This chapter provides an overview of the economic, legal and administrative barriers that affect the ability and willingness of Peruvian employers to hire youth. The key challenges it identifies include high labour costs, overly strict employment protection legislation for both permanent and temporary contracts, as well as burdensome administrative procedures to starting a business. The chapter also develops a set of policy recommendations to help remove each of these barriers, while paying attention to the political economy of these reforms.
Investing in Youth: Peru
Investing in Youth
Chapter 2. Removing demand-side barriers to youth employment in Peru
Abstract
2.1. Introduction
Improving youth inclusion in the Peruvian labour market depends crucially on job creation in the formal sector for young people. This will require the support of an economic setting favourable to job creation, underpinned by appropriate macroeconomic policies, and the removal of a range of structural weaknesses that prevent economic growth from being sustainable and inclusive. As part of this comprehensive policy framework, an important role is played by those actions aimed at tackling demand-side barriers to youth employment, i.e. the economic, legal and administrative weaknesses that affect the ability and willingness of employers to hire youth. This chapter provides an overview of these constraints, by focusing on the cost of hiring at the minimum wage level (including both wage and non-wage costs), the strictness of employment protection legislation, and the administrative burdens involved in starting a business.
The chapter points to the following demand-side barriers to youth employment in Peru:
The tax wedge acts as an important drain to the expansion of youth employment. The analysis portrays a complex picture of tax schemes that, if not properly addressed, may alter economic activity and employment creation in several unintended ways. Particularly, binding size-based thresholds for the payment of social security contributions deter the expansion of small enterprises, reflecting the incentives to remain small. This takes place in a context where other non-wage labour costs (paid annual leave, profit sharing and family allowance) also weigh heavily on medium-sized and large companies. Youth job seekers lose the most from an unfriendly regulatory framework that restrains the opportunities for sectoral diversification of productive activities.
The net minimum wage relative to the net median wage is considerably higher in Peru than in the mean OECD country. This suggests that the level of the minimum wage, while attractive to Peruvian young job seekers, may concomitantly act as a disincentive for employers to hire youth formally.
The dualism of the labour market is a particular challenge for youth workers. The transition from less productive jobs to more productive and better quality jobs, capable of offering career prospects, including the access to permanent contracts, can be difficult for youth workers.
The administrative procedures to starting a business are burdensome. Despite recent improvements, lengthy and costly procedures, associated with burdensome administrative requirements, hamper firms’ creation in Peru. This has a detrimental effect on youth employment since newly created firms have a greater propensity to hire young workers.
The chapter develops a set of policy recommendations to help remove each of these barriers (see Box 2.1), while paying attention to the political economy of these reforms. In particular, it builds on the lessons from the repeal in 2015 of the Special Youth Labour Scheme, widely known as Ley Pulpín, , which underscores the key importance to engage an open social dialogue with all concerned stakeholders when developing and implementing new youth policies. Although addressing informality is not a specific objective of the Chapter, some of the insights developed could complement the reflections currently promoted by the MTPE aimed to the design of a new action plan for labour formalisation.
Box 2.1. Policy recommendations
Demand-side barriers to youth employment relate to economic, legal and administrative constraints that affect the ability and willingness of employers to hire young people. The OECD suggests to:
Contain the cost of hiring young workers
In line with the key findings of the recent report by the OECD on the Taxation of SMEs in OECD and G20 countries, ensure that incentives to the firm sector do not alter economic activity in unintended ways, particularly by exacerbating the effects of strong sized-based thresholds. These thresholds encourage the small and medium sized enterprises to remain small, hindering the expansion of youth employment.
While the real value of the minimum wage should not be allowed to erode in years to come, the prevailing long-term stance that prioritises avoiding important (real) increases should be maintained.
Future policies should ensure that the minimum wage remains attractive to Peruvian youth job seekers, but also that the minimum wage is set in a way that does not create a disincentive for employers to hire workers formally. Mechanisms that link minimum wages with productivity or price levels can help reduce such disincentives. A related action would be to allow for a differentiated minimum wage across different regions in Peru so that they are more closely linked to actual levels of worker productivity and/or price levels in the region.
Tackle labour market duality
Alleviate the protection provided by permanent contracts. For collective dismissals grounded on economic, technological and structural reasons, today’s cumbersome compliance procedures preventing the recourse to these dismissals could leave the way to a simpler notification requirement. For individual dismissals, a number of outstanding legal barriers that prevent employers from the possibility to plea for a justified dismissal could be relaxed. The recognition of adverse economic circumstances among the reasons justifying a dismissal is a primary candidate.
Regarding temporary contracts, Peru could benefit from a reduction of the administrative barriers that discourage the creation of temporary work agencies. There also seems to remain scope for expanding the circumstances under which Peruvian firms can use temporary contracts for permanent tasks related to the core activities of the firm. At the same time, the maximum cumulated duration should be fixed by regulation as a way of preventing young workers from being trapped in precarious jobs, but also ensuring that the employers can screen youth workers for future permanent hiring.
Policies need to consider the development of a comprehensive strategy to reduce the strong duality of the Peruvian labour market between permanent and temporary contracts. The objective of such reforms should be to reduce incentives for employers to hire people on temporary contracts when not justified by the temporary nature of the tasks.
At the same time, the policies to reduce the strong duality of the Peruvian labour market for young workers would require the support of the actions to reinforce the social protection system. This requires reforming the current unemployment benefits system in Peru to meet the following two prerequisites: (i) providing income protection to all workers in the formal sector, including those whose work experience is insufficient to cover them; and (ii) making such a protection contingent upon the active search for a job and/or a serious engagement in employment programmes.
Abolish administrative barriers to firm creation
Replace the presently highly fragmented system of notaries and municipalities for the registration of businesses with a national government agency. By reducing fragmentation and limiting risks of arbitrariness, this would strengthen the level playing field, while at the same time reducing the length and the cost of procedures.
Create an online one-stop shop for firm registration.
Ensure that reform decisions are embedded into a strong framework for social dialogue
Together with the rigor and quality of ex-ante evaluation analysis, social dialogue is essential to create a consensus for reform and to the effective implementation of policy decisions once agreed upon. The example of the Ley Pulpín points to the need for ensuring a strong social dialogue framework that supports the identification of reform needs while at the same time ensuring protection.
