## wp17125 ## Source details **Canonical URL:** [wp17125](https://www.imf.org/-/media/files/publications/wp/2017/wp17125.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2017/wp17125.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2017/wp17125.pdf.json) --- ### Motivation and literature - Context: - Lackluster growth after the global financial crisis and limited scope for macroeconomic stimulus renewed interest in growth-enhancing structural reforms. - IMF (2014) argues product and labor market deregulation (promotion of competition, relaxation of hiring and firing regulations) can yield a sizeable growth dividend. - Key literature (select examples as presented): - Blanchard and Gali (2010); Kugler and Pica (2004); Berger and Danninger (2005); Boken and Hallett (2008); Fernandez-Villaverde et al. (2014); Cacciatore and Fiori (2016). - Open-economy extensions: Lusinyan and Muir (2013); Andres et al. (2014); Vogel (2014); Eggertson et al. (2014); Cacciatore et al. (2016a). - Shadow economy and tax evasion literature: Schneider et al. (2010); Charlot et al. (2015). ### Model structure (STRESS: Structural Reforms and Shadow Sector) - Framework: - Small open-economy dynamic general equilibrium model with formal and informal sectors in both labor and goods markets. - Unemployment due to hiring costs and wage bargaining following Blanchard and Gali (2010); endogenous firm entry following Bilbie et al. (2012). - Novelty: explicit distinction between formal and informal sectors; only formal goods are traded internationally; only formal labor income is taxed. - Key functional forms and components (verbatim where provided): - Household utility: U[C_t] = (1−hc) ln(C_t − C_{t−1}); discount factor β; habit parameter hc∈(0,1); preference shock ζ_{C,t}. - Consumption aggregator: C_t = [α^{1/η} C_{H,t}^{(η−1)/η} + (1−α)^{1/η} C_{f,t}^{(η−1)/η}]^{η/(η−1)} where α∈(0,1), η>0. - Home consumption nested: C_{H,t} = [ω^{1/μ} C_{F,t}^{(μ−1)/μ} + (1−ω)^{1/μ} C_{I,t}^{(μ−1)/μ}]^{μ/(μ−1)} where ω∈(0,1), μ>0. - Capital accumulation: K_t = (1−δ)K_{t−1} + (P_{INV,t}/P_t) I_t − φ_{INV}/2 ((P_{INV,t}/P_t I_t K_{t−1} − δ)^2 / K_{t−1}). - Hiring cost (formal): HC_{F,t} = β_{HCF,t} (probh_{F,t})^{α_{HCF}} with probh_{F,t} = H_{F,t} / (U_{t−1} + probf_{F,t} L_{F,t−1} + probf_{I,t} L_{I,t−1}). - Wage bargaining: Nash bargaining with exogenous sectoral bargaining powers λ_{F,t}, λ_{I,t}; formal wages taxed by τ_{F,t}. - Retailers: monopolistic competition with endogenous markup ε_{F,t} = α_F N_{F,t}; price adjustment costs a la Rotemberg with parameter φ_F. - Entry condition: entry_F,t = E_t Σ_{k=t}^∞ Q_{t,k} (1−δ_F)^{k−t+1} Prof_{R,F,k}; new firms enter until entry cost equals firm value. - Exports: Q_{X,t} = (P_{F,t}^e P^?_t α_X)^{−ς_X}; only formal goods exported. - Monetary policy: Taylor-type rule with interest rate smoothing ρ_i and responses ρ_π and ρ_GDP; shock ε_{i,t}. ### Role of informality and openness (mechanisms) - Composition and substitution effects: - Composition effect: larger informal sector reduces the fraction of the economy directly affected by government reforms. - Substitution effect: deregulation may reduce incentives to operate informally, increasing formal sector size; productivity differential between sectors can magnify reform impacts. - Features differentiating sectors (as presented): - Regulation: higher in formal sector (higher hiring costs, higher bargaining power, higher entry costs, higher markups, lower exit and dismissal rates). - Taxation: only formal labor income taxed. - Government demand and investment: government purchases and investment use formal goods only. - Productivity: labor productivity lower in informal sector. - Trade: only formal goods are traded abroad. - Open-economy interaction: - Openness interacts with informality because only formal goods respond to foreign demand and prices. - Home production Y_{HP,t} included in informal resource constraint; Y_{HP,t} = α_{HP} (W_F,t L_F,t + W_I,t L_I,t) L_t U_t. ### Calibration, estimation, and numerical experiments - Parametrized economies and simulation tools: - Three parametrized economies: baseline open-economy with shadow sector; closed-economy with same shadow sector; open-economy with shadow output size 1/3 of baseline. - Deterministic simulations carried out by Dynare 4.4.3. - Reform experiments: - 10 percent permanent and unexpected reductions in formal (i) hiring cost, (ii) bargaining power of workers, and (iii) entry cost. - Long-run evaluation horizon: 25 years. - Bayesian estimation notes: - Priors of consumption habit and interest rate smoothing maximized to 0.9; prior of interest rate premium maximized to 0.005. - Priors for autocorrelations and standard deviations of shocks maximized to 0.9 (Appendix B). - Dynamic structural parameters estimated using Dynare 4.4.3 on quarterly South African data (2000Q3 to 2012Q2). ### South Africa data points and calibration targets (as used) - Labor market and informality: - Unemployment (Labor Force Survey): hovered around 28.7 percent over the last two decades. - Share of informal employment in labor force: - University of Stellenbosch: 15.8 percent. - Cassim et al. (2016): 34.6 percent. - Schneider et al. (2010) finds size of the shadow economy in GDP: 27.3 percent. - Schneider (2005) reports 16 percent of OECD countries’ GDP and 41 percent of African countries’ GDP is informal. - South Africa: share of informal GDP in total GDP is 28.4 in Schneider (2005), and 24 percent in IMF (2017); number of informally employed people increased by 400 thousand since 2010 (SSA 2017). - Sectoral firing probabilities (own estimates): - Formal sector firing probability: 14.5 percent. - Informal sector firing probability: 84.8 percent. - Hiring and firing costs: - Since 2006 redundancy costs were 21.9 weeks of salary on average → ratio of firing costs to quarterly wages = 1.7. - Hiring costs assumed similar magnitude to firing costs; informal-sector hiring costs assumed to be half as much (fraction of hiring costs to wages) as in the formal sector. - Bargaining power: - Literature usual range: between 0.3 and 0.5 (Mortensen and Nagypal 2007). - Calibrated values: formal bargaining power of workers = 0.6; informal bargaining power = 0.4. - Sectoral bankruptcy rates: - Formal sector bankruptcy rate: 10.9 percent. - Informal sector bankruptcy rate: 17.3 percent. - Entry costs: - Entry cost of new companies = 2.1 months of yearly output (proxy); informal entry cost-output ratio assumed equal to half of the formal sector’s value. - Consumption and substitution parameters: - Formality bias: normalized to 50 percent. - Elasticity of substitution between formal and informal goods: 1.5. - Openness parameters: - Home bias: 0.8 (share of imported goods = 20 percent). - Elasticity of substitution between home- and foreign-produced goods: 0.6. - Export price elasticity: 4.5. - Exchange rate pass-through to import prices: reference "0.8 according toKaroro et al.(2008)" appears in source excerpt. ### Long-run (25-year) effects of single reforms (quantitative) - Reform specification: permanent and unexpected 10 percent reductions in the formal sector. - Long-run GDP effects (25 years post-policy implementation): - 10 percent lowering of formal hiring cost → 2.9 percent increase in GDP. - 10 percent reduction in formal bargaining power of workers → 3.3 percent increase in GDP. - 10 percent decrease in formal entry cost → 1.1 percent increase in GDP. - Long-run unemployment effects (percentage-point changes): - Lowering hiring cost → 2.8 pp decline in unemployment. - Lowering bargaining power of workers → 4.6 pp decline in unemployment. - Lowering entry cost → 0.5 pp decline in unemployment. - Additional reported illustrative magnitudes (verbatim from text excerpts): - "GDP goes up by 1 or 1.8 per cent in the long-run, if hiring costs or bargaining power of workers in the formal sector are lowered, respectively;" (sentence in source continues beyond excerpt). - "2.8 per cent if the size of the shadow economy is 1/3 of the original level." (context: unemployment or other metric in excerpt). ### Impact of informality on macroeconomic responses (specific comparisons) - Presence of informality materially alters both the sign and magnitude of macroeconomic responses to structural reforms. - Example quantitative effects: - A 10 per cent reduction in hiring costs implies a 1.7 pp drop in the rate of unemployment with low informality, while in the baseline scenario unemployment only goes down by 1.2 pp. - A bargaining power policy induces 3.3 and 2.4 pp decreases in unemployment (low informality and baseline/high informality respectively). - A bargaining power policy induces a 3.2 pp drop in formal employment with low informality, but only a 2 pp drop with high informality. - Mechanism emphasized: - The lower the size of the shadow economy, the larger the share of the economy directly affected by structural reforms; this effect outweighs other channels in the model. ### Short-run dynamics and impulse responses (first 5 years) - General: - Impulse responses with low informality are about 0.5-1 pp higher (Figures A1 and A2 in the Appendix). - Short-run costs include declines in consumption, exports or output, reductions in wages, or lower competition, varying by reform. - Hiring cost reduction (10 percent): - GDP slightly declines in the first year. - Less inflationary pressure accompanies this policy. - Formal employment rises; unofficial employment also goes up. - Net exports go down in the short run. - Formal wages tend to decrease. - Reduction in bargaining power of workers (10 percent): - GDP significantly declines during the first year (GDP decreases in the first four quarters). - Unemployment declines immediately; shadow employment goes down. - Net exports go up. - Formal wages decrease more significantly. - Number of formal firms initially goes down. - Reduction in entry cost (10 percent): - GDP declines in the first two