The implications of Institutional Quality on Employee Income: The influence of Country-Specific Characteristics Master Thesis Mara Momčilović 10076697 29-06-2015
University of Amsterdam: Faculty of Economics and Business MSc Business Studies
Supervisor: dr. I. (Ilir) Haxhi
Statement of Originality
This document is written by Student Mara Momčilović who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
I Table of Contents List of abbreviations ... IV Abstract ... V Acknowledgements ... VI 1. Introduction ... 1 2. Literature review ... 6
2.1 Defining the Institutional Environment ... 6
2.2 Institutional quality ... 7
2.2.1 A narrow perspective on institutional quality ... 7
2.2.2 A broad perspective on institutional quality ... 9
3.The institutional environment of a country ... 12
3.1 Institutional quality and employee income ... 12
3.2 The Institutional quality and the process of selecting, monitoring and replacing governments ... 16
3.2.1 Voice and Accountability... 16
3.2.2 Political Stability and Absence of Violence/Terrorism ... 18
3.3 The institutional quality and effectiveness of formulating and implementing sound policies ... 19
3.3.1 Government Effectiveness ... 19
3.3.2 Regulatory Quality ... 21
3.4 Institutions that govern economic and social interactions ... 22
II
3.4.2 Control or Corruption ... 23
3.5 Job satisfaction, unemployment and the Institutional environment ... 26
3.5.1 Job satisfaction ... 26
3.5.2 Unemployment ... 28
3.6 The Global Financial Crisis ... 30
3.7 General model ... 30 4. Methodology ... 32 4.1 Data sources ... 32 4.2 Data Collection ... 33 4.3 Dependent Variable ... 34 4.3.1 Wages ... 34
4.3.2 Purchasing power parities ... 35
4.4 Independent variables ... 35
4.5 Moderating variables ... 37
4.6 Control variables ... 38
4.6.1 Foreign direct investment ... 38
4.6.2 GDP ... 39 4.7 Method ... 40 5. Results ... 45 5.1 Descriptive Analysis ... 45 5.2 Correlation ... 46 5.3 Regression Analysis ... 50
III
5.3.1 PPP regression ... 51
5.3.2 Wage regression ... 52
5.4 Moderation ... 53
5.4.1 PPP as dependent variable ... 54
5.4.2 Wage as dependent variable ... 55
6. Discussion ... 58 6.1 Findings ... 58 6.2. Limitations ... 64 6.3 Future Research ... 66 7. Conclusion ... 68 References ... 71 Appendices ... 85
Appendix 1 List of countries used for the analysis... 85
Appendix 2 Descriptive Statistics ... 86
Appendix 3 Correlation analysis ... 88
Appendix 4 Regression Analysis 2009 ... 91
Appendix 5 Regression Analysis 2010 ... 97
Appendix 6 Regression Analysis 2011 ... 103
Appendix 7 Regression Analysis 2012 ... 109
IV
List of abbreviations
CC = Control of Corruption FDI = Foreign Direct Investment GDP = Gross Domestic Product GE = Governmental Effectiveness MNE = Multinational Enterprise
OECD = Organization for Economic Cooperation and Development OFDI = Outward Foreign Direct Investment
OLI = Ownership, Location, Internalization PPP = Purchasing Power Parity
PV = Political Stability RL = Rule of Law RQ = Regulatory Quality
UNCTAD = United Nations Conference on Trade and Development VA = Voice and Accountability
V
Abstract
Institutions have been heavily analyzed in the last decades. Scholars have argued that the quality of institutions is not only of importance for economic growth, but also determines the (social) welfare of a country. Previous studies yield mixed results with respect to how institutional quality affects employee income. Although scholars have found mixed results on the relationship between institutional quality and employee income, most studies suggest that institutional quality positively affects employee income. Rather than analyzing the effect of institutional quality on employee income, we aim to understand which dimensions within institutions affect employee income. We argue that multiple dimensions can influence the country's employee income (i.e., Voice and Accountability, Political Stability, Regulatory Quality, Governmental Effectiveness, Rule of Law, and Control of Corruption). Further, we argue that two country-specific dimensions - job satisfaction and unemployment rates - should be included in the analysis to identify how these dimension influence the relationship between institutional quality and employee income. In line with previous studies, we found that the degree of institutional quality can have a positive, negative, or no impact on employee income within a country. Further, we found that the effect of institutional quality on employee income can be positively influenced by job satisfaction and unemployment rates. This research contributes to previous literature by making a distinction in institutional quality dimensions, leading to a more comprehensive study. Furthermore, it sets to investigate the country-specific characteristics that influence the effects of institutional quality on employee income. From a managerial perspective, we distinguish what type of institutional dimensions can directly affect employee income and how this is moderated by country-specific characteristics.
VI
Acknowledgements
I want to express my gratitude for the efforts of all those who have contributed to the completion of the final stage of my Master in Business Administration in the track International Management. First, I would like to thank my supervisor dr. I. Haxhi for the pleasant cooperation during the process of writing my Master Thesis. Second, I wish to thank dr. N. Pisani for reading and grading my thesis together with Dr. I. Haxhi. Third, I want to thank the University of Amsterdam for providing excellent study programs in the past years. Fourth, I would like to thank the WageIndicator database for letting me use their data for this study. Finally, I would like to thank my family for their support throughout my studies.
1
1. Introduction
In the last decades, the world is witnessing an increase in globalization and economic growth. The world gross domestic product (GDP) has grown from 3.4 trillion U.S. dollars in 1970 to 75,6 trillion U.S. dollars in 2013 and the world foreign direct investment (FDI) has grown from 13.3 billion U.S. dollars in 1970 to 1.8 trillion U.S. dollars in 2013 (World Bank, 2014). As a result of the economic growth and increase in FDI, scholars are increasingly focused on identifying the drivers of economic growth.
