Government size and unemployment in developing countries

Abstract

Using data from 52 developing countries, this article analyses how the size of government affects unemployment. It tackles the reverse causality issue by instrumenting for the government size variable. According to the regression results, a large government sector is likely to increase the unemployment rate. The magnitude of the effect appears to be substantial, both among the total labour force as well as among women and young people. Furthermore, the estimates indicate that a large government sector is likely to substantially increase the share of long-term unemployed in the total number of unemployed. The results are robust to variations in specification.

Notes

¹ Developing countries are defined as low and middle income countries according to World Bank classification.

² The indicator for government size most commonly used is the government expenditure ratio. However, data on this indicator is very scant for developing countries.

³ Prior to 2001, the EFW index was calculated for every fifth year from 1970.

⁴ According to our estimates, more flexible labour market regulations are correlated with higher, rather than lower, unemployment rates (Tables 1 and 2). Although this contrasts with results from many studies on industrial countries, our result is not completely surprising. Heckman and Pagés (2004) find labour market regulations to have no statistically significant effect on the unemployment rate in Latin America and the Caribbean. Their result and ours may be due to the fact that labour market regulations are not strictly enforced in many developing countries.