quarters. - Unemployment immediately starts to go down (less than with a labor market reform). - Formal and informal wages increase. - Short-run net exports fall. - Number of formal firms rises considerably immediately; informal firms first decline then rise. - Labor market specifics: - Labor market reforms do not raise informal employment. - Informal wages go up instead of down if the bargaining power of workers is lowered. - Inflation increases more with low informality. - Product market deregulation: - In the baseline scenario, GDP increases immediately after the shock. - With low informality, GDP decreases during the first couple of quarters — indicating a severe transition cost because investment declines while unemployment drops more than before. - Speed of adjustment: - Product market reform: output is already close to the post-reform level one year after the shock. - Labor market reform: takes about two to four years to reach similar proximity to post-reform level. ### Reform packages (combinations) and sequencing - Packages (all in formal economy) considered: - (i) decrease in hiring cost and bargaining power of workers - (ii) decrease in hiring cost and entry cost - (iii) decrease in bargaining power of workers and entry cost - (iv) decrease in hiring cost, bargaining power of workers, and entry cost (all three) - Key package outcomes: - Hiring cost + bargaining power cut: output does not decrease during the first year compared to the single bargaining power cut; household consumption and investment similarly avoid decline. Net exports, formal wages, and number of formal firms still go down. - Hiring cost + entry cost cut: can avoid a decrease in GDP in the short run. - Bargaining power + entry cost cut: neither household consumption nor net exports fall. - General conclusion: mixing reforms can mitigate short-term costs, especially when product market deregulation is included. - Sequencing findings (examples): - Hiring cost first, then reduce bargaining power: - Output goes up faster in the first half of the transition and increases gradually thereafter. - Bargaining power first, then hiring cost: - Unemployment falls more quickly and stays lower longer; informal employment lower initially and higher later compared to opposite sequence; formal wages quickly decline and do not recover. - Bargaining power first, then entry cost: - Better to start with bargaining power: output goes up faster and stays high; unemployment goes down faster and stays low. - Hiring cost first, then entry cost: - More efficient to start with hiring cost: GDP immediately and permanently increases; unemployment decreases accordingly. - All three policies mixed: - Starting with labor market reform: output rises faster and remains higher during most of the transition; unemployment falls more quickly and steadily. - Net exports always decrease but recovery is quicker. - Overall sequencing conclusion: - Except for formal wages and market competition, it is usually better to start with a labor market reform than with a product market reform regarding speed of adjustment and several macroeconomic outcomes. ### Model performance, robustness, and calibration notes - Estimation and data: - Bayesian estimation time span: 2000Q3 to 2012Q2. - Quarterly time series from IMF, SARB, SSA and own estimates (listed in source). - All national accounts’ time series are expressed in real terms, in 2005 prices and in South African RAND; seasonally adjusted and divided by population when necessary. - Model steady-state performance: - The model matches the size of the shadow economy in GDP well. - Shadow employment share in total employment is closest to Cassim et al. (2016). - Unemployment is slightly underestimated by the model. - Investment-to-GDP ratio in the model is slightly higher than in the data. - Robustness: - Technical Appendix shows evidence on the robustness of long-run macroeconomic impacts of structural reforms with respect to calibration assumptions. ### Conclusions and policy implications - Main conclusions: - Incorporating a shadow economy into an open-economy DSGE model matters for the sign and magnitude of macroeconomic effects of labor and product market deregulation. - In the long run both labor and product market reforms considerably increase output; labor market reforms are more successful in decreasing unemployment. - Level of underground employment may not decrease in the long run, but its share in total employment declines. - Several short-term costs are identified (decreases in household consumption, investment, net exports, output, or competition); combining reforms often mitigates these costs. - It is often preferable to start with a labor market reform regarding speed of adjustment and several macroeconomic outcomes (except formal wages and competition). - Calls for further research: - Optimal structural reform packages and sequencing. - How monetary or fiscal policies can support implementation and mitigate short-term costs of reforms. *Source: wp17125 - References (IMF working paper content unit).