2.2. Complex firm regulations discourage formal youth employment
Peru’s labour taxation is not high compared with the OECD average. For an average worker in Peru, the tax wedge - the difference between the total labour cost and the workers take home pay, measured as a percentage of the total labour cost - is 23.4%, compared to 35.9% for the OECD average (Figure 2.1). This gap reflects the extent of the personal income tax in the OECD; in Peru low income workers - including at the minimum wage - are exempt from the personal income tax (see Box 2.2). For the average worker, the combined social insurance contribution, levied on the employee and the employer, is 23.4% in Peru, a level slightly above the OECD average (22.5%). However, measured at the level of the minimum wage the difference is wider, with the two rates being 23.4% and 20.5%, in Peru and the OECD average, respectively. Within this setting, one source of unbalances that stands out in Peru is the very strong segmentation of the private firm sector into different categories of enterprises, each subject to a specific labour cost scheme.
Figure 2.1. Decomposition of the tax wedge, Peru and OECD average, 2016
Note: Data refer to single individuals without children, within the age range 15-64 and working as dependent workers in formal sector. It is expressed as a percentage of the total labour cost. Labour costs are defined as the sum of gross earnings, social security contributions and payroll taxes, where applicable. Low income refers to 67% of the average wages; average-income refers to 100% of average wages; high-income refers to 167% of average wages. For Peru, the obligatory universal contributions paid by the employer comprise Health Insurance and the employer’s contribution to the unemployment benefit system (Compensación por Tiempo de Servicio, CTS, compensation for length of service). Those paid by the employee are contributions to the pension system. The contributions taken into account in the analysis refer to the General Regime.
Source: OECD calculations based on Ministerio de Trabajo y Promoción del Empleo, MTPE (2016) and ENAHO survey for 2016.
2.2.1. Youth lose most from size-contingent employers’ social security contributions
Special rules for promoting the creation of micro and small enterprises were introduced by Peru in 2003. These include a combination between tax incentives and reduced labour obligations for such firms (Act No. 28015 on the Promotion and Formalization of Micro- and Small Enterprises of 2003). There exist three categories of private enterprises in Peru today, each subject to a distinct labour cost scheme (Weller, 2009; ILO, 2014; and Ministerio de Trabajo y Promoción del Empleo, MTPE, 2016):
Micro-enterprises: up to ten workers and maximum sales of 150 Tax Levy Units (TLUs)1;
Small enterprises: up to 100 workers and maximum sales of 1 700 TLUs; and
Other enterprises: i.e. medium-sized and large enterprises, which fall into the “general” labour scheme (Legislative Decree No. 1086 of 2008).
A detailed discussion of the different components of the tax wedge in Peru is provided in Box 2.3.
Figure 2.2 decomposes the tax wedge at the minimum wage for Peru’s three legal labour cost schemes. It portrays a complex picture of tax schemes which, if not properly addressed, may alter economic activity and employment in several unintended ways. Namely, from 14.7% for micro-enterprises the social insurance contributions rise sharply for the small enterprises (21.6%) and the larger firms to (23.4%). This reflects a spike in the employers’ social security contributions, from 2% for micro-enterprises to close to 11% and 14% for small enterprises and medium-sized and large companies, respectively. Another salient feature of differentiation between Peruvian firms is the comparatively high level of social security contributions paid by the employees in micro enterprises. At 12.7% this level is 2 and 3 percentage points higher than for small enterprises and medium-sized and large companies, respectively.
Figure 2.2. Decomposition of the tax wedge at the minimum wage level for different categories of enterprises
Note: OECD is an unweighted average of 27 countries legislating the statutory Minimum Wages.
Source: Data for the OECD come from Taxing Wages 2017, data for Peru are OECD calculations based on information provided in Policy Questionnaire by MTPE and ENAHO 2016.
Evidence analysis shows that binding labour cost regulations, contingent upon the size of the enterprises, may engender strong asymmetries in the distribution of firms (Garicano, Lelarge and Van Reenen, 2016).2 Many highly productive firms that would have been larger without the regulation will likely refrain from expanding, to avoid the higher labour costs incurred by the change of the legal threshold. When they decide to expand, they often do so by splitting into small units, at the cost of considerable efficiency losses. Recent work on Peru by Dabla-Norris, Jaramillo Mayor, Lima and Sollaci (2018) find that size-dependent policies may even led to increase labour informality, since some firms ultimately prefer to hire informal workers to avoid the regulation. The result can manifest in substantial productivity and employment gaps with firms producing too little output, using too few employees (Restuccia and Rogerson, 2008; Bartelsman, Haltiwanger and Scarpetta, 2013). In France, for example, a country where the cost of labour increases significantly when firms reach 50 workers, aggregate output losses are estimated to represent 3.4% of GDP. Hsieh and Klenow (2009) argue that such misallocations account for a significant proportion of the difference in aggregate productivity between the United States, China, and India.
Youth job seekers are likely to lose the most from these adverse dynamics. Evidence from a wide range of countries at different levels of per capita incomes (including Peru) shows that rates of job creation are higher amongst small young firms, provided that they are allowed to grow3 (Haltiwanger, Jarmin, and Miranda, 2013; Ayyagari, Demirguc-Kunt and Maksimovic, 2014). Three are the main reasons explaining why small young firms are particularly likely to hire young workers (Ouimet and Zarutskie, 2014):
Young job seekers typically have just attained education and therefore can be expected to carry the most up-to-date technical skills at a relatively low cost. Therefore, they might be particularly attractive to young firms aiming to develop new products and/or methods of production;
Youth are known to be less risk averse and therefore more willing to bear the risk of working for a young firm whose survival is more uncertain;
Finally, assortative mating implies that young workers are more attractive to young firms and vice-versa.
Box 2.2. Components of the tax wedge in Peru
The tax wedge is the sum of (i) employees’ social security contributions, (ii) the income tax paid by the employee, and (iii) employers’ social security contribution, expressed as a percentage of labour costs. Social security contributions typically refer to compulsory payments, either by the employees or by the employers that confer entitlement to the employees to receive a future social benefit. These contributory schemes (whereby the benefits accrued by each recipient depend on a minimum years of contributions) typically include old-age protection, health and unemployment. They contrast to non-contributory social protection programs that are granted to all or to specific beneficiaries, regardless of their contributions’ history. In Peru for instance, Pension 65 is a non-contributory means-tested pension for Peruvians over 65 identified as being in extreme poverty. Similarly, the Seguro Integral de Salud (SIS) is a non-contributory means-tested health coverage for deprived individuals and their families (OECD, 2016a).