Numerous scholars have found that various variables contribute to economic growth and social welfare. For instance, Rodrik (1991) found that inward oriented countries have higher economic growth than outward oriented economies. Although scholars have identified various drivers of economic growth, most recent studies found that growing economies require not only an appropriately designed economic system, but also a political foundation to protect and develop its economic growth (Weingast, 1995). Consequently, the influence of institutions on economic growth has become an interesting research field among scholars. In this study, we build on the definition of Powell and Dimaggio (1991) and Scott and Meyer (2008), and define institutions as the formal and informal rules that provide behavioral guidelines to actors within a network. This enables us to include both formal and informal rules and, therefore, gain a better understanding of what institutions really are. Differences in the governance system of a nation are known to originate in administrative, legal, and political institutions (Henisz, 2000). The quality of these institutions can affect the level of foreign investment, economic growth, and wage distribution within a country (Dollar & Kaay, 2002; Morck et al., 2008). Defining and measuring the differences of institutional governance results in different types of institutional quality. Focusing on what, and how, factors of
2 institutional quality drive economic growth and the distribution of wages could therefore contribute greatly to the international business literature.
The relationship between institutions and income has been inconclusive as a result of methodological differences among scholars and ambiguous definitions (Hopkins, 2004). First, sociological theory suggests that differences among institutional environments within society may translate into different status of occupations. This can affect the choice of education and occupation, influencing the level of output and employee income (Fershtman & Weiss, 1996). Second, the institutional factors that can be seen as the determinants of employee income inequality include the extent of collective bargaining coverage, the scope of collective bargaining, union pay policies, and government policy toward the labor market (Blau & Kahn, 1994). Even though there are several econometric studies on linkages between economic growth and social welfare, there are few systematic analyses of the effects of institutional quality on income. Furthermore, even less studies have tried to identify country-specific dimensions that affect the effects of institutional quality on employee income.
We argue that broad-based studies will continue to lead to inconclusive results. Rather than analyzing institutions as an isolated and individual indicator of employee income, scholars should analyze in-depth dimensions to determine how individual dimensions can impact employee income. Furthermore, we argue that future research should incorporate country-based dimensions as indicators of employee income. This enables us to determine if other indicators can influence the relationship between institutions and employee income. Although scholars have scrutinized the relationship between institutions and employee income, no empirical research has been conducted to determine how country-specific indicators can impact the relationship between institutions and employee income.
The research question of this thesis is twofold. First, scholars have found that most studies show a positive relationship between high quality government institutions and
3 attracting investment, fostering economic growth and developing effective labor markets. The combined results suggests that there is a positive relationship, and little evidence of a negative relationship between institutional quality and economic development (DiNardo, Fortin & Lemieux, 1995; Kaufmann et al., 2011). Rather than scrutinizing whether institutional quality has a positive effect on employee income, we use this signal as a starting point. Rather than questioning whether institutional quality positively affects employee income, we aim to understand when institutional quality affects employee income. In line with previous research (Kaufmann et al., 2011), we argue that different configurations will have different effects on employee income. Therefore, in contrast to many studies to date, we argue that a distinction has to be made with regards to the type of institutional quality of a country. Following the World Indicator Database, the quality of institutions will be analyzed on a country-level and determined by six Worldwide Governance Indicators (WGI): 1) Voice and Accountability (VA), 2) Political Stability and Absence of Violence / Terrorism (PV), 3) Government Effectiveness (GE), 4) Regulatory Quality (RQ), 5) Rule of Law (RL), and 6) Control of Corruption (CC). This enables us to answer the following research question:
To what extent does institutional quality influence employee income?
Second, we aim to study the existence of country-specific characteristics under which institutional quality leads to higher employee income. We argue that merely developing policy initiatives will not be enough to contribute to employee income. Rather, several country-specific operations have to be aligned for institutional quality to have a positive effect on employee income. Building on previous research (Peng, 2009), we argue that two country specific characteristics - job satisfaction and unemployment - will positively affect the effects of institutional quality on employee income. As such, we aim to study:
To what extent is the effect of institutional quality on employee income influenced by country specific characteristics?
4 More specifically, this study aims to analyze the extent to which institutional quality affects employee income and how the relationship between institutional quality and employee income is influenced by: 1) job satisfaction, and 2) unemployment. Furthermore, since previous studies have emphasized that major events have different impact on different institutions (Boughton, 2004), we examine to what extent the Global Financial Crisis had an impact on the effects of institutional quality on employee income.
This study aims to identify the role of the institutional environment measured by governance quality, using a sample of 48 countries. Following the WGI, we distinguish the following indicators that measure the quality of institutions – Violence and Accountability, Political Stability, Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption - to analyze their direct relationship to employee income (Kaufmann et al., 2011). In addition, we investigated whether two country-specific characteristics - job satisfaction and unemployment - moderated the relationship between institutional quality and employee income. Finally, we aim to analyze the effects of the Global Financial Crisis. We found that institutional quality can have a negative, positive and no relationship with employee income and that this relationship can be moderated by country-specific characteristics.
This study contributes to theory as it distinguishes different dimensions of institutional quality and country-specific characteristics that can have an effect on employee income. Defining and measuring these dimensions of institutional quality is of importance, as differences among institutions can affect the economic growth within a country. This answers the call of measuring institutional quality as a non-isolated indicator, implying that multiple configurations of dimensions contribute to institutional quality. This will lead to more comprehensive studies, as it distinguishes multiple dimensions of institutional quality and measures their effect on employee income. Further, we aim to extend previous research by
5 including country-specific dimensions in this study. More specifically, we aim to identify the existence of country-level characteristics, influencing the relationship between institutional quality and employee income. From a managerial perspective, we aim to determine which institutional, and country-specific, dimensions can directly influence employee income. In turn, these findings will help us to understand why some countries are better resilient to crisis-situations, while other countries struggle to enhance their economic growth.
The structure of this study is as follows. First, the concept of institutions and institutional quality will be introduced. Here we discuss the difficulty of defining institutions and eventually presenting the definition that will be used throughout this study. Further, we review the ongoing debate of the importance of institutional quality in the economic and social wellbeing of a country. This leads us to our hypothesis, presupposing a relationship between institutional quality and employee income. In order to adjust for price differentials in the international comparison of employee income, PPP is used as dependent variable. Employee income will be measured by annual wages and PPP, as used in the World Bank‟s Country Policy and Institutional Assessment (CPIA). In addition, we investigate whether country-specific characteristics - job satisfaction and unemployment rates – moderate the relationship between institutional quality and employee income. More specifically, this study tests the effect of the quality of institutional environments on employee income, moderated by the amount of job satisfaction and unemployment rates across countries. The second part focuses on the study‟s methodology, describing the process of data collection, reflecting the chosen sample size. Resulting from our analysis, chapter 5 presents the results of the study. Chapter 6 follows with a discussion of the findings and limitations that are part of this study. Finally, chapter 7 provides an overall conclusion in which the theoretical and managerial implications will be discussed and considerations for further research will be noted.