* ### References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ### References ### Tables and Figures inventory - Tables: - 1. Formal and informal rigidities - 2. The role of shadow economy and openness in long-run (25-year) effects of labor and product market deregulation policies. All deregulation policies are implemented in the formal sector, and mean permanent and unexpected 10 percent reforms. Low informality means that the size of shadow economy in output is 1/3 of the baseline value. - 3. Evaluating the steady state of the model - 4. Calibration of steady-state parameters based on South African data - 5. Prior and posterior distributions of structural dynamic parameters. The priors of consumption habit and interest rate smoothing are maximized to 0.9, while the prior of interest rate premium is maximized to 0.005. - 6. Long-run (25-year) effects of single structural reforms in South Africa. All deregulation policies are implemented in the formal sector, and mean a permanent and unexpected 10 percent reforms. - A1. Steady-state parameters of the parametrized economies - A2. Dynamic parameters of the parametrized economies - B1. Prior and posterior distributions of autocorrelations and standard deviations of shocks based on Bayesian estimation using South African data. All priors are maximized to 0.9. - C1. Long-run effects of structural reform packages in South Africa. The table shows the long-run (25 years) effects of permanent and unexpected policies of size 10 percent implemented in the formal sector. - Figures: - 1. Level of labor market deregulation. The EPL index shows the strictness of employment protection (individual and collective dismissals of regular contracts) published by the OECD. - 2. Level of product market deregulation. The OECD’s Product Market Regulation indicator measures the degree to which policies promote or inhibit competition in areas of the product market where competition is viable. - 3. The structure of the model - 4–8. Short-run effects (first 5 years after the shock) of a permanent and unexpected 10 percent decrease in: formal hiring cost (HCF), formal bargaining power of workers (BPF), formal entry cost (ENTRYF), and their combinations in South Africa. - 9–12. Sequencing of decreases in (combinations of) formal hiring cost, bargaining power of workers, and entry cost in South Africa. Lines show long-run (25 years + 25 years) effects of permanent and unexpected policies of size 10 percent with alternative implementation orders. - A1–A2. Role of shadow economy in short-run effects of a permanent and unexpected 10 percent decrease in combinations of formal hiring cost, bargaining power, and entry cost. Low informality means shadow economy in output is 1/3 of the original value. - B1. Prior and posterior distributions of structural parameters based on Bayesian estimation using South African data. Parameters: interest rate smoothing, inflation and output weights in Taylor rule, formal and informal Rotemberg price rigidity costs, interest rate premium, investment adjustment cost and consumption habit. ### Motivation and literature - Context and motivation: - Lackluster growth after the global financial crisis and limited scope for macroeconomic stimulus renewed interest in growth-enhancing structural reforms. - IMF (2014) argues product and labor market deregulation (promotion of competition, relaxation of hiring and firing regulations) can yield a sizeable growth dividend. - Key literature cited (select examples as presented): - Blanchard and Gali (2010); Kugler and Pica (2004); Berger and Danninger (2005); Boken and Hallett (2008); Fernandez-Villaverde et al. (2014); Cacciatore and Fiori (2016). - Open-economy extensions: Lusinyan and Muir (2013); Andres et al. (2014); Vogel (2014); Eggertson et al. (2014); Cacciatore et al. (2016a). - Shadow economy and tax evasion literature: Schneider et al. (2010); Charlot et al. (2015) (only paper noted to combine labor/product market reforms with informality). - Empirical context: - Informal sector estimates: Schneider (2005) reports 16 percent of OECD countries’ GDP and 41 percent of African countries’ GDP is informal. - Share of informal employment may be higher (60.5 percent in Africa referenced). - South Africa: share of informal GDP in total GDP is 28.4 in Schneider (2005), and 24 percent in IMF (2017); share of informal employment varies between 15.8 and 34.6 percent (Table 3); the number of informally employed people increased by 400 thousand since 2010 (SSA 2017). ### Model structure (STRESS: Structural Reforms and Shadow Sector) - Framework: - Small open-economy dynamic general equilibrium model with formal and informal sectors in both labor and goods markets. - Unemployment due to hiring costs and wage bargaining following Blanchard and Gali (2010); endogenous firm entry following Bilbie et al. (2012). - Novelty: explicit distinction