Social security contributions
Unlike the level of the minimum wage, which is unique, social security contributions depend upon the category of enterprises in which employees are hired. They are set at particularly low levels for employers in micro-enterprises in order to encourage firm and job creation in the formal sector (see the Act on the Promotion and Formalization of Micro- and Small Enterprises of 2003).
Employees
Employees contribute to public or private pension schemes. This contribution is compulsory and accounts for 13% of the gross wage in all types of enterprises (micro-, small, medium-sized and large enterprises). The legislation for micro-enterprises aims to reduce employees’ social security contributions in these enterprises to 4%, which the State would match with equal contributions into personal accounts. This system has not yet been implemented (OECD (2016a).
Employers
Employers contribute to:
health insurance (EsSalud)
unemployment benefits.
The latter was introduced in 1991, to relax the overly strict severance pay system and, hence, switch from job to worker protection. More precisely, in exchange of abolishing severance pay for justified dismissals, Peru established a system of unemployment insurance savings accounts (UISAs), as did many other Latin American countries. The UISAs are mandatory savings schemes in which employers contribute on a regular basis a fraction of the employees’ wage towards special individual bank accounts for which employees are typically responsible. These accounts aim to provide employees in the formal sector with unemployment benefits in case of a dismissal (or retirement). Specifically, employers’ contributions to unemployment benefits in Peru is called the Compensation for Length of Service (Compensación por Tiempo de Servicio, CTS) and was established by Legislative Decree No. 650. The CTS is a legal payment to workers for their time spent working for a company. The CTS is deposited to a bank chosen by the employee each semester and amounts to one monthly average salary per year of service (Ferrer and Riddell, 2012 and Vodopivec, 2013).
The employers’ contributions to health and unemployment benefits are strongly contingent upon firm’s size (Table 2.1).
Table 2.1. Employers’ social security contributions, 2016
Percentage of the gross wage
Note: MTPE (2016).
It is important to note that small enterprises and firms under the general regime are also submitted, under certain conditions, to the following employers’ social security contributions:
Life insurance (between 0.53% and 1.46% of the gross wage, applicable starting from the fourth year of service of the employee).
Dangerous work insurance (1.89% of the gross wage, applicable to hazardous activities).
The National Apprenticeship and Labour Service (also called SENATI – 0.75% of the gross wage applicable to manufacturing industries with more than 20 workers).
Given that these employers’ social security contributions are conditional, they are not considered in order to generate Figure 2.1 to Figure 2.4.
The income tax paid by the employees
Personal income taxes in Peru are progressive, with a maximum marginal tax rate of 30% for annual incomes above PEN 205 400 (USD 60 951 or EUR 54 855). Annual incomes below PEN 27 650 (USD 8 205 or EUR 7 384) are exempted, which implies that individuals paid at the minimum wage level do not pay taxes.
The above segmentation appears exacerbated by the regulations concerning paid annual leave, profit sharing and family allowances, which also vary significantly across categories of enterprises in Peru. They are considerably more stringent for medium-sized and large firms in the general regime than for small firms. Paid annual leave due corresponds to 30 calendar days in medium-sized and large companies, compared to 15 calendar days in small and micro-enterprises. Furthermore, firms under the general regime that are involved in trade, mining and industry must transfer a share of their annual revenues before tax to their employees. Firms with less than 21 employers are exempt from such a profit sharing mechanism, with the overall share of profits to be distributed varying by industry (Dabla-Norris, Jaramillo Mayor, Lima and Sollaci, 2018).4 Finally, employees working in medium-sized and large companies are entitled to a monthly family allowance equal to 10 per cent of the gross minimum wage (approximately PEN 85; USD 25 or EUR 22) if they have dependent children under 18 or children below 24 receiving higher education.5
2.2.2. Policy insights to address size-contingent social security contributions
The question as to whether the current size-based threshold structure should be maintained goes beyond the scope of this report. In fact, addressing it properly would require a thorough examination of the overall system of tax policies and tax arrangements in Peru, assessing the pros and cons of various approaches. The recent OECD study on the Taxation of SMEs in OECD and G20 countries (OECD, 2015) provides insights into the influence of tax systems on SMEs. The report concludes that the heterogeneity of the SME population means that careful targeting is required to ensure that any government interventions, including tax preferences, achieve their stated policy objectives. With the exception of the disproportionately high compliance costs on SMEs, the size of a business alone may not be sufficient justification for government intervention in the form of special rules. Careful targeting of special tax rules can reduce their costs and potential distortions while ensuring that the intended goals are met.
The report acknowledges that there may be a particular case for targeting preferences and simplification measures toward younger SMEs. These could be the SMEs who are most affected by finance and cash flow difficulties, face barriers to entry and growth from incumbent firms, are more likely to grow than older SMEs, face the highest compliance cost burdens and are likely to have higher spillover effects from innovation. In effect, some of these SMEs may play a particularly strong role in supporting the expansion of youth employment. Nonetheless, even within this group, measures should be carefully targeted to address the specific problem (e.g. access to finance, compliance costs) or particular objective (e.g. innovation). Young, small firms are also the riskiest and most likely to go out of business.
Moreover, the OECD report on Taxation of SMEs in OECD and G20 countries underlines that a high degree of caution is needed to ensure that tax preferences or simplification measures do not introduce further distortions. These distortions can result in incentives to alter economic activity in unintended ways to benefit from special tax rules, horizontal inequities in the treatment of different firms or individuals depending on their characteristics. They can also stem from the creation of additional barriers to SME growth owing to the creation of sized-based thresholds, which provide incentives to remain under that threshold, whether artificially or by restraining growth.
An additional policy insight of the report is that, when introducing special tax rules for SMEs, care should be taken to ensure that these measures do not increase complexity. The costs associated with tracking eligibility, keeping specific records and interacting with the tax system for multiple different preferences or simplification measures can increase the complexity of the system. In this regard a simpler general tax system may be more advantageous to SMEs than a series of simplification measures.