6
2. Literature review
2.1 Defining the Institutional Environment
While institutions have been an interesting research field over the last decades, scholars have yet to define a universal, unbiased and inclusive definition of institutions (Santiso, 2001). The lack of consensus, caused by various definitions, might pose a threat to the understanding of institutions. Furthermore, different understandings of institutions can lead to diverging biases and, therefore, prevent productive research. In order to define how institutional quality is measured, we argue that a clear definition of institutions is needed. In order to contribute to an improved understanding of institutions, we will discuss two main definitions of institutions.
According to North (1993), each country has its own unique institutional framework, which consists of the humanly devised constraints that structure political, economic and social interaction. This definition entails that institutions define the rules of the game, where organizations (i.e., the players of the game) are influenced by these rules. North (1993) argues that a distinction can be made between two kind of institutions: 1) formal institutions, and 2) informal institutions. The former are defined by rules, regulations, law enforcement, and property rights, whereas the latter are defined by the unwritten rules that govern life. The informal institutions, such as the customs and traditions, describe the behavior that is expected of citizens. This is described as the culture of a country and code of conduct (Ali et al., 2010). Building on this definition, Scott and Meyer (1995) argue that institutions are defined as social structures, composed of regulative, normative, and cognitive elements that provide stability and meaning to social life. These structures or socials systems have been identified by scholars as central elements of institutions (Scott & Meyer, 1995). These three elements mutually reinforce each other to contribute to the institutional context. Regulatory structures, such as policies and legal systems, are the regulative organizational elements that are driven
7 through coercive means. Normative structures, such as work roles and norms, focus on the social obligation of citizens and cognitive structures on the symbolic aspects of society (Powell & Dimaggio, 1991). Cognitive structures are the cultural systems, values, beliefs, and assumptions within a country. These structures combined provide individuals stability and ethical guidelines (Scott & Meyer, 1995).
Based on these definitions and previous research on institutions, we argue that both formal and informal elements must be incorporated in defining institutions. Therefore, we argue that institutions can be defined as the formal and informal rules that provide behavioral guidelines to actors within a network.
2.2 Institutional quality
The well-being, growth of economic development, and FDI of a country is influenced by the quality of its institutions (Dollar & Kraay, 2002). In order to establish a measurement of institutional quality, we will discuss two perspectives of institutional quality. Traditionally, institutional quality was measured by local policies and development of the labor market (Meyer et al., 2009). Recently, scholars have emphasized that institutional quality cannot be measured by merely focusing on formal aspects and the labor market (Kaufman et al., 2011). Rather, multiple interdependent dimensions must be measured to capture institutional quality. The former can be defined as the 'narrow' perspective, whereas the latter can be defined as the 'broad' perspective. We will discuss these perspectives to define how quality is measured within this study.
2.2.1 A narrow perspective on institutional quality
Traditionally, scholars have focused on the narrow perspective to measure institutional quality, where labor markets have been the central indicator of quality. According to Fortin and Lemieux (1997), the labor market rigidness, distribution of wages, and decentralizing nature of wage bargaining affects the labor market performance. In turn this effects the quality
8 of a country's institutions and economic development of the country. Thus, differences in the labor market cause differences in institutional quality, even in countries with similar levels of income (DiNardo, Fortin & Lemieux, 1995).
While various scholars have argued that labor markets influence the institutional quality, scholars have also argued that institutional quality influences the labor market quality. For instance, Fortin and Lemieux (1997) and Dollar and Kraay (2002) argue that institutions are key factors in the development of the labor market. Furthermore, they argue that institutional quality determines the economic growth of a country. This relationship between institutional quality and economic development of a country has been widely accepted by scholars (Islam & Montenegro, 2002; Fortin and Lemieux ,1997). Numerous scholars have scrutinized the relationship between institutional quality and economic development. For instance, Salai et al. (2011) examined the competitiveness of economies around the world and the impact on institutions, while Eicher and Röhn (2007) assessed the extent to which individual Organization for Economic Cooperation and Development (OECD) countries possess the institutional quality to achieve economic growth.
When the effects of institutional quality on labor markets is measured, a distinction between two kind of institutions can be made. Strong institutions support the labor market, while underdeveloped (i.e., weak) institutions lack support of their labor markets (Meyer et al., 2009). For instance, in the presence of political stability and a positive investment climate, institutions can be labeled as "strong" (Meyer et al., 2009). These factors of institutions, which results in either strong or weak, determine the quality of institutions. Stable and effective institutions, known as the "social infrastructure" of a country, are required to foster economic growth (Knack and Keefer, 1995).
Whereas scholars have tried to present a universal theory with respect to the effects of labor markets on institutions, there is lack of consensus on how to measure these effects. This
9 is the result of differences in the institutional framework of a country (Freeman, 1999). Consequently, what might affect the institution in one country, will not affect the institution in another country.
2.2.2 A broad perspective on institutional quality
Next to the narrow perspective, scholars have measured institutional quality by using the broad perspective. Scholars have emphasized that institutional quality cannot be measured by merely focusing on formal aspects and the labor market (Kaufman et al., 2011). For instance, research has shown that FDI location determinants are strongly connected to the quality of institutions and government involvement of a country. When a positive investment climate is found in a country due to political stability, strong institutional factors are found (Meyer et al., 2009). What these studies have in common is the emphasis on proposing that well-functioning institutions are essential in achieving economic development and growth of a country (Fortin & Lemieux, 1997). FDI is a form of investment where organizations buy a stake in an existing company or set up a new firm, outside the home country. In doing so, they invest in, control, and manage value-adding activities in a foreign country. Attracting this kind of investment by host countries is determined by the quality of its institutions (Globerman & Shapiro, 2003). Host country governments are willing to attract FDI because it is a stable source of investment in comparison to loans or portfolio investment, where active management or control of the issuing company is not possible (Schaub, 2004).
