The incredible shrinking Portuguese firm

Serguey Braguinsky, Lee Branstetter, André Regateiro, 10 September 2011

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The Portuguese economy has been making headlines. After months of deteriorating economic circumstances and declining confidence in the nation's ability to make good on its rapidly expanding debts, Portugal became the third Eurozone bailout case. The crisis led to the fall of the ruling party, an acrimonious election, and widespread pessimism on the part of Portuguese workers, managers, and investors.

Low productivity levels

A central weakness plaguing Portugal for decades is its low productivity levels. Even when compared to Western Europe's other weaker economies, Portugal's productivity record is uninspiring and has been so for years (Blanchard 2007). There is a link between Portugal's unusually poor productivity performance and another distinctive feature of its economic landscape – a firm size distribution that has been shifting to the left for almost 30 years (see Figure 1).

Figure 1. Firm size distribution in Portugal in 1980 and 2009

Our analysis using Portugal's matched employer-employee database demonstrates the surprising extent and persistence of this shift (Braguinsky et al 2011). It is not found in other advanced industrial economies, such as the US or Denmark. Theoretically this could be an artefact of expanding data coverage – a reflection of the shift from manufacturing to services, or a response to the efforts of Portuguese governments in the 1980s and 1990s to de-monopolise sectors. However, even generous allowances for all of these factors leaves most of the shift unexplained.

Labour-market problems and firm size

To explain the residual, we need to resort to Portugal's uniquely restrictive labour-market practices and their implications for the allocation of labour across firms.

  • Even after the partial labour-market reforms of the late 1980s, it remains very difficult for enterprises to fire workers for cause or to lay off workers even in difficult economic circumstances.
  • It remains all but impossible for firms to reduce employees' nominal wages, even when the firms face very adverse circumstances.
  • Legally mandated severance payments are high, even by European standards, and Portuguese courts have been consistently characterised by a pro-worker orientation.
  • Portuguese firms are required to provide a range of services to employees. OECD rankings of member states on the basis of labour-market protections consistently placed Portugal at the very top through the mid-1990s.

At that point, it was ranked second after Turkey, and Turkey's macroeconomic performance in the 1990s and 2000s has also been quite uneven.

There are ample reasons to believe that government interventions in the labour market distort the allocation of labour across firms. An emerging literature in development economics finds that the largest part of the productivity gap between developed and developing countries can be attributed to the inefficient allocation of resources across firms in the latter countries (see for example Jones 2011, Restuccia and Rogerson 2008, and Hsie and Klenow 2009). Whereas well-developed factor and product markets and a high level of competitive intensity ensure that the most productive factors are allocated to the most productive enterprises in developed countries, this often fails to happen to the same degree in developing countries. Building on this literature, we show that this problem not only exists in developing Asia, Africa, or Latin America, but also in the countries along Europe’s periphery.

  • As many of the labour-market regulations are waived for sufficiently small firms, the literature has often found a “bulge” at a certain firm size just where extra regulations kick in (see for example Garicano et al 2011).
  • But there is no such bulge around one particular firm size in the firm size distribution in Portugal because there are many different size thresholds at which restrictions apply and no single one is referenced often enough to matter on its own.

Instead, labour protection is observed throughout the economy and the whole firm size distribution is shifted to the left.

Another dimension of labour-market distortion revolves around the increasing extent to which the Portuguese legal, tax, and administrative regime discriminates against larger enterprises. As Portuguese enterprises grow in size, they confront a steadily growing set of rules, regulations, and mandates that increasingly drive a wedge between the value of employees to the firm and the cost of employing workers while maintaining compliance with all relevant laws.

A span-of-control model

In order to guide our thinking on these issues, we present a variation of the celebrated Lucas ‘span-of-control’ model (Lucas 1978), which describes the firm size distribution of an economy taking into consideration the occupational choice as well. Labour protection costs are modelled as a tax on labour. We view this as a simplification of a far more complex interaction between workers and firms in which greater labour protections transfer bargaining power to workers.

  • By driving a wedge between the costs firms must pay for employees and their value to the firm, these protections lead firms to reduce their employment, lowering the demand for workers in the aggregate.
  • Somewhat unexpectedly, labour protection also forces some workers out of the employed workforce and into creating their own firms.
  • These newly created “marginal” firms are particularly unproductive as their managers and employees would be better off working for more skilled managers. In effect, these protections distort and degrade the distribution of employees across managers of different quality.

Not only is the entire firm size distribution shifted to the left, but productivity in terms of national per capita output falls.

The economic logic

Why does an increase in labour protection lead to entry by more marginal firms? Intuitively, this happens because the equilibrium decline in wage earnings turns out to be stronger for the marginal worker/entrepreneur than the equilibrium decline of his/her profits as an entrepreneur. In other words, increased labour protection depresses not just business profits but also, working through market equilibrium repercussions, pushes down the wages of those very workers it was supposed to protect, even more than it pushes down profits. This is the mechanism that leads some workers to switch occupation and start their own highly inefficient firms.

Given the reality of a labour-protection regime that hits larger firms more intensely, we also examine the case where the ‘tax on labour’ is non-linear. While the qualitative features of the analyses with linear and non-linear tax are very similar, examining the non-linear tax case shows how labour protection reforms that reduce the overall degree of this protection but are biased against larger firms can in fact lead to very big distortions and efficiency losses, even as compared to a much higher linear tax.

Conclusions

We engage in some simple calibration exercises to quantify the level of policy distortion that is consistent with the shifts in the firm size distribution we observe in the data. We then link these to the productivity gains that might result if these distortions were partly or completely eliminated. Our results strongly suggest that Portugal could achieve first-order productivity gains by moving to a less distorted labour market.

References

Blanchard, O (2007), “Adjustment within the euro. The difficult case of Portugal”, Portuguese Economic Journal, 6(1):1-21.

Braguinsky, S, L Branstetter, and A Regaterio (2011), “The incredible shrinking Portuguese firm”, NBER Working Paper No. 17265.

Garicano, L, C LeLarge, and J Van Reenen (2011), “Firm size distortions and the productivity distribution: Evidence from France”, Working Paper.

Hsie, CT and P Klenow (2009), “Misallocation and manufacturing TFP in China and India”, Quarterly Journal of Economics, 124(4):1403-1448.

Jones, CI (2011), “Misallocation, economic growth, and input-output economics”, NBER Working Paper No. 16742.

Lucas, RE (1978), “On the size distribution of business firms”, The Bell Journal of Economics, 9(2):508-523.

Restuccia, D and R Rogerson (2008), “Policy distortions and aggregate productivity with heterogeneous establishments”, Review of Economic Dynamics, 11(4):707-720.

Topics: Europe's nations and regions, Labour markets, Productivity and Innovation
Tags: firm size, labour-market protection, Portugal, productivity

Serguey Braguinsky
Associate Professor of Economics at Carnegie Mellon University
Associate Professor of Public Policy and Economics at Carnegie Mellon University.
André Regateiro
PhD Candidate, Heinz College, Carnegie Mellon University

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