Furthermore, the reports points to process simplifications, particularly through targeted use of technology, as offering many advantages in lowering compliance costs by streamlining and reducing the steps required to comply. They can, therefore, be a powerful tool to enhance compliance and reduce its costs.
2.2.3. Lessons from the past: The importance to strengthen social dialogue
Supported by rigorous evidence based analysis, social dialogue is a key pre-requisite to the development and the implementation of policy change. However, social dialogue has been missing during the recent negotiations to reform youth labour market policies in Peru. In December 2014, a Special Youth Labour Scheme (Law No. 30288) was introduced to reduce non-wage labour costs paid by small enterprises and firms under the general regime willing to hire youth workers. The new scheme, expected to stay in vigour for a period of five years, foresaw significant cuts of employers’ social security contributions as a way of supporting the hiring of youth workers aged between 18 and 24 years. Contributions to health insurance would be subsidised by the Peruvian State, while contributions to unemployment benefits, the so-called CTS, would be eliminated. At the same time, the scheme envisaged to abolish existing entitlement of young workers to bonuses and profit sharing. Furthermore, paid annual leave would drop from 30 to 15 calendar days for youth employed under the general regime.
The law was bitterly opposed by Peruvian youth. In particular, the abolishment of the CTS implied that youth workers would be excluded from unemployment savings accounts and, hence, deprived of any social protection following a dismissal (unless the latter be judged as “unfair”). The Special Youth Labour Scheme was dubbed the Ley Pulpín (Pulpín Law), after the name of a brand of fruit juice targeted at children – with the term Pulpín evocating a naïve or immature young person who can be easily mislead. Against rising social pressures, it was almost immediately repealed (as early as January 2015). The example of the Ley Pulpín points to the need for ensuring a strong social dialogue framework that supports the identification of reform needs while at the same time ensuring protection (OECD, 2017). Together with the rigor and quality of ex-ante evaluation analysis, social dialogue is essential to create a consensus for reform and to the effective implementation of policy decisions once agreed upon.
2.3. Making the minimum wage pay
Being less productive on average than the rest of the working age population, due to their shorter work experience, youth are primary candidates to work at the minimum wage in countries where it is enforced (Cahuc, Carcillo and Zylberberg, 2014). However, the level of this wage floor must be appropriately set. Too low a minimum wage may result in undesirable low wages for youth workers whose bargaining power is relatively weak and therefore may induce them to prefer an occupation in the informal sector. By contrast, if set too high the minimum wage leaves little room for rewarding youth workers in line with their productivity, and may again lead to more informal work or reduced working hours for some (Neumark and Wascher, 2008).
2.3.1. The framework of prudent changes of the minimum wage should be maintained
According to the 1993 Constitution the minimum wage in Peru is regulated by the state in consultation with the social partners. This principle was reaffirmed by two rulings issued in 2004 (laws 27711 and 28318), which established that the minimum wage is set by the government taking into account a proposal by the National Council for Labour and Employment Promotion (CNTPE), a tripartite body including the government, the business associations and the labour unions.
Since 2007, the CNTPE relies on the support of an expert body, in charge of providing a technical advice on how to adjust the minimum wage. This is done taking into account two criteria: i) inflation trends, which ensures maintaining the purchasing power of workers who earn the minimum wage; and ii) the pattern of average labour productivity, which allows taking into account the broader economic and competitiveness outlook of the country.
There is a single value of the minimum wage in Peru, which applies nationwide and accordingly does not vary between sectors or regions (MTPE, 2016). It is calculated on a monthly basis, assuming a maximum limit of 48 working hours per week. Although the law does not mention the frequency of adjustments, the evidence available suggests that the minimum wage has not been increased “mechanically” throughout the years but rather prudently and in a way broadly in line with labour-market conditions.
During the period between 2007 and 2017, the cumulative increase of the real net minimum wage (i.e., excluding taxes and social security contribution) has approximated 12%, which is smaller than the corresponding increase of the real net median wage (Figure 2.3). It is also significantly smaller than the corresponding increase of real GDP (56.7%). The minimum wage was last increased in March 2018 -- to PEN 930 (EUR 245, or USD 284) per month.
Figure 2.3. Annual real net minimum and median wages of full-time employees in Peru, 2007-17
Note: The annual real median wage is computed for employees in the formal and informal sector who work between 40 and 48 hours a week. Indeed, the official workday in Peru is eight hours a day, with full-time employees working between five and six days a week. Self-employed individuals are excluded from the computation.
Source: Policy Questionnaire by MTPE (2016) and ENAHO 2007-17.
While the real value of the minimum wage should not be allowed to erode in years to come, the current stance that prioritises avoiding important (real) increases should be maintained. This conclusion is supported by the results of recent evidence analysis, which points to the fact that formal employment in Peru, if not strongly affected, tends to respond negatively to changes in the minimum wage (ILO , 2017; Céspedes and Sánchez, 2013; Jaramillo, 2012; Palomino Samaniego, 2011; Del Valle, 2009; Céspedes Reynaga, 2006). These works also conclude that the risk of unemployment following a rise of the minimum wage is higher among youth workers. There is also evidence that the minimum wage is used as a benchmark for the determination of wages in the Peruvian labour market. This reflects the existence of mechanisms of indexation to the minimum wage, both at the firm level and regarding the allocation of family benefits.
2.3.2. Supporting decent minimum wages for youth while keeping costs in check
The international comparison depicts a mixed picture for the level of the minimum wage in Peru. Figure 2.4 (Panel A) shows that regardless to the category of enterprise, the minimum wage in Peru is well below the average of the OECD countries. On average, labour costs at the minimum wage level are between two (general regime) and three times (micro-enterprises) lower in Peru than in the average OECD country. This result is as expected, insofar as it reflects the existence of broad differences in productivity and average wage levels between Peru and the OECD countries.6 While the minimum wage in Peru does not depart significantly from the level observed in Chile, it is much higher than in Mexico.