According to Buckley and Casson (1998) the general principles of FDI can be described as twofold. When imperfect external markets are missing, firms tend to internalize them as long as the benefits outweigh the costs. This internationalization process implies that firms replace imperfect external markets by engaging in FDI. The lacking of these intermediate products and knowledge causes firms to engage in FDI in order to yield the firm significant profits. To lower costs and obtain sufficient benefits, firms choose to operate in
10 favorable locations for the construct of their activities. These favorable locations depend on the strength of the institutional environment (Buckley & Casson, 1998). When institutions support the labor market, they are called strong, in contrast to underdeveloped institutions which are described as weak (Meyer, et al, 2009). An example of this is the absence of a regulatory framework, causing undermining of the effectiveness and efficiency of doing business in a foreign country. Thus, when a positive investment climate is found in a country due to political stability, one indicator of a strong institutional factor is found. An ineffective market mechanism is a result of „weak‟ institutions (Meyer et al, 2009).
The eclectic paradigm (i.e., OLI-framework), is a well-developed instrument to analyze institutional determinants of FDI, incorporating a variety of theories of FDI in one framework (Dunning, 1998). The OLI-framework can be described as integrative of both micro-economic theory of the firm and the macro-economic theory of international trade. The eclectic paradigm is driven by the OLI-advantages which are Ownership-advantages (O), Location-advantages (L) and Internalization-advantages (I). Ownership advantages refer to the property asset advantages and institutional assets. The location aspects of the framework correspond with the location the firm chooses to engage in FDI activities (Peng, 2012). The characteristics of this location, such as its institutional strength, need to produce significant value when a firms decides to invest there. The benefits, produced by the FDI operations, have to outweigh the costs of doing business abroad. The location specific advantages are related to factor endowments and formal and informal institutional structures. The final aspect of the OLI-framework focuses on the internationalization aspect. As mentioned before, doing business abroad is not without risk, which results in costs. The imperfections in international market transactions cause transaction costs to occurs. In order to keep these costs at a minimum, or prevent them from occurring, specific internationalization advantages can be used (Dunning & Lundan, 2008). An example of internalization advantages are minimizing
11 search and negotiating costs, avoiding costs of broken contracts, and ensuing litigation. Furthermore, the avoidance of moral hazard and adverse selection, exploiting government intervention, capturing of interdependent economies, and compensating for the absence of future markets are examples of such specific internalization advantages. A firm that operates on an international level will search for host countries where they can possibly gain resource-seeking advantages or strategic asset advantages. It is this internalization factor in the OLI-framework that results in a reduction of transaction costs and is critical in the decision making process of FDI activities. This implies that institutions play an important role in the decision making process of FDI activities of firms that operate abroad (Globerman & Shapiro, 2003).
In line with previous theories, we argue that rather than only looking at one indicator of institutional quality, multiple indicators should be included to determine the quality: 1) process of selecting, monitoring and replacing governments, 2) effectiveness of formulating and implementing sound policies, and 3) the respect for institutions that govern economic and social interactions (Kaufmann et al., 2011). This entails that multiple dimensions should be taken into account when measuring institutional quality. More specifically, the following dimensions should be incorporated in the measurement of institutional quality: 1) Voice and Accountability, 2) Political Stability and the Absence of Violence / Terrorism, 3) Government Effectiveness, 4) Regulatory Quality, 5) Rule of Law, and 6) Control of Corruption. This has two important implications. First, this means multiple dimensions must be included in measuring institutional quality. Second, interdependencies might exist among the dimensions, resulting in reciprocal reinforcements.
We argue that a broad perspective must be used to measure institutional quality. This will incorporate multiple dimensions and will help gain a better understanding of institutional quality. Consequently, we will use these six dimensions to measure institutional quality in this paper.
12
3.The institutional environment of a country
3.1 Institutional quality and employee income
Scholars have increasingly researched the effect of institutional quality on employee income. However, methodological differences and ambiguous definitions among scholars results in inconclusive results with respect to the effect of institutions on employee income (Hopkins, 2004). The economic outcomes that determine employee income within a country should be associated with countries governed by effective institutions (Easterly et al, 2006). Sociological theory suggests that differences among institutional environments within society may translate into different status of occupations. This can affect the choice of education and occupation, influencing the level of output and employee income (Fershtman & Weiss, 1993).
The institutional factors, which are the determinants of employee income include the extent of collective bargaining coverage, the scope of collective bargaining, union pay policies, and government policy toward the labor market (Blau & Kahn, 1996). The labor market is characterized by imperfect competition, since employee income is set as a result of a bargaining process between representatives of the employees and the employer (Freeman, 1999). Various research in the last decade has been focused on this concept of mutual interdependence between the institutional context and labor market (DiNardo, Fortin & Lemieux, 1995; Blau & Kahn, 1996). Research has shown that when the institutional environment is stable, the labor market outcomes are more positive in the long run.
However, whereas many scholars developed theories with explanatory power, no theories have yet provided predictive power. This results in the labor market institutions varying significantly across countries with comparable levels of income. Therefore, a countries‟ institutional framework is not a set of independent elements, but a result of the interaction with other interdependent dimensions (Teulings & Hartog, 1998). This entails that
13 institutions must be governed different in each country, as the set of interdependent dimensions cannot be the same in two countries.
It is likely for countries with effective formal institutions to be associated with high quality institutions. For instance, in countries with slim government effectiveness, such as its independence from political pressures, the steady state level of wage to which they can aspire should be lower (Easterly et al., 2006). This results in the quality of a country‟s institution, influencing the distribution and decentralizing nature of employee income (Blau & Kahn, 1996). Freeman (1999) emphasizes these differences by stating that certain institutional features may perform divergently depending on the overall institutional framework.
Tijdens et al. (2010) found that employee income depends on certain attributes such as: 1) employment status, 2) contract information, 3) working hours, 4) the calculation of hourly wages, 5) bonuses, 6) educations, 7) occupation classification, 8) job level, 9) blue and white collar workers, 10) supervisory position, 11) employees‟ workplace representation, 12) collective bargaining coverage, 13) industry, 14) region, 15) migration, 16) ethnic background, and 17) household characteristics. Various studies have focused on the relationship between education and income on the role of education levels in determining income convergence across countries (O‟Neill, 1995). First, according to empirical research, the rise of neo-liberalism is accompanied by greater income inequalities (OECD, 2011). Second, the level of a countries' education has an important impact on its development according to UNESCO (2015). Finally, within the European Union, higher education is considered to be a responsibility of the state. The policies that are designed at supra-national level are therefore aimed at supporting national policies and addressing issues that are of common interest (Deiniger & Squire, 1996). Besides the difference in institutional framework, the exchanges and monetary currency rates vary across countries. Differences in the levels of wages that can be found in the international economy can be caused by structural
14 and institutional change (Fagerberg & Verspagen, 1996). In order to adjust for price differential in international comparisons of income, the purchasing power parity (PPP) can be used.