between formal and informal sectors; only formal goods are traded internationally; only formal labor income is taxed; formal sector subject to higher regulation (hiring costs, bargaining power, entry costs, markups, lower exit and dismissal rates). - Key components and functional forms (as presented): - Household utility: U[C_t] = (1−hc) ln(C_t − C_{t−1}); discount factor β; habit parameter hc∈(0,1); preference shock ζ_{C,t}. - Consumption aggregator: C_t = [α^{1/η} C_{H,t}^{(η−1)/η} + (1−α)^{1/η} C_{f,t}^{(η−1)/η}]^{η/(η−1)} where α∈(0,1), η>0. - Home consumption nested: C_{H,t} = [ω^{1/μ} C_{F,t}^{(μ−1)/μ} + (1−ω)^{1/μ} C_{I,t}^{(μ−1)/μ}]^{μ/(μ−1)} where ω∈(0,1), μ>0. - Capital accumulation: K_t = (1−δ)K_{t−1} + (P_{INV,t}/P_t) I_t − φ_{INV}/2 ((P_{INV,t}/P_t I_t K_{t−1} − δ)^2 / K_{t−1}). - Hiring cost (formal): HC_{F,t} = β_{HCF,t} (probh_{F,t})^{α_{HCF}} with probh_{F,t} = H_{F,t} / (U_{t−1} + probf_{F,t} L_{F,t−1} + probf_{I,t} L_{I,t−1}). - Wage bargaining: Nash bargaining with exogenous sectoral bargaining powers λ_{F,t}, λ_{I,t}; formal wages taxed by τ_{F,t}. - Retailers: monopolistic competition with endogenous markup ε_{F,t} = α_F N_{F,t}; price adjustment costs a la Rotemberg with parameter φ_F. - Entry condition: entry_F,t = E_t Σ_{k=t}^∞ Q_{t,k} (1−δ_F)^{k−t+1} Prof_{R,F,k}; new firms enter until entry cost equals firm value. - Exports: Q_{X,t} = (P_{F,t}^e P^?_t α_X)^{−ς_X}; only formal goods exported. - Monetary policy: Taylor-type rule with interest rate smoothing ρ_i and responses ρ_π and ρ_GDP; shock ε_{i,t}. ### Role of informality and openness (mechanisms) - Composition and substitution effects: - Composition effect: larger informal sector reduces the fraction of the economy directly affected by government reforms. - Substitution effect: deregulation may reduce incentives to operate informally, increasing formal sector size; productivity differential between sectors can magnify reform impacts. - Features differentiating sectors (Table 1 summary): - Regulation: higher in formal sector (higher hiring costs, higher bargaining power, higher entry costs, higher markups, lower exit and dismissal rates). - Taxation: only formal labor income taxed. - Government demand and investment: government purchases and investment use formal goods only. - Productivity: labor productivity lower in informal sector. - Trade: only formal goods are traded abroad. - Modeling assumptions underscoring interactions: - Openness interacts with informality because only formal goods respond to foreign demand and prices. - Home production Y_{HP,t} included in informal resource constraint to capture home work; Y_{HP,t} = α_{HP} (W_F,t L_F,t + W_I,t L_I,t) L_t U_t. ### Calibration, estimation, and numerical experiments - Calibration and parametrization: - Three parametrized economies simulated: baseline open-economy with shadow sector; closed-economy with same shadow sector; open-economy with shadow output size 1/3 of baseline. - Deterministic simulations carried out by Dynare 4.4.3. - Reform experiments: 10 percent permanent and unexpected reductions in formal (i) hiring cost, (ii) bargaining power of workers, and (iii) entry cost. - Priors and Bayesian estimation notes: priors of consumption habit and interest rate smoothing maximized to 0.9; prior of interest rate premium maximized to 0.005; priors for autocorrelations and shock standard deviations maximized to 0.9. - Estimation exercise: - Model estimated on South African data using Bayesian estimation techniques. - Structural parameters estimated include: interest rate smoothing, inflation and output weights in Taylor rule, formal and informal Rotemberg price rigidity costs, interest rate premium, investment adjustment cost and consumption habit. ### Key results and comparative findings (as presented) - Long-run effects (summary statements presented in the text): - Both labor and product market reforms imply a significantly positive impact on South African output in the long run. - Labor market reforms are somewhat more successful than product market reforms at reducing unemployment. - Structural reforms reduce informality by increasing employment in the formal sector, but have little impact on the absolute level of employment in the informal sector. - Short-run costs in the transition include declines in consumption, exports or output, reductions in wages, or lower competition. - Combining reforms, especially with product market deregulation, can reduce short-term costs. - Regarding speed of adjustment, it is usually better to start with a labor market reform. - Sensitivity to openness and shadow economy: - Long-run macroeconomic impacts in open- and closed-economy versions are quite similar, with exceptions in labor market reactions to bargaining power reforms. - The shadow economy crucially influences reactions, especially for labor market policies; product market deregulation responses are also affected. - Representative numeric findings (as reported verbatim): - Reform experiments consider permanent and unexpected 10 percent reforms and long-run (25-year) effects. - Low informality scenarios set the size of shadow economy in output to 1/3 of the baseline value. - Example reported magnitudes in text: "GDP goes up by 1 or 1.8 per cent in the long-run, if hiring costs or bargaining power of workers in the formal sector are lowered, respectively;" (sentence in source continues beyond excerpt). *Italic: Source: wp17125 - References (IMF working paper content unit).