Figure 2.4. Annual labour costs and minimum wage relative to median wage in Peru and OECD countries
Note: The annual median wage in Peru is computed for employees in the formal and informal sector who work between 40 and 48 hours a week. Indeed, the official workday is eight hours a day, with full-time employees working between five and six days a week. Self-employed individuals are excluded from the computation. The national poverty line in Peru is computed by the National Institute of Statistics and Informatics (Instituto Nacional de Estadísticañ e Informática, INEI) for year 2016. OECD is an unweighted average of 27 OECD countries where minimum wage is enforced. Annual net minimum and median wages are expressed in USD PPP.
Source: Data for the OECD come from Taxing Wages 2017 and the OECD Employment database (estimates as of year 2015) while data for Peru are from Policy Questionnaire by MTPE (2016) as well as ENAHO 2016.
However, the net minimum relative to the net median wage is considerably higher in Peru than in the mean OECD country. It ranges from 60% in micro-enterprises to 66% in small enterprises and 72% in firms under the general regime (Figure 2.4, Panel B). By contrast, this ratio is 55% in the mean OECD economy. No OECD country shows a ratio greater than that which prevails in Peru for firms under the general regime, with the exception of Turkey. Accordingly, the ratio is high also in comparison to Mexico and Chile.
Future policies should ensure that the minimum wage remains attractive to Peruvian youth job seekers but also that the minimum wage is set in a way that does not create a disincentive for employers to hire workers formally. Mechanisms that link minimum wages with productivity or price levels can help reduce such disincentives. A related action would be to allow for a differentiated minimum wage across different regions in Peru so that they are more closely linked to actual levels of worker productivity and/or price levels in the region.
One policy approach used by many OECD countries and other Latin American countries (Table 2.2) consists in the introduction of a legal subminimum wage for young people. This scheme could allow for progressive increases of the minimum wage up to or above the standard minimum wage, as is the case for instance in Australia and the Netherlands. By avoiding large jumps in labour costs from one level to the next, the advantage of this approach is twofold: i) to limit risks of job separation around the point of eligibility to the standard minimum wage; and ii) to help youth workers remain on a path of gradual career progression.
Table 2.2. Sub-minimum wages for young people in OECD and selected Latin American countries
Source: Kristensen and Cunningham (2006), Marinakis (2007), OECD (2015a) and the Wage Indicator Foundation (https://wageindicator.org/main/Wageindicatorfoundation).
2.4. Tackling labour market dualism
Employment protection legislation (EPL) refers to the procedures and costs involved in dismissing workers on permanent contracts and hiring them on temporary ones. It aims to protect employees against unfair dismissals and earnings reductions at the time of job loss, and to shield them from precarious jobs (e.g. the overuse of temporary contracts). While protecting workers in the context of poor job quality is a high priority in Peru, an excessively strict or poorly designed EPL can hamper the economy by discouraging the flow of workers from less productive jobs to more productive and better quality jobs. Job creation can be reduced as a result, with youth workers being particularly exposed to this risk, and productivity growth can also be affected. In addition, the duality of the labour market can be accentuated. EPL should therefore be used judiciously and effectively in combination with other measures that protect workers themselves, rather than specific jobs. Unlike the framework for non-wage labour costs, EPL essentially applies uniformly across firms of different size in Peru. Therefore, it also covers the micro- and small enterprises on top of the larger firms under the general regime.
Figure 2.5 (Panel A) shows how Peru compares internationally regarding the protection of workers on permanent contracts, distinguishing between individual and collective dismissals. Peru scores around the OECD average on this indicator, although its regulation is stricter than the average of the LAC countries shown in the figure. This mainly reflects the regulation on collective dismissals, which is stricter in Peru, both compared to the average of the OECD countries and that of the LAC countries.
The provision on collective dismissals grounded on economic, technological and structural reasons applies when it involves at least 10% of a firm’s employees in Peru. One main reasons explaining the strictness of this regulation relates to the fact that starting from this threshold the fulfilment of complex compliance procedures, involving employers, trade unions, or workers’ representatives, and the Labour Administrative Authority, is required in order to launch a collective dismissal. The regulation applies across all firms, irrespective of their size, thus including small firms, which are the large majority in Peru. In many OECD countries, employers who proceed to collective dismissals are subject to only a notification requirement.
Concerning individual dismissals, the level of compensation following unfair dismissal is fairly in line with the standards of the OECD and LAC benchmark countries in Peru -- 1.5 monthly salaries per each full year of service up to a maximum of 12 monthly wages, on top of wage arrears and social security contributions in firms under the general regime. However, one particularly constraining regulation from the perspective of the employers relates to the limited chances to have dismissal decisions recognized as “justified” -- ranging from the proof of misconduct or incapacity, to adverse economic circumstances -- if the dismissed worker brings the case to court. Whenever the court rules the dismissal as “unfair”, the reinstatement is nearly automatic and prevails over the options of compensation, which discourages hiring formally in the first place.7 Reinstatement is less typical in many OECD countries, and even rarer in Latin American benchmark countries.
Panel B of Figure 2.5 places Peru in the international comparison with regards to the legal constraints of initiating a temporary form of employment. It is important to highlight that the Peruvian law involves more than 10 types of temporary contracts today and allows the recourse to temporary contracts for some permanent tasks related to the core activities of the firm. At the same time, Peru’s restrictions on the maximum cumulated duration of successive temporary contracts are broadly in line with the regulation prevailing in the OECD countries. Despite these elements of background, Peru scores above the average of both the OECD countries and the LAC benchmark countries in the overall indicator capturing the legal constraints of initiating a temporary form of employment. This essentially reflects the fact that the administrative requirements governing the authorisation of a temporary work agency are highly demanding. Once in operation, these agencies have to meet some very strict periodic reporting requirements.
Figure 2.5. Strictness of employment protection in Peru, OECD countries and selected Latin American countries
Note: Panel A presents the synthetic indicator for individual and collective dismissals for workers with a regular contract (EPRC). The height of the bar represents the value of the EPRC indicator. Panel B presents the synthetic indicator for temporary contracts (EPT). Countries are ranked in decreasing order of EPRC (respectively, EPT) indicator in Panel A (respectively, Panel B).
Source: OECD Employment Protection Database. http://www.oecd.org/employment/oecdindicatorsofemploymentprotection.htm.