PPP is an exchange rate determination theory seen as one of the primary principles in international business and economics. The idea behind PPP originated from Cassel (1992), who was motivated by the vast dispersion in national price levels driven by wartime inflations. In order to reinstate the gold standard credibility, the adjustment of exchange rates in order to be consistent with PPP became a macroeconomic issue, requiring monetary stringency. It is identified as an essential condition for the most rigorous of capital market integration tests, the international equalization of real interest rates (Papell, 1997). The PPP has become commonly accepted practice among empirical researchers, since the study of MacDonald (1998), who tested 40 OECD countries to the long-run PPP hypothesis. The result of this study indicated that differences in prices between countries, measurement errors, transportation costs and differential productivity shocks can influence the powerfulness of PPP. The results of other studies on PPP indicate that the particular condition of PPP is often violated in the short run, due to the fact that exchange rates fluctuate more than price levels (Frankel & Rose, 1996; Wu & Crato, 1995). Therefore, research indicates that methods for the purpose of investigating the PPP require a longitudinal design. In order to compare the historical success or failure of capital market integration, the exchange rate should be derived from the ratio of aggregate price levels of countries (Taylor, 1996).
We argue that key development outcomes (i.e., employment income) should be associated with countries governed by effective formal institutions, and that those institutions should be more likely to be found in countries with high quality institutions. Therefore, we will focus on employee income, which can be affected by the institutional quality within a country. In this study, employee income will be measured by country-level wages and PPP.
15 Wage will be measured using the WageIndicator concept, which is part of a non-profit organization dedicated to improving labor market transparency by offering precise wage and wage related information (Tijdens et al, 2010). The Living Wage calculations, developed by WageIndicator, is based on its Cost of Living Survey. The WageIndicator survey is a continuous, multilingual, multi-country web-survey that spans across 65 countries since 2000 (Tijdens, Besamusca, & Ndereyahaga, 2013). The web-survey provides researchers with information and stimulates public contribution to scientific information gathering. This survey, which is available online, takes into account the national food preferences, basic calorie intake needs, cost of housing, transportation, medical insurance, and family life. The survey uses international standards for calculating and making acceptable and comparable results across borders. By using this database of wage and labor practices, potential institutional and firm-level determinants of wage and labor practices across different countries will be reflected in this study. The sample of the database is the labor force, consisting of individual paid employees. Since wage setting processes vary across countries, country-specific translations have been preferred over literal translations (Tijdens et al, 2010). This longitudinal data on wages that spans over multiple countries might develop into a worldwide database on wages, benefits working hours, working conditions and the relationships that occur between different industries. With the use of this database in the study, our understanding of institutional influences on labor markets and employee income will increase.
We argue that different configurations of institutional quality will have different effects on employee income. Rather than scrutinizing whether institutional quality has an effect on income, we have to distinguish the dimensions of institutional quality that have an effect on employee income. Besides the suitability of theoretical classification, one must take into account the possibilities for conceptualization of chosen theoretical constructs. Therefore, we will focus on our empirical application on the formal institutions. The reason for excluding
16 social and organizational institutions is the lack of sufficient and reliable data. The lack of a clear distinction causes both groups to be too heterogeneous to be able to represent a common underlying dimension. For formal institutions, the availability of indicators across countries as well as in time is much better than for the informal institutions, which lack international comparing (Netanel, 2006). We will look at formal institutions following the WageIndicator database and WGI and take the following dimensions into account: 1) Voice and Accountability, 2) Political Stability and Absence of Violence / Terrorism, 3) Government Effectiveness, 4) Regulatory Quality, 5) Rule of Law, and 6) Control of Corruption. This will result in a more inclusive analysis, as it will distinguish different institutional quality dimensions and determine which dimension directly influences employee income. As previously discussed, we argue that a distinction between different types of dimensions of institutional quality has to be made to effectively study the effects of each dimension on employee income. This will result in a more comprehensive study between institutional quality and employee income, as we argue that multiple dimensions individually can contribute to employee income. Therefore we propose:
H1: The institutional quality of a country will positively affect employee income.
3.2 The Institutional quality and the process of selecting, monitoring and replacing governments
3.2.1 Voice and Accountability
As emphasized above, the process of selecting, monitoring and replacing governments in a liberal democracy must encompass and nurture a “system of freedom of expression”. Freedom of expression is interlinked with the selection of a government when individuals can partake in the creation of rules. This will enhance obedience and willingness to cooperate and
17 act in line with the formalized rules. According to Emerson (1963), this comprises various speech-related rights, institutions, types of speakers, and affirmative state support. The measurement of political, civil and human rights has been identified by early research, resulting in models such as the Social Responsibility model (Siebert, 1956). The relationship between freedom of expression and institutions has been scrutinized in more recent research (Himelboim & Limor, 2008). Freedom of expression can be divided in freedom of press and the freedom of speech (Netanel, 2006).
According to media and political science scholars, freedom of press is a function of the relevant country‟s political ecology. Freedom of press is part of the relations between the state and media in society and should be upheld by societies‟ institutions, since it is recognized as a basic right in various United Nations decisions (Bollinger, 1976). The freedom of speech is grounded in a basic humanistic worldview and is considered a fundamental right regarding human relations with society and the state (Netanel, 2006). Freedom of speech enables civic discourse and gives citizens the ability to participate in civic life with the information they need (Littlejohn & Foss, 2010; Brennan, 1965). McEwen and Mainmann (1986) state that this will enhance obedience and willingness to participate in the rules. In their study they found that the more people are involved in establishing rules, the stronger their sense of obligation to a certain government will be. The ability to voice their opinions or concerns and be accounted on that is part of freedom of expression (McEwen & Mainman, 1986). The measurement of political, civil and human rights is of importance when looking at the ability of citizens to partake in the selection of government.
