A new report from the IMF “Labor and Product Market Reforms in Advanced Economies : Fiscal Costs, Gains, and Support” looks at concerns about persistently sluggish growth amid high public debt and mounting long-term fiscal pressures in advanced economies.
High on the agenda are a range of reforms designed to strengthen the functioning of product and labor markets. Nevertheless, progress toward these reforms has remained slow because of political opposition and concerns about their distributive and short-term economic effects. Reform adoption may also have been hindered by strained government budgets.
This raises questions about the fiscal costs and gains from reforms. To what extent can reforms help strengthen fiscal positions over the medium term? Can policy packages combining reforms with temporary upfront fiscal support yield a net fiscal gain over the medium term as well as facilitate implementation?
Persistently sluggish growth has led to growing policy emphasis on the need for structural reforms that improve the functioning of labor and product markets in advanced economies. However, reforms have progressed slowly because of political opposition and concerns about their distributive and short-term economic effects. At the same time, the ability to cushion these effects is hindered by high public debt and mounting long-term fiscal pressures. This note provides new empirical analysis, numerical simulations, and case studies to assess the fiscal impact of labor and product market reforms in advanced economies and evaluate the case for complementing reforms with fiscal support. As such, it provides a major addition to recent IMF analysis that examined the output and
employment effects of reforms.
Main findings of the analysis:
- Most labor and product market reforms can strengthen medium-term public finances indirectly by raising output. In some cases, such as lower entry barriers for firms, this indirect fiscal gain can be sizable. In other instances, the gains can be amplified or offset by the direct fiscal impact of the reform. For instance, unemployment benefit reforms improve fiscal outcomes both indirectly and directly through lower spending, but the up-front costs of labor tax cuts and higher spending on active labor market policies are only partly recouped over time as output rises. A budget-neutral implementation of these reforms can yield unambiguous fiscal gains.
- The effects of reforms on fiscal outcomes depend on business cycle conditions. Employment protection reforms strengthen fiscal positions in an expansion, but weaken them in periods of slack due to their short-term output cost. Similarly, the fiscal gains from unemployment benefit reforms are larger under strong cyclical conditions. In contrast, debt-financed labor tax cuts and active labor market policy spending have stronger indirect positive effects on public finances in times of economic slack because of larger fiscal multipliers, which must be weighed against their direct costs.
- Under weak cyclical conditions, a package combining certain labor market reforms—such as easing job protection or reducing the level or duration of unemployment benefits where particularly high—and credible, temporary, and well-designed up-front fiscal stimulus on average can yield a net fiscal gain over the medium term. This is because the stimulus enhances the effect of these reforms on output and thereby on tax revenues. The package is self-financed over the medium term insofar as the increase in tax revenues from the reform exceeds the financing cost of the initial stimulus. The cost of temporary up-front fiscal stimulus may also be fully offset by subsequent gains if it helps reduce political obstacles to major reforms that yield medium-term fiscal gains, for instance by improving their distributive impact. However, country-specific circumstances—such as government funding costs and their response to stimulus, the magnitude and quality of that stimulus, and the strength of reform implementation—affect the extent to which such gains can be reaped.
- Case studies suggest that fiscal incentives have indeed facilitated reforms by alleviating transition and social costs. These incentives comprised permanent reductions in distortive taxes and one-time measures, accompanied by a strong consensus and political commitment to reform. Even so, reforms have occasionally been reversed. Incentives have been provided in the context of either a supportive overall fiscal stance or fiscal consolidation—in which case they were financed by other reforms or harmful cuts in public investment. Policy implications—The case for temporary fiscal stimulus and incentives for labor and product market reforms depends on the type of reform, the initial cyclical position, the credibility of the political commitment to and consensus for comprehensive reforms—including strong ownership—and available fiscal space.
- Countries with fiscal space can use it to provide temporary up-front reform support, especially if there is economic slack. Such support can take the form of targeted budgetary incentives to mitigate adjustment costs, especially for the most vulnerable; recalibration of distortive fiscal
measures; or other spending that raises long-term output—for example, infrastructure spending on high-return projects. A strong commitment to reforms is an essential prerequisite. - In countries that lack fiscal space, the decision to provide up-front fiscal support depends on the credibility of the government’s commitment to strong implementation of comprehensive reforms and sustainable fiscal policies. If these are forthcoming, temporary up-front fiscal support could in theory help mitigate the short-term economic or social costs of some reforms while delivering a medium-term fiscal gain. However, if a country’s commitment to fiscal prudence and reforms lacks credibility because of weak ownership or a track record of reform reversals or weak implementation, fiscal support is not warranted even when cyclical conditions are weak. In such cases, careful prioritization and sequencing of reforms are crucial to maximize output and fiscal gains and ensure that they are widely shared. Lower-cost measures with a beneficial impact on output and public finances, such as product market reforms, should be
implemented first. Labor market reforms should be designed in ways that mitigate possible short-term costs—for example, passing employment protection reform that takes effect over time can immediately boost hiring. Unemployment benefit reforms, labor tax cuts, and active
labor market policies should be implemented in a budget-neutral manner. Fiscal incentives could be considered, but as part of broader growth-friendly fiscal rebalancing. However, offsetting their cost by cutting public investment would be highly counterproductive. - The design and implementation of fiscal rules should encompass the flexibility to incentivize reforms and acknowledge their medium-term fiscal benefits. Such flexibility reduces the risk that support for reforms will be offset by harmful cuts in public investment. To preserve the credibility of the fiscal framework and confidence in efforts to ensure fiscal sustainability, such flexibility should be conditional on a credible political commitment to strong reforms (possibly only after the reforms), as well as on a strong medium-term fiscal plan. Institutions such as politically independent fiscal councils and productivity commissions can be helpful on this front.