2.4.1. Policy options to reduce labour market dualism
The high protection of Peruvian workers on permanent contracts can discourage employers from hiring youth on this type of contracts for fear of not being able to adjust to employees’ misconduct or incapacity, or changes in demand and technology. This implies that employers would rely on temporary contracts as “dead ends”, rather than stepping stones during the transition to a permanent job, which is especially desirable in the case of youth workers. The function of these contracts as on the “job training” and “screening tool” of young job seekers, would be reduced and the duality of the labour market would increase as a result. Box 2.3 provides a review of the empirical evidence about the links between employment protection legislation and the duality of the labour market.
Box 2.3. Employment protection legislation and labour market duality
According to theoretical arguments, if the use of fixed-term contracts is liberalised while maintaining strict employment protection regulations for open-ended contracts, firms will adjust by substituting temporary for regular workers. There will be no long-run effect on employment, due to the smaller cost involved with the termination of the employment relationship at the end of a fixed-term contract (see e.g. Boeri and Garibaldi, 2007; Bentolila et al., 2008). In addition, a large asymmetry between the employment protection provisions (and, sometimes, tax wedge) applying to the two types of contracts will reduce the conversion rate of fixed-term contracts into permanent ones, thereby transforming fixed-term contracts into a trap rather than a stepping stone into more stable employment (Boeri, 2011).
It has also been argued that in a setting where extensive employment protection for workers with open-ended contracts coexists with lighter regulation for fixed-term contracts, wage pressure and therefore unemployment may increase (Bentolila and Dolado, 1994). The argument behind is that “insiders” on permanent contracts can raise their wage claims without much risk of losing their jobs as any resulting negative effects on employment will be borne mainly by the “outsiders” who work on fixed-term contracts (often youth and other workers with little work experience or fewer skills). More generally, these observations imply that the effect of employment protection regulations on fixed-term contracts cannot be seen in isolation, but is conditional on the degree of stringency of employment protection for regular contracts. In countries with highly protective regulations for permanent contracts, those under fixed-term contracts (often youths and other disadvantaged groups) will bear the main burden of employment adjustment (Saint Paul, 1996). Overall, this literature suggests that a large wedge between regulations for temporary and permanent contracts is likely to contribute to the emergence of a persistent divide across workers holding different types of contract in terms of both current working conditions and future prospects. This situation is often referred to as contractual segmentation or duality.
There is a vast empirical literature showing that the incidence of temporary contracts tends to be increased by the rigidity of regulations concerning dismissal for permanent contracts and reduced by legislation limiting hiring on, and renewal of, temporary contracts. For example, Lepage-Saucier et al. (2013) analysed hiring patterns in a cross-country regression setting and found that changes in OECD indicators for dismissal of permanent contracts and hiring of temporary contracts have opposite patterns of association with the share of temporary contracts in new hires. Kahn (2010) uses longitudinal microdata for nine European countries and finds that recent policy reforms making it easier to create fixed-term jobs raised the probability that a worker will be on a fixed-term contract. However, he finds no evidence that such reforms increased employment: instead they appear to have encouraged substitution of temporary for permanent work. In a similar vein, several studies focus on major Spanish reforms in the early 1980s that liberalised fixed-term contracts without changing dismissal costs for regular contracts and find, in general, that this led to a very large increase of fixed-term contracts and a reduction in employment on permanent contracts (see e.g. Bentolila et al., 2008; Aguirregabiria and Alonso-Borrego, 2009). Evidence from Spain also suggests that, when the regulatory gap between permanent and temporary employment is large, transition rates across these two states are low (e.g. Güell and Petrongolo, 2007), thereby confirming the “duality” theory: outsiders tend to move from one temporary contract to another while insiders enjoy high protection and employment stability. Finally, several papers find that the difference in the cost of adjusting the stock of workers on different types of contract explains both the share of workers on fixed-term contracts and their relative volatility of temporary jobs (see, for example, Goux et al., 2001). Overall, this evidence suggests that, all else equal, stringent regulation on regular contracts tends to encourage the use of temporary contracts (see e.g. Boeri, 2011; Boeri and Van Ours, 2013; OECD, 2013a). Indeed, rigid dismissal regulations have also been shown to reduce job and worker turnover in general (see OECD, 2010; Bassanini and Garnero, 2013) but increase churning of temporary jobs (see Centeno and Novo, 2012; Hijzen et al., 2013).
Turning to Peru, until the early 2000s the interpretation of the labour contract law was that the dismissed worker should receive a monetary compensation. However, in 2001 the Constitutional Court issued questioned this interpretation and issued a ruling establishing that the worker could request to be reinstated in the previous position. Evaluation of the impact of this ruling by Jaramillo et al. (2017) suggests that the change has contributed to significantly discourage the use of permanent contracts, ultimately leading to strengthen the segmentation of the labour market. The estimated average short term impact of the reform (during the first five years since the change) is a reduction of 50%in the probability to be hired under a permanent contract, while the long-term impact is a fall of 80%. By 2015 approximately 900 000 permanent jobs might have become temporary due to the reform.
Source: OECD (2014) and Jaramillo et al. (2017).
Figure 2.6 shows the proportion of full-time workers in the formal sector who are employed with a permanent contract (rather than a temporary one) in OECD countries and Peru. On average, workers under a permanent contract constitute a majority in the OECD countries, but a minority in Peru. Moreover, with strict EPL requirements on permanent contracts being particularly harmful to youth access to stable jobs, the probability for young people (15-24) in Peru to work under a permanent contract is half than that of the working age population (21% vs 42%). By contrast, it is only one third lower in the mean OECD country (62% vs 87%).
Tackling the strictness of the EPL on permanent contracts can therefore be an important lever to reduce the large proportion of Peruvian young workers who are either trapped in precarious jobs in the formal sector or entirely excluded due to high informality. For collective dismissals grounded on economic, technological and structural reasons, today’s cumbersome compliance procedures preventing the recourse to these dismissals could leave the way to a simpler notification requirement. For individual dismissals, a number of outstanding legal barriers that prevent employers from the possibility to plea for a justified dismissal could be relaxed. The recognition of adverse economic circumstances among the reasons justifying a dismissal is a primary candidate. Moreover, the high penalty following an unfair dismissal could be reduced with a view to aligning it more closely to the standards prevailing in OECD countries. Recent reforms undertaken by a number of OECD countries go in this direction (Estonia, Spain Slovenia and Italy). Regarding temporary contracts, Peru could benefit from a reduction of the administrative barriers that discourage the creation of temporary work agencies. There also seems to remain scope for expanding the circumstances under which Peruvian firms can use temporary contracts for permanent tasks related to the core activities of the firm. At the same time, the maximum cumulated duration should be fixed by regulation as a way of preventing young workers from being trapped in precarious jobs, but also ensuring that the employers can screen youth workers for future permanent hiring.