We argue that a better degree of 'Voice and Accountability' (VA) will positively contribute to institutional quality. The degree of VA is measured in the freedom of expression, freedom of association and free media in the process of selecting, monitoring and replacing governments (Kaufmann et al., 2011). Consequently, it measures the degree of
18 involvement with respect to the selection of governments of residents. A higher degree of VA will, therefore, result in more involvement in designing the formal and informal rules for a country´s population and higher institutional quality. Involvement enables a country's population to involve its rights in the formal and informal rules within an institution. An element of these rights is employee income, as this ensures the basic human needs can be met (Pittman & Zeigler, 2007). Hence, we propose:
Hypothesis 1a : Countries with higher Voice and Accountability will have higher employee income.
3.2.2 Political Stability and Absence of Violence/Terrorism
Political stability in a country can be described as the establishing of a government through constitutional means and without violence. In contrast, political instability is found when governments are destabilized or overthrown by unconstitutional or violent means, including politically-motivated violence and terrorism (Kaufmann et al., 2011). The consequences of political instability is confirmed by multiple scholars, who found that political instability has a negative effect on foreign direct investment (FDI) due to risks and costs associated with this instability (Schneider & Frey, 1985; Borensztein et al., 1998; Busse & Hefeker, 2007; Jensen, 2003). For instance, Williamson (1985) argues that political instability can result in high risk for organizations operating in such a country. He states that political instability will result in higher costs, due to the increase in the amount of uncertainty. According to Dunning (1993), political instability is described as an uncertainty, thereby increasing costs for safeguarding against this uncertainty. It could be described as a location disadvantage when speaking in the terms of the OLI-paradigm (Dunning, 1993). Furthermore, in periods of political instability, institutional mechanisms for protecting property and contractual rights are at risk. This effects the economic performance of a country, because investments are likely to be reduced and reallocated to avoid risk (Knack & Keefer, 1995).
19 We argue that Political Stability is needed for economic growth within a country. Rather than only focusing on internal dimensions (e.g., population satisfaction), we argue that external elements (e.g., trade) are equally important for a country's economic growth. Political stability ensures that a country's population has the needed resources to fulfill its duties and contribute to the economic growth, while also ensuring that external factors will enhance the growth (Dunning, 1993). As a result, we argue that the degree of Political Stability will positively affect the country's GDP and, in turn, employee income.
Consider the development of (North and South) Korea. Prior to the Korean war, both countries were part of a single country (i.e., a dictatorship). Whereas South Korea has chosen to transform itself into a democracy and open its borders to foreign countries, the North Korean dictator chose socialism. From 1980 onwards, North Korea has been plagued by numerous (external) conflicts. Politically motivated violence, political assassinations, and war threats have been usual occurrences in North Korea. Not surprisingly, the GDP of South Korea was 31,900 U.S. dollars in 2013, while the GDP of North Korea was 1,800 U.S. Dollars in 2013 (World Bank, 2014). Therefore, we propose:
Hypothesis 1b : Countries with higher political stability and absence of violence/terrorism will have higher employee income.
3.3 The institutional quality and effectiveness of formulating and implementing sound policies
3.3.1 Government Effectiveness
According to Taylor (1996), policies can be realized through a balance of pressure and support. In order to implement a policy, pressure is required to set a certain amount of attention on a reform objective. Likewise, pressure can provide a necessary legitimacy for program officials in the presence of uneven consensus with respect to merit of a policy or when a policy aims at weak benefits. On the other hand, support is needed to enable the
20 implementation of a policy. Taylor (1997) argues that it is difficult to align all parties involved in solving a policy issue. It is this type of support and pressure that is determined by the quality of the institutions within a country. According to the basic model of policy implementation, governments implement policies to change old patterns of interaction within society. Policies are created in order to encourage change in society (Spillane et al., 2002). The overall conclusion of research on policy implementation is that it is hard to implement policies across layers of government and institutions (McLaughin, 1987). For instance, policy makers can be in conflict with stakeholders and implementers at different ranks of the government. In order to mediate through this turbulent relationship, compromise of certain ideals are needed. The difficulty of implementing policies is also found in the European Commission, where Directorates-Generals inside the Commission regularly discuss issues during policy formation (Daviter, 2007).
We argue that effective governments are necessary to realize efficient and effective policies within a country. These policies help define the formal and informal rules of an institution, which, in turn, provide public services of quality and stable civil services. Brown et al. (2007) argue that governmental failure contributes to lower economic growth, adverse economic circumstances, and lower employee income growth. In line with Brown et al. (2007), we argue that higher effectiveness contributes to stable economies, quality governmental infrastructure, processes, and policies. In turn, these effects contribute positively to a country's employee income as they provide guidelines to employees' rights.
Consider the reunification, and aligned policies, of Germany after the fall of the Wall in November 1989. Political unification followed in October 1990 to implement governmental policies and reduce income inequality. Through these policies, eastern markets were reopened and economic employment and growth rose dramatically. This resulted in a reduction of income inequality and increase in overall employee income. We propose:
21
Hypothesis 1c : Countries with higher government effectiveness will have higher employee income.
3.3.2 Regulatory Quality
Regulatory quality, such as the founding of secure and stable property rights, have been a key element in the rise of the West and the start of modern economic growth according to North and Weingast (1989). They argue that a firm would not have the incentive to accumulate and innovate, unless it has sufficient control over the return to the assets that are thereby created or improved. Empirical research has shown that investors search for a form of institutions that provide protected and well enforced property rights. When entrepreneurs can count on the government to honor the contracts it has with private actors, they will be able to rely on the government to impose on contracts between private parties (Knack & Keefer, 1995). The occurrence of this impartial enforcement of contracts obtains government effectiveness and regulatory quality. Countries in which officials have the ability to modify or ignore contractual agreements are likely to be unconstrained in other ways (Rodrik, 2000).
We argue that regulatory qualities and effective governments have an influence on the quality of institutions because they capture the perceptions of the ability of the government to formulate and implement sound policies. Furthermore, effective government regulations permit and promote private sector development (Kaufmann et al, 2011). In general, every successful market economy is overseen by a panoply of regulatory institutions, regulatory conduct in goods, services, labor, asset and financial markets. These regulatory institutions prevent fraudulent behavior and incomplete information results in moral hazard selection, resulting in higher GDP and employee income.
