestructuringandassociatedskilland</sup> spatial mismatches. These factors seem to play<sup>anegligibleorasecondaryrole.</sup> Thus, reforms of the employment<sup>protectionlegislationand thewagebargaining</sup> system are key for improving<sup>labor market performancein Croatia.</sup> The overarching objective of<sup>.suchreforms istoenhancelabor market</sup> flexibility through _deregulation_<sup>and</sup><sup>_decentralization_of industrial relationsin Croatia.</sup> The following specific measures<sup>should help to achievethis objective.32</sup>

- Lowering barriers to.<sup>entrybysmallprivate firmsandimproving</sup> business environment for SMEs;

- Liberalizing the employment<sup>protectionlegislation through amending</sup> the Labor Code. Specifically:

- Lowering costs of individual<sup>dismissalsbyshorteningthe</sup> notice period and lowering<sup>thestatutory severancepay;</sup>

- Relaxing restrictions on<sup>theuseoffixed-term and temporary</sup> contracts;

- Revising the definition of<sup>collectivedismissalsso that it applies</sup> to at least 20 workers (released<sup>within 90days),andexempting</sup>

> **32** The reformns recommended here<sup>areconsistentwith thoseagreed upon betweenthe</sup> Government of Croatia and the<sup>World Bank under the StructuralAdjustmentLoan (SAL).</sup>

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small employers from special provisions regarding group layoffs;

- Decentralizing industrial relations, in particular moving away from industry level bargaining toward firm level bargaining.

In addition, aggressively applying job availability and search tests would help to discriminate between those unemployed who are registered in order to find a job and those who are registered to have access to benefits. This in turn would allow the relevant agencies to have a clearer picture of actual unemployment and its changes.

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