* ### 2.8 per cent if the size of the shadow economy is 1/3 of the original level. As regards unem- ### wp17125 - 2.8 per cent if the size of the shadow economy is 1/3 of the original level. As regards unem- ### Impact of informality on macroeconomic responses to structural reforms - Presence of informality materially alters both the sign and magnitude of macroeconomic responses to structural reforms. - Example quantitative effects: - A 10 per cent reduction in hiring costs implies a 1.7 pp drop in the rate of unemployment with low informality, while in the baseline scenario unemployment only goes down by 1.2 pp. - A bargaining power policy induces 3.3 and 2.4 pp decreases in unemployment (low informality and baseline/high informality respectively). - A bargaining power policy induces a 3.2 pp drop in formal employment with low informality, but only a 2 pp drop with high informality. - Mechanism: The lower the size of the shadow economy, the larger the share of the economy directly affected by structural reforms; this effect outweighs other channels in the model. Models that do not (or do not fully) incorporate the underground sector behave as if some part of the macroeconomy were formal when it is informal, exaggerating macroeconomic impacts. ### Short-run dynamics and impulse responses - Impulse responses with low informality are about 0.5-1 pp higher (Figures A1 and A2 in the Appendix). - Labor market reforms: - Do not raise informal employment. - Informal wages go up instead of down if the bargaining power of workers is lowered. - Inflation increases more with low informality. - Product market deregulation: - In the baseline scenario, GDP increases immediately after the shock. - With low informality, GDP decreases during the first couple of quarters — indicating a severe transition cost toward the post-reform equilibrium because investment declines while unemployment drops more than before. - Aggregate conclusion: informality is crucial for both the sign and magnitude of macroeconomic responses, including transitional dynamics. ### Calibration and Bayesian estimation overview - Quarterly data on South Africa are used; South Africa is treated as a small open-economy example where the underground economy plays a stronger role than in developed countries. - Main calibration objective: match data on unemployment and the size of the shadow economy as accurately as possible. - Model performance in steady state: - The model matches the size of the shadow economy in GDP well. - Shadow employment share in total employment is closest to Cassim et al. (2016). - Unemployment is slightly underestimated by the model. - Investment-to-GDP ratio in the model is slightly higher than in the data. - Note: Investment only slightly changes both in the baseline and the alternative scenarios. ### South Africa data points and calibration targets (as used in the model) - Labor market and informality: - Unemployment (Labor Force Survey): hovered around 28.7 percent over the last two decades. - Share of informal employment in labor force: - University of Stellenbosch: 15.8 percent. - Cassim et al. (2016): 34.6 percent. - Schneider et al. (2010) finds size of the shadow economy in GDP: 27.3 percent. - Sectoral firing probabilities (own estimates using LFS and SSA data): - Formal sector firing probability: 14.5 percent. - Informal sector firing probability: 84.8 percent. - Hiring and firing costs: - Since 2006 redundancy costs were 21.9 weeks of salary on average → ratio of firing costs to quarterly wages = 1.7. - Hiring costs assumed to be similar magnitude to firing costs; this ratio is used to calibrate hiring costs relative to formal-sector wages. - Informal-sector hiring costs assumed to be half as much (fraction of hiring costs to wages) as in the formal sector. - Bargaining power (assumptions to match labor market characteristics): - Literature usual range: between 0.3 and 0.5 (Mortensen and Nagypal 2007). - Calibrated values: formal bargaining power of workers = 0.6; informal bargaining power = 0.4. - Sectoral bankruptcy rates (based on Companies and Intellectual Property Commission and SSA 2006/2010/2014 data): - Formal sector bankruptcy rate: 10.9 percent. - Informal sector bankruptcy rate: 17.3 percent. - Entry costs: - Proxy from Cacciatore and Fiori (2016): entry cost of new companies = 2.1 months of yearly output (used to calibrate steady-state level of formal entry costs). - Informal entry cost-output ratio assumed equal