Figure 2.6. Incidence and composition of permanent employment, Peru and OECD countries in 2015
Note: Permanent employees are wage and salary workers under contracts without a clear end date. The figures for Peru include individuals working under a verbal contract since in Peru verbal contracts are as valid as written contracts. The OECD figure is calculated as an unweighted average.
Source: OECD Employment database and ENAHO 2016.
In setting up policies to address EPL challenges, policy makers typically face some key trade-offs. In particular, the effect of relaxing employment protection on permanent contracts may not be the creation of more and better quality jobs for youth, if temporary contracts are eased at the same time. Indeed, the overall effect could be that, as a way of benefiting the smaller cost of terminating an employment relationship at the end of a fixed-term contract, firms will adjust by substituting temporary for permanent workers. To counter the risk of this offsetting effect, several OECD countries have introduced measures recently to harmonise the regulation of temporary and permanent contracts. The objective of such reforms should be to reduce incentives for employers to hire people on temporary contracts when not justified by the temporary nature of the tasks.
Several OECD countries have introduced measures recently to harmonise the regulation of temporary and permanent contracts. One policy option to achieve this would be through merging the two employment contracts into one single open-ended contract. However, firms not only make recourse to temporary contracts as an on-the-job training or screening device, possibly leading to a permanent hiring. They also rely on temporary contracts to respond to fluctuations in activity, or for filling their truly temporary job openings. Therefore, removing temporary contracts altogether may not be a realistic solution. Moreover, since not all temporary jobs can be expected to be converted into permanent ones it could result in serious employment losses (OECD, 2014).
In order to address these problems, several observers have sueggested implementing a unified contract (OECD, 2014). The idea would be to both maintain all types of contracts and have termination costs increasing with seniority, independently of the type of contract. In addition, in the case of termination, firms would pay a layoff tax to the public authorities, while dismissals would be unfair only in cases of discrimination and prohibited grounds (see e.g. Blanchard and Tirole, 2003; Cahuc, 2012). The layoff tax would yield resources to mutualise the reallocation costs of displaced workers and induce firms to internalise the social cost of dismissals, without any need of reinstating workers, if set at a sufficiently high level (Cahuc and Zylberberg, 2008). The clear advantage of this proposal is that it would leave unchanged the cost of termination of short-term contracts, thereby not making more burdensome their use for tasks that are truly temporary.
However, real situations are complex and actual reform approaches differ, reflecting the specific circumstances of each country. Box 2.4 discusses recent EPL reforms implemented by four European countries during the past decade, Estonia (July 2009), Spain (February 2012), Slovenia (April 2013) and Italy (December 2014). Italy opted for a standard contract, according to which employment protection is set to increase with tenure as a way of taking into account the experience and seniority acquired during a career path.
Box 2.4. Recent EPL reforms in Estonia, Slovenia, Spain and Italy
Estonia. In Estonia, a new Employment Contracts Act came into force in July 2009, in the middle of a sharp contraction of economic activity. Notice periods were shortened and made more dependent on job tenure. Moreover, severance pay was significantly reduced, with some additional compensation being provided by the Estonian Unemployment Insurance Fund (but with no upfront cost for employers at the time of dismissal). Importantly, reinstatement in the case of unfair dismissal was made conditional on the mutual agreement of the parties while compensation was reduced to a maximum of three months wages, except in exceptional circumstances. One significant policy change brought about by the reform was an increase in employers’ contributions to the Unemployment Insurance Fund from 0.9% to 4.2% of the gross wage.
Spain. The Spanish labour market reform was approved by the government in February 2012. Substantial changes were introduced with respect to dismissal legislation. The reform redefined the conditions for a fair dismissal, specifying that a redundancy is always justified if the company faces a persistent decline in revenues or ordinary income and that the employer does not have to prove that the dismissal is essential for the future profitability of the firm. Monetary compensation for unfair dismissal was reduced by more than 25% and a much lower ceiling was introduced. At the same time, the reform removed a worker’s right to interim wages between the effective date of dismissal and the final court ruling. Prior to this change, employers often exercised the option to declare a dismissal unfair and pay upfront the corresponding compensation, so as to close the procedure and avoid paying interim wages. Indeed, this was the most commonly-used dismissal mechanism by employers before the reform rendered it obsolete. Finally, the reform eliminated the requirement that employers obtain administrative authorisation for collective redundancies. The reform of EPL was also accompanied by a large reform of collective bargaining. In particular, a greater priority was given to collective bargaining agreements at the firm level over those at the branch or regional level and firms were allowed greater latitude to opt-out from a collective agreement and adopt measures to enhance internal flexibility so as to limit job destruction. In addition, the reform limited the extension of collective bargaining agreements to a maximum period of one year after their expiration in the absence of agreements on their renewal.
Slovenia. A new Employment Relations Act entered into force in Slovenia in April 2013. The proposed reform reduced notice periods, making them more dependent on service duration. A few amendments were also made to severance pay. Moreover, the reform suppressed the requirement that employers provide proof of having attempted redeployment within the company before making redundancies. In addition, opposition by trade unions can no longer delay the date of dismissal. The reform was accompanied by some changes as regards temporary contracts. In particular, it is no longer possible for employers to hire a series of workers on fixed-term contracts to fill the same post for a cumulative period of more than two consecutive years. In addition, the reform has imposed a maximum quota on temporary-work-agency employment in the user-firm, if fixed-contracts are used. Unemployment insurance contributions are no longer paid for the first two years after hiring a worker on an open-ended contract, while they were increased for fixed-term contracts.
