The ‘return to Europe’ has had a dark side for the economies of Central and Eastern Europe: low rates of labour force participation, a spectacular rise in unemployment and an increasingly unbearable social security burden. A new Report explores some solutions.

Over the past few years, the economies of Central and Eastern Europe have gone through a radical transformation from state socialism to various forms of market capitalism. During this time, employment rates plummeted from dubious ‘full employment’ levels to rates comparable to or even lower than those in the OECD and wealthier developing economies. This labour market transformation led to a high and persistent rate of unemployment, suggesting that individuals are still seeking work despite a dramatic deterioration in their chances of finding it.

A sustainable economic recovery in these countries, as well as their successful integration into the European Union will very much depend on their capacity to mobilize unused labour supply. Yet to date, policy has had the opposite effect: as a result of measures encouraging labour supply reductions, the actual retirement age has fallen significantly below the statutory retirement age, itself low by Western standards.

Low labour force participation is placing an unbearable social security burden on the active population. Systemic dependency ratios are significantly above those in the OECD despite the more favourable demographic conditions. Full integration with Western Europe, with the consequent adoption of standards for social security provisions, will further increase the fiscal burden on the active population unless the ratio of employment to population, and hence the tax base for social policies, are increased.

A new Report by the Economic Policy Initiative (EPI), a joint venture by CEPR, the Institute for EastWest Studies and six local partner institutes in the Associated Countries, analyses unemployment in the region, the unsustainable social security burden arising from low participation, and policies for alleviating the problem. The Report proposes a number of ways to enhance labour supply:

Income support for the unemployed: The short duration of unemployment benefits (compared with the currently long duration of unemployment) has pushed many individuals onto social assistance (generally based on means tests), which has negative effects on work incentives. The resulting poverty trap may worsen as time goes on, since to date, high inflation and partial indexation of benefits have provided countervailing incentives to work. Unemployment traps are especially likely to arise in two-earner families where both individuals are unemployed and face very high effective marginal tax rates. The solution is better integration of unemployment benefits and social assistance provisions, as well as enforcement of work tests throughout the period of benefit receipt.

Active labour market policies: While not a panacea, active labour market policies serve important flanking functions and should be maintained and developed. They force the unemployed to reveal their willingness to work and tend to motivate them to search the labour market more vigorously. The public employment services established in all of these countries have, for example, an important brokerage function: they help to monitor workers and provide an efficient flow of job information to individuals with limited access to credit or other economic means.

Taxes, regulations and the underground economy: Rather than letting extra-budgetary funds run surpluses and thereby relieving fiscal pressure elsewhere, policy-makers should strive to reduce the state’s contribution to labour costs wherever possible. Not only are fiscal traps important, but high tax rates on labour encourage the spread of the underground economy. One solution is the direct translation of economies in social policy spending (for example, those associated with future declines in unemployment) into reductions in statutory contribution rates.

Severance benefits and other firing costs: Non-negotiated restrictions on job and labour turnover, widespread elsewhere in Europe, should be abolished or reduced. They seem particularly inappropriate during transition, when a high value is placed on fostering new matches between firms and workers that bring together capital, talent and ideas. Employment security costs tend to have significant fixed costs. Small firms especially should be exempt from some of these regulations, for example, those creating procedural obstacles to layoffs.

Education policy: Increased spending on general secondary education is essential. Education is an excellent example of a public good with large externalities. It is also an investment with high returns that is often difficult to finance. Enrolment rates in secondary education in these countries, notably general secondary education, are low – despite a widespread view to the contrary – as previous regimes over-invested in narrowly-based (and dead-end) curricula, such as those offered under vocational training.

Investment in infrastructure: By improving the transport network and hence encouraging commuting, governments could contribute significantly to enhanced regional labour mobility. Given the small size of most of these countries, significant labour mobility in response to regional mismatch in the allocation of posts and jobseekers can be achieved without requiring changes in residence.