to half of the formal sector’s value. - Consumption and substitution parameters: - Formality bias (share of formal goods in household and government consumption): normalized to 50 percent. - Elasticity of substitution between formal and informal goods: 1.5 (robustness checked with unit elasticity). - Openness parameters: - Home bias: 0.8 (share of imported goods = 20 percent). - Elasticity of substitution between home- and foreign-produced goods: 0.6. - Export price elasticity: 4.5. - Exchange rate pass-through to import prices: slightly above (value not provided in excerpt). ### Calibration methodology notes - Sectoral firing probabilities estimated using LFS data on the number of job losers and on the number of new entrants among the unemployed, and SSA formal/informal employment data. - In the absence of direct data, several parameters are calibrated using proxy estimates from literature and reasonable assumptions (hiring costs, entry costs, formality bias, elasticities). - Robustness: Technical Appendix shows evidence on the robustness of long-run macroeconomic impacts of structural reforms with respect to calibration assumptions. *Source: wp17125 (excerpt).* ### 0.8 according toKaroro et al.(2008). ### wp17125 - 0.8 according toKaroro et al.(2008). ### Data and estimation - Dynamic structural parameters are Bayesian estimated using Dynare 4.4.3. - Bayesian estimation time span: 2000Q3 to 2012Q2. - Quarterly time series used (data sources in parenthesis): - gross domestic product (International Monetary Fund, IMF) - household consumption expenditure, government consumption expenditure, private investment, exports and imports of goods and services (South African Reserve Bank, SARB) - real exchange rate (SARB) - consumer price index (SSA) - treasury bill rate (IMF) - compensation of employees in the formal sector (SARB) - formal and informal employment (SSA and own estimates) - Priors: consumption habit and interest rate smoothing are maximized to 0.9; prior of interest rate premium is maximized to 0.005. (All priors are maximized to 0.9 for autocorrelations and standard deviations of shocks in Appendix B.) - Notes on data processing: - All national accounts’ time series are expressed in real terms, in 2005 prices and in South African RAND. - All time series are seasonally adjusted and divided by the number of population (if necessary). - All time series are official data, except formal and informal employment, which are estimated by the authors before 2008Q2. ### Long-run (25-year) effects of single reforms - Reform specification: permanent and unexpected 10 percent reductions in the formal sector (hiring cost, bargaining power of workers, or entry cost). - Long-run GDP effects (25 years post-policy implementation): - 10 percent lowering of formal hiring cost → 2.9 percent increase in GDP. - 10 percent reduction in formal bargaining power of workers → 3.3 percent increase in GDP. - 10 percent decrease in formal entry cost → 1.1 percent increase in GDP. - Long-run unemployment effects (percentage-point changes): - Lowering hiring cost → 2.8 pp decline in unemployment. - Lowering bargaining power of workers → 4.6 pp decline in unemployment. - Lowering entry cost → 0.5 pp decline in unemployment. - Mechanisms and sectoral responses: - Labor market reforms imply a decline in long-run formal wages; product market reforms imply a rise in competition and formal wages increase. - Informal wages always go up (but less after a product market reform). - All policies increase both formal and informal employment, with formal employment increasing more; the share of underground employment drops even if its level is largely unaffected. - Decrease in shadow economy size implies a positive response of net exports for all policies considered. ### Short-run (transition) effects of single reforms (first 5 years) - General: all single reforms entail short-term costs in various variables; magnitude and duration differ by policy and sector. - Hiring cost reduction (10 percent): - GDP slightly declines in the first year. - Less inflationary pressure accompanies this policy. - Formal employment rises; unofficial employment also goes up. - Net exports go down in the short run. - Formal wages tend to decrease (firms cut wages because lower hiring costs reduce the need to retain workers). - Reduction in bargaining power of workers (10 percent): - GDP significantly declines during the first year (GDP decreases in the first four quarters). - Unemployment declines immediately and similarly to the hiring cost cut in overall effect. - Shadow employment goes down. - Net exports go up. - Formal wages decrease more significantly. - Number of formal firms initially goes down. - Reduction in entry cost (10 percent): - GDP declines in the first two quarters. - Unemployment immediately starts to go down (less than with a labor market reform). - Formal and informal wages increase. - Short-run net exports fall. - Number of formal firms rises