Italy. In Italy, with the Jobs Act adopted in December 2014, the government received a mandate to introduce measures to rationalise employment protection, expand active labour market policy, make social protection more effective, and boost female labour force participation. As part of this broad strategy and with a view to rebalance job protection, a standard contract with employment protection increasing with tenure was introduced in early 2015. This new arrangement implied quite radical changes for Italy and to avoid unwarranted disruption, a decision was taken to apply it only to new employment contracts (“grandfathering” existing rights). As part of the Jobs Act the government also introduced a new form of out-of-court procedure for dismissals, under which the employer pays the worker an indemnity equal to one monthly wage per year of service. The acceptance of this transaction prevents any further dispute by the worker. Both parties have a strong incentive to settle the dispute through this procedure, since the sum paid is not subject to social contribution or fiscal taxation.
Source: OECD (2016b) and OECD (2015c).
One important requirement to increase the acceptability of the reforms to address excessive job protection is that worker protection is concomitantly reinforced. Policy options for introducing such an element of security are discussed in Chapter 3.
2.5. Complementary strategies to tackle barriers to firm creation
There are other drivers to the creation of a buoyant business sector were firms are created and use opportunities to expand and invest in youth resources (ILO, 2014). These include a friendly administrative environment to formal registration of companies. Yet, “inefficient government bureaucracy” is ranked as the most burdening factor for doing business in Peru by a representative sample of business leaders from the country, just before “restrictive labour regulations” (Schwab, 2017).
The 2017 Doing Business indicator on “Starting a business” produced by the World Bank confirms that Peru is lagging behind on this dimension, despite recent improvements (World Bank, 2017). This indicator records the procedures required to, or commonly confronted in practice by, an entrepreneur to start up and formally operate a business, as well as the time and cost to complete these procedures and the paid-in minimum capital requirement. Peru ranks 103 out of 190 economies on the ease of starting a business, as opposed to an average rank of 48 among OECD countries. This gap mainly reflects the time and cost involved in starting a business: in Peru, it takes at least 26 days and costs 10% of income per capita to formally register a company, compared to an average of only eight days and 4% of income per capita in OECD countries (see Figure 2.7). By contrast, the number of procedures required (a total of six) is close to the OECD average (at five), and there is no paid-in minimum capital, while a minimum amount of 9% of income per capita is required in the mean OECD country.
Figure 2.7. Ease of starting a business in OECD countries, Peru and other Latin American benchmark countries, 2016
Note: OECD is an unweighted average.
Source: World Bank, Doing Business database.
Unsurprisingly, the two lengthiest and costliest procedures to start a business in Peru regard notaries and subnational governments. Indeed, professional services are typically characterized by anti-competitive regulatory restrictions in many countries and Peru is no exception with the evidence available being that providers’ self-imposed regulations heavily limit entry conditions (World Bank, 2017). This notably suggests that notaries do not provide the most competitive and best-quality services to Peruvian firms. Moreover, having municipalities granting the operating license increases their exposure to the pressure of local incumbents in order to limit market entry. As an illustration, barriers imposed by local governments and decentralized bodies account for most of the complaints related to bureaucracy that are processed by the independent competition authority, the National Institute for the Defence of Competition and Protection of Intellectual Property (Instituto Nacional de Defensa de la Competencia y de la Protección de la Propiedad Intelectual, INDECOPI. See, INDECOPI, 2017).8
The international evidence suggests that countries where formal registration of companies requires professional services and/or a license from a subnational government typically perform worse than others with respect to the “Starting a business” indicator. Their involvement is particularly pervasive among LAC countries and may account for their poor average rank of 120 out of 190. It is important to stress that the role played by anticompetitive practices among notaries and municipalities may be even underestimated outside Lima, where oversight by INDECOPI might be more challenging to accomplish.
It is therefore critical that Peru continues the efforts to simplify the administrative procedures to formally register companies and, hence, promote firm creation and youth employment. Since 2004, Peru has reduced the number of procedures to start a business from 10 to 6, the number of days required from 98 to 26 and the overall cost from 40% to 10% of income per capita (OECD, 2015d). However, these reforms must be continued by (i) having government agencies substitute to notaries and municipalities in the registration process in order to limit anti-competitive practices and (ii) creating an online one-stop shop for firm creation. More progress is needed to establish the “e-government” that the Strategic Plan for Electronic Commerce 2012 – 2021 is longing for (OECD, 2016c). One notable step in the right direction was the launch by the MTPE in 2018 of Formalizate Peru, an integrated platform to orient and accompany workers and employers in the process of formalization for both labour and business.
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Notes
← 1. As of 2016, a Tax Levy Unit amounts to PEN 3 950, hence USD 1 172 or EUR 1 155 (DS N° 397-2015-EF).
← 2. This is particularly true when a minimum wage is enforced since the potential for wages to be flexible downward is limited.
← 3. By contrast, large mature firms have the largest share of total employment.
← 4. Notably, it ranges from 10% for manufacturing, fishing and telecommunications, 8% for mining, retail, wholesale and restaurants, and 5% for other industries. Certain legal types of firm are also exempt, such as cooperatives, non-profits, and religious associations.
← 5. Family allowances are granted as a fixed amount. They do no depend on the number of children an employee may have. However, in case both parents are employed by the same employer, each parent is entitled to receive this benefit.
← 6. Technically, observed gaps in the levels of minimum wages could also reflect a difficulty to fully account for cross-country differences in costs of living using the exchange rate at Purchasing Power Parity.
← 7. The list of cases for reinstatement include: (i) null dismissal (when dismissal is based on a prohibited ground of discrimination such as sex, race, religion, political opinion or language, participation in union activities, pregnancy…etc); (ii) dismissal without cause (when no cause is alleged by the employer for dismissing an employee); (iii) fraudulent dismissal (when the employer alleges a cause that is false or dismisses a worker in a disloyal, hostile or perverse manner); (iv) dismissal in breach of fundamental constitutional rights (when the employer dismisses an employee breaching a fundamental constitutional right, different from the ones listed in (i) but including the “right to work”).
← 8. Created in 1992, INDECOPI is a specialised public body attached to the Presidency of the Council of Ministers. It promotes the free and efficient development of markets, protects consumer rights and safeguards intellectual property rights. It plays an important advocacy role by recommending the implementation of pro-competition measures to the legislative, political and administrative authorities (OECD, 2015d).