Consider how the United States has a range of institutions involved: FTC, FDIC, FCC, FAA and EPA (Johnson & Shleifer, 2004). Previous studies show that successful market economies are overseen by regulatory institutions which regulate conduct in goods, services,
22 labor, assets and financial markets. The degree of freedom influences the burden on regulatory institutions to uphold copy right laws. This is seen in the United States, which is known for having numerous institutions, while maintaining a great degree of freedom (Rodrik, 2000). Consequently, we propose:
Hypothesis 1d : Countries with higher Regulatory Quality will have higher employee income. 3.4 Institutions that govern economic and social interactions
3.4.1 Rule of law
The power of Rule of Law within countries can be seen as a perception of how well governments protect their bureaucratic quality (Hall & Jones, 1999). When individuals have confidence in the rules of society (i.e., particularly in the quality of contract enforcement, property rights, the police, and the courts), the likelihood of crime and violence will decrease (Kaufmann et al., 2011). A high score on this dimension indicates a sound political institution that consists of a strong court system. This is accompanied by the provisions of an orderly succession of power. A high level of Rule of Law suggests that no individual or group stands above the law. The rules of such a country are written down, which are executed and lived by (Asiedu, 2006). Low scoring countries are likely to suffer a decrease in the amount of investment in physical and human capital (Knack & Keefer, 1995). In an unambiguous situation, Rule of Law guards a firm against subjective governance when laws are unclear and rules are not being enforced. Therefore, high levels of Rule of Law is of importance for foreign investors, since it displays a high regard of the legal system which is enforced within a country (Asiedu, 2006). According to Haggard and Tiede (2011), there are four distinct causal mechanisms through which the Rule of Law has been related with economic growth: 1) the provision of security of person, 2) the security of property and enforcement of contract, 3) checks on government, and 4) through checks on corruption and private capture. The establishment of Rule of Law for developing countries is an ongoing challenge. Studies show
23 that the level of violence is one of the most important factors in differentiating them in this regard. Recently, scholars have argued that institutional shortcomings could possibly be accountable for continuing weak economic performance over the long run (Acemoglu et al, 2001). They argue that the protection of property rights is often violated in countries where institutional quality is lacking. The Rule of Law is seen as an essential pillar upon which any high quality democracy rests (O‟Donnell, 2004). Other studies have shown that societies categorized as “fractionalized” have worse Rule of Law (La Porta et al, 2000). The impact of legal origin on institutional development is that legal systems, which have historically less policy making power in the hand of independent and autonomous agencies, have consistently poor institutional quality in comparison to those with other legal traditions (Chong & Zanforlin, 2000).
In line with Haggard and Tiede (2011), we argue that Rule of Law positively influences employee income. Next to protecting property rights (Acemoglu et al, 2001), which will increase long-term trade and FDI, we argue that the degree of Rule of Law decreases the uncertainty factor to doing business in a country (Williamson, 1985). When civil and property rights are protected and trust between both government and individual actors is achieved, the institutions of a country are well functioning. In such a institution, firms and investors are more likely to invest in a country, raising the overall GDP and employee income. Hence, we propose:
Hypothesis 1e: Countries with higher Rule of Law will have higher employee income.
3.4.2 Control or Corruption
Numerous studies have focused on the relationship between corruption and institutional quality. According to Aidt (2009), there are two styles of corruption. On the one hand, briberies can speed up the process of wealth creation when avoid long bureaucratic procedures, also known as „grease the wheels‟. On the other hand, corruption can „sand the
24
wheels‟ and become an obstacle for further economic development. According to the
Transparency International (i.e., a global organization fighting corruption) the definition of corruption is: “The abuse of public power for private gains or benefits” (Gelos & Wei, 2002). This lack of transparency increases uncertainty and raises costs for investors, making it a negative factor for economic development. Recently, studies have shown that institutional quality depends on the levels of transparency within a country (Gelos & Wei, 2002). These findings are confirmed by Aron (2000), who indicates that an increase in economic growth is found in countries that have low levels of corruption. Low levels of transparency are often indicators of corruption and poor governance quality, as it conflicts with a positive investment climate. Countries that struggle with development fail to construct and maintain high-quality institutions that pursuit the common good of its people (Easterly, Ritzen & Woolcock, 2006). Countries in which bribes are accepted often fail in terms of law enforcement systems. As a result, this can lead to the discouragement of possible investors. High levels of corruption in a country often results in higher risks and costs for firms as it is likely to enhance the transaction costs (Williamson, 1985). According to the OLI-paradigm, corruption can be placed under a location disadvantage, since it is a risk for investing abroad (Dunning, 1993). For instance, the presence of rent seeking opportunities and lack of competition affects corruption within a country (Ades & Tella, 1999). Djankov et al., (2006) state that the proliferation of regulation or the presence of natural resources may have an impact on the Control of Corruption within a country. When corruption is high within a country, its property rights are likely to be infringed against, resulting in distortions in investment (Knacker & Keefer, 1995). Likewise, corruption, if caught, can have an relentless impact on the image of a company, given that corruption is perceived as moral wrong doing (Bloningen, 2005).
We argue that the degree Control of Corruption will have a positive influence on employee income. In line with Aron (2000), Estarly, Rizen, and Woolcock (2006), and
25 Knacker and Keefer (1995), we argue the degree of Control of Corruption positively contributes to FDI and uncertainty reduction. Furthermore, we argue that corruption may cause misallocation of talents (Li, Xu, and Zou, 2000). Innovators and entrepreneurs must obtain government-supplied licenses and permits, resulting in a significant competitive disadvantage. Consequently, the pool of talents and entrepreneurs in a country is reduced, resulting in less investors and opportunities in a country. In sum, we argue that the degree of Control of Corrpution contributes to FDI, uncertainty reduction, innovation, and entrepreneurs, which ensures investors are drawn to a country and results in increased employee income.