considerably immediately; informal firms first decline then rise. - Speed of adjustment: - Product market reform: output is already close to the post-reform level one year after the shock. - Labor market reform: takes about two to four years to reach similar proximity to post-reform level. - Short-run demand effects: investment and consumption decline or increase less at the beginning; it takes time for new firms to enter the market and for demand to pick up. ### Reform packages (combinations) and short-run mitigation - Combinations explored (all in formal economy): - (i) decrease in hiring cost and bargaining power of workers - (ii) decrease in hiring cost and entry cost - (iii) decrease in bargaining power of workers and entry cost - (iv) decrease in hiring cost, bargaining power of workers, and entry cost (all three) - Key package outcomes: - Hiring cost + bargaining power cut: output does not decrease during the first year compared to the single bargaining power cut; household consumption and investment similarly avoid decline. Net exports, formal wages, and number of formal firms still go down. - Hiring cost + entry cost cut: can avoid a decrease in GDP in the short run. - Bargaining power + entry cost cut: neither household consumption nor net exports fall. - General conclusion: mixing reforms can mitigate short-term costs, especially when one reform targets the goods market (product market deregulation is successful at reducing short-term costs). Joint policies can still be costly depending on combinations and targeted variables. ### Reform sequencing - Importance: sequencing affects the transition path and speed of adjustment (pace from pre-reform to post-reform equilibria). - Findings on sequencing (examples): - Hiring cost first, then reduce bargaining power: - Output goes up faster in the first half of the transition and increases gradually thereafter. - Bargaining power first, then hiring cost: - Formal employment response leads to unemployment falling more quickly and staying at lower levels longer. - Informal employment is lower in the first half of transition and higher later, compared to the opposite sequence. - Net exports: decrease after a hiring cost decrease, increase after a bargaining power decrease. - Drawback of starting with bargaining power reform: formal wages quickly decline and do not recover; inflation pressure is higher. - Bargaining power first, then entry cost: - For both output and unemployment it is better to start with the bargaining power policy: output goes up faster and stays high; unemployment goes down faster and stays low (mainly due to formal employment reaction). - Entry cost must be cut to induce a considerable increase in the number of firms. - Hiring cost first, then entry cost: - More efficient to start with hiring cost: GDP immediately and permanently increases, unemployment decreases accordingly (due to formal and unofficial employment responses). - Net exports fall regardless of sequence, though they decrease less after product market reform. - All three policies mixed: - Starting with labor market reform: output rises faster and remains higher during most of the transition; unemployment falls more quickly and steadily. - Net exports always decrease but recovery is quicker. - Drawback: formal wages decline; product market reform increases competition more. - Overall sequencing conclusion: - Except for formal wages and market competition, it is usually better to start with a labor market reform than with a product market reform, particularly concerning the speed of adjustment. - Political economy constraints and the timing of favorable outcomes that materialize sooner matter for implementation. ### Conclusion and research gaps - Main conclusions: - Incorporating a shadow economy into an open-economy dynamic general equilibrium model matters for the sign and magnitude of macroeconomic effects of labor and product market deregulation. - In the long run both labor and product market reforms considerably increase output; labor market reforms are more successful in decreasing unemployment. - Level of underground employment may not decrease in the long run, but its share in total employment declines. - Several short-term costs are identified (decreases in household consumption, investment, net exports, output, or competition); combining reforms often mitigates these costs. - It is often preferable to start with a labor market reform regarding speed of adjustment and several macroeconomic outcomes (except formal wages and competition). - Calls for further research: - Optimal structural reform packages and sequencing. - How monetary or fiscal policies can support implementation and mitigate short-term costs of reforms. *Source: https://www.imf.org/-/media/files/publications/wp/2017/wp17125.pdf* ### REFERENCES ### REFERENCES ### Informal economy, shadow economy, and informality measurement - Carre, F. - Chen, M. 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