Trade Liberalization, Wages, and Employment in Developing Countries: The Role of Political Economy and the Informal Sector

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The public debate on the merits and perils of trade liberalization often centers on the question of how trade reforms affect labor markets. But despite the prominence of this question in public policy, empirical research to date has offered no conclusive evidence on the effects of trade liberalization on employment and wages. This reflects two main difficulties associated with empirical work in the area. The first one is a measurement issue: in recent years, trade protection in developed countries has taken the form of non-tariff barriers that are inherently hard, if not impossible, to measure. A second limitation is that the political economy of trade protection, while having made inroads in trade theory and empirical studies of import penetration, has remained a second-order concern in studies of the effects of trade reform on wages. This study makes progress on these issues by exploiting the Colombian trade liberalization between 1985 and 1994. The Colombian trade reforms consisted primarily of multiple tariff reduction episodes that not only drastically lowered the average tariff, but also affected the structure of protection across industries. The advantage of focusing on tariffs is that they are both well measured, and -- contrary to NTB measures -- comparable across time. The basic idea in this project is to link tariff changes, which varied substantially across industries, to wages and employment in each industry, in order to investigate whether trade liberalization leads to lower wages in sectors that experienced larger tariff reductions, and/or labor reallocation across sectors. The adopted framework explicitly accounts for the political economy of trade protection. The focus on industry-level adjustment differs from the previous literature that has concentrated on the effects of trade policy changes on the returns to particular worker characteristics (most prominently, returns to skill and education). These studies focus on the consequences of trade reforms in the long run, when worker industry affiliation does not matter. However, industry affiliation is crucial in predicting the impact of trade reforms in short- and medium-run models of trade. These models seem particularly relevant in developing economies (like Colombia) where labor market rigidities obstruct labor mobility across sectors. Because Colombia, like many other developing countries, is characterized by a large informal sector, a significant part of this research is devoted to the analysis of the adjustment process in this sector. In particular, the study examines whether trade liberalization has contributed to the increase in informality of the workforce documented in the 1990's, and whether wages and employment were affected differentially in the formal and the informal sectors. The analysis utilizes information on industry tariffs from the Colombian Department of National Planning and detailed worker level data from the National Household Survey (that include information on workplace characteristics and informality) over the period 1984-1998. While this work does not attempt a general analysis of income inequality, it has implications for the current debate on the effects of trade reform on wage dispersion. The question is of particular importance in developing countries that are characterized by substantial inequalities. The work identifies a source of disparity beyond the well-documented increase in the economy-wide skill premium: to the extent that tariff reductions in developing countries are larger in sectors with lower initial wages, employing a larger fraction of less-skilled workers, a decrease in the industry wages of these sectors will affect such workers disproportionately. Similarly, a trade liberalization-induced expansion of the informal sector, which is typically associated with lower wages and zero benefits, may increase inequality. While such considerations do not imply that trade liberalization is undesirable, they point to the need to identify sectors and worker groups that may need adjustment assistance in the short and medium run. More generally, an analysis of the adjustment process following trade liberalization may help understand and address the resistance of particular groups to trade reforms we often observed in practice.