Consider how the economic growth of the Former Yugoslavian Republic has developed. After the Former Yugoslavian Republic was divided in multiple countries in the 1990s, various governmental influences were identified in these countries. For instance, Slovenia ranked 39th on the world corruption index, while Bosnia ranked 80th in 2014. The GDP per capita was 20,019 U.S. dollars in Slovenia, while it was 4,661 U.S. dollars in Bosnia. We argue that the Control of Corruption has a significant influence on Employee Income. Hence, we propose:
Hypothesis 1f : Countries with higher Control of Corruption will have higher employee
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3.5 Job satisfaction, unemployment and the Institutional environment
3.5.1 Job satisfaction
Research on the well-being of employees and employee income has produced various findings with mixed results (Dunn, Gilbert & Wilson, 2011). Scholars found a negative association between income inequality and employee well being (Hagerty, 2000), while others found no association at all (Berg & Veenhoven, 2010). Studies also indicate a strong association between high subjective well-being and social behavior (e.g., being a better colleague, neighbor, and citizen) (Nelson & Winter, 2009). Job satisfaction has been an interesting research field for a long period as it proved to have a great impact on organizational success and practical consequences in organizations (Morgeson & Campion, 2003). Weissenfeld et al., (2001) have defined job satisfaction as an attitude: “A positive (or
negative) evaluative judgment one makes about one‟s job or job situation”. Recent studies
have added new elements into account that influence motivation and satisfaction of employees in the workforce (Morgeson & Campion, 2003). These new elements are found in the social information processing (SIP) theory. This theory puts work satisfaction in a new light, depending on information provided by the context of the employee such as attitudes, behavior, and beliefs. This means that the characteristics of work are not fixed but depend on the context in which they occur. The perception of job characteristics and levels of job satisfaction are influenced by factors outside of the objective features of work, such as the social and institutional context of the employee. According to a quantitative review, job satisfaction is a key predictor of job performance, showing that happy employees are better performers in the workplace (Smith, 2013). Consequently, these studies indicate that job satisfactions is a reliable indicator of job income.
According to the World Happiness Report (2013), there is a rising worldwide demand that demands policies to be more closely aligned with what really matters to people. The
27 report focuses on six key variables that have found to explain 75% of the international differences in the world's lowest national average values: 1) GDP per capita, 2) years of healthy life expectancy, 3) social support, 4) perceptions of corruption, 5) prevalence of generosity, and 6) freedom to make life choices (UNDP, 1991). For instance, the improvement of perceptions of corruption in Latin America, Western Europe, and East Asia resulted in overall greater levels of wellbeing for their inhabitants. Similarly, due to the increase of perceived freedom to make life choices in the Sub-Sahara, Southeast Asia and Latin America, the levels of overall well-being and job satisfaction grew in these regions. The levels of trust remain much lower in developing countries than in Western Europe. Since the economic crisis and levels of trust have become more important than income in explaining why life evaluations have been rising since the crisis (Blinder, 2013). Levels of subjective well-being are found to predict future health, mortality, productivity, and wages, controlling statistically for other possible determinants.
We argue that the relationship between the degree of institutional quality and wages will be influenced by job satisfaction. More specifically, we argue that job satisfaction will positively affect the effect of institutional quality of employee income. Scholars have recently found that job satisfaction is a key indicator of job performance. We argue that when job performance increases, income increases on a firm-level, increasing the salary that can be distributed among its employees. In turn, if firm-performance continuously exceed expectations, firms will have more resources to reward their employee. As a result, we argue that employee income will increase.
Consider how numerous firms have combined their employee rewards with the yearly performances. Yearly results are key indicators for yearly salary increases and individual economic rewards. Next to being a key indicator for employee's wages, yearly results also influence the periodic bonus. We argue that these financial rewards will increase job
28 satisfaction, which, in turn, will increase the firm's yearly performance. Consequently, we propose:
H2a: The effect of institutional quality on employee income will be positively affected by job satisfaction.
3.5.2 Unemployment
The unemployment rate of a country has an effect on individuals and the society. Unemployment causes a rise in the expenditure of the welfare state and decreases the tax income of the state. Furthermore, seeing as most voters are part of the labor market and depend on the labor market for their income, governments may be judged on their performance of labor market strategy and employment rates (Offe & Hinrichs, 1985). Comprehensive policy packages are likely to be more effective at reducing unemployment than labor market reforms (Coe & Snower, 1997; Belot & van Ours, 2001). Research has shown that there are certain determinants on how unemployment is related to economic growth and employee income. These determinants include unemployment benefits, taxes, trade union bargaining power and the structure of collective bargaining, employment protection legislation (EPL), minimum wages, and housing policies (Bassanini & Duval, 2006). Levels of unemployment are determined by aggregated demand which is influenced by many factors, of which most are outside the direct control of policy makers. Policy makers can, however, have an influence through the monetary policy, which has a significant impact on aggregated demand (Nickell, 2003). Monetary policy tends to be set in order to stabilize inflation at relatively low levels. For instance, if the economy of a country is in a recession, as a result of adverse shock, levels of unemployment are likely to be high. Consequently, monetary policy will be loosened, aggregated demand will recover and the unemployment rate will decline (Hunt, 1995). Today, governments and international institutions are agreeing on two fronts: 1) GDP is an partial and imperfect measure to determine the future
29 development of countries, and 2) subjective well-being has an important role to play in defining performance of a country and its success. Since countries are struggling to recover from the consequences of the Global Financial Crisis, resulting in high rates of unemployment, governments are working out how to incorporate well-being into standard policy making. Often, the need for government intervention arises because of risks to individuals' well-being. For instance, the misery caused by unemployment puts strains on private income and the public sector budget. Employed citizens pay taxes, are not collecting benefits, have higher self-esteem and rely less on the State. Further, mental illness is a great cause of misery, unemployment, and low productivity. It is not surprising that in these examples, the case for the policy interventions is both to increase civil well-being and wages on a national scale. Unemployment, which has grown significantly in Western Europe since the Global Financial Crisis, has been shown to have a large effect on the well-being of the unemployed and employed individuals.
We argue that the unemployment rates have a significant impact on the effects of institutional quality on employee income. As we have argued before, we proposed that the institutional quality will positively affect employee income. This relationship depends on the percentage of employment within a country. The effect of this relationship will influence more people within a country if the employment rate is higher. Therefore, we argue that the effect of institutional quality on employee income will be positively affected by the country's employment rate. Hence, we propose:
H2b: The effect of institutional quality on employee income will be positively affected by employment rate.
