Suresh de Mel David McKenzie Chris Woodruff Labor Drops: Experimental Evidence on the Return to Additional Labor in Microenterprises Suresh de Mel David McKenzie Chris Woodruff

The Microenterprise Sector is dominated by the self-employed

Would more of these firm owners find it profitable to hire workers? Lucas (1978) view: optimally small because of poor managerial ability and low productivity Alternative view: a number of profitable investments that households and businesses could make, but don’t – and where one-time subsidy has lasting impacts: Seasonal migration (Bryan et al, 2014) Keeping enough change on hand (Beaman et al, 2014) Using good management practices (Bloom et al, 2013) Adopting a new production technology (Atkin et al, 2016) Is labor also one of these potentially profitable investments?

Why might firms owner sub-optimally not hire workers? Lack information on own ability (Jovanovic, 1982) and selective inattention (Hanna et al, 2014) Labor market frictions: Training costs + worker turnover => workers should pay for on-the-job training, but liquidity constraints & contractual form mean they don’t Imperfect information => hard to identify good matches for job

What do we do? Conduct an RCT with microenterprises in Sri Lanka, in which treated firms given temporary wage subsidy (8 months) Track firms using 12 surveys over 2008-2014 period, to measure impact and dynamics Supplementary savings and training treatments to investigate complementarities Detailed survey evidence on functioning of labor market => Allows us to measure return to additional labor in these firms, and extent to which lack of labor is the constraint to growth.

Outline Theory: why might small firms be labor-constrained, and how might a temporary subsidy have lasting impacts on firm employment? Experimental design Sample, Treatment, Surveys, and Attrition Take-up Results Impacts on survival, employment, profits and sales, return to labor Mechanisms Conclusions

Theory: Standard complete markets model (e.g. Lucas, 1978) Differences in employment size among firms facing the same output production technology f(.) reflect differences in their management ability, θ Employment and Capital stock determined by first-order conditions Implications: Firms small because have low ability. Temporary wage subsidy lowers w in short-run, leads to more short-run labor, but once subsidy is over, return to pre-subsidy levels.

Theory: model with credit constraints Let A be the wealth of the business owner, and the borrowing constraint is such that K≤bA Then new first-order conditions are: Use less capital than in unconstrained case, but could use more employment if substitute for labor, or less if complement. Implications: Firm small because low ability, or because highly credit constrained and labor and capital are complements Subsidy will have similar impact as classic model in short-run, except may be lower effect if need capital to adjust to make additional labor productive – again should be no long-run impact Exception: if firms have lower bound on profitability below which they shut down, then short-term subsidy, by providing temporarily higher profits, provides buffer that helps firms survive.

Theory: Learning & Labor market constraints frictions involved in identifying, hiring, and firing workers in an environment where firm owners are unsure of worker types (Mortensen and Pissarides, 1994) If firms find it hard to find workers they can trust, and costly to fire them, then may be deterred from hiring Subsidy makes it less costly to hire and take a chance on new workers- if some of these then are good matches, long-term employment increases. 2) firm owners may not know their own type (θ), as in Jovanovic (1982). pool of firm owners who have not previously hired a worker will then consist of owners with low actual managerial ability, as well as though with high actual ability but who believe they have low managerial ability Wage subsidy induces some of these to hire a worker and learn their type – and then high type keeps workers on after subsidy ends.

Theory: Labor market constraints In many businesses workers may not be very productive in their first few months on the job while they learn the specifics of the job, but then be productive once they have accumulated several months of training. Standard model: firm would pay a new worker his or her marginal product, so would pay a low (or even zero or negative) wage in these first months, and then a higher wage once productivity increases. But poverty constraints, minimum wage laws, and social norms may limit the ability of workers to take low initial wages to compensate for their low initial productivity - imposes the constraint w≥m on the optimization problem, where m is this lower bound on the wages that can be paid Subsidy can overcome constraint in short-run, and then if workers increase productivity during subsidized period, worker can stay employed (Bell et al, 1999).

Theory: one-time vs recurring constraints Some constraints one-time (e.g. learn own ability), others might be faced each time go to hire new worker Affects whether permanent impact on employment or not But in neither case should there be spike in exits right when subsidy ends – if problem is that over time workers quit, should see gradual fade-out as firm once again faces constraint.

Experimental Design The Sample random sample of urban microenterprises with two or fewer paid employees, owned by males aged 20 to 45 and operating in non-agricultural sectors Selected by door-to-door listing within GNs in Colombo, Kandy, and the Galle- Matara areas Done in two rounds: April 2008, and October 2008 (booster) Got sample of 1533 firms Choose from this 286 pure control enterprises and 250 enterprises assigned to the wage subsidy treatment alone

Firm characteristics average owner is 35 years old, has finished 10 years of schooling, and works 58 hours a week in their business. Only 11 percent having at least one paid worker, and an average of 0.17 paid workers per firm. Most informal (only one-third are registered for tax purposes) 40% in retail (e.g. groceries, hardware, plastic products), and the remainder in manufacturing (e.g. tailoring, brasswork, carpentry, food production) and services (e.g. electricians, vehicle repair, haircutting, transportation). In 2008, mean monthly profits were 14,184 LKR (approx.. US$130) on 46,434 LKR (approx.. US$430) of monthly sales

Wage subsidy intervention temporary wage subsidy to firms with the purpose of encouraging owners to hire an additional full time employee. April 2009 survey (pre-intervention) asked for information about each employee currently working at the enterprise. Treated offered a flat amount of 4000 LKR per month for a period of six months if they hired an additional employee working at least 30 hours per week, and a flat amount of 2000 LKR per month for a further two months. The employee had to be someone living outside owner’s household and could not be an immediate family member (spouse, parents, siblings, and children). Participants were told that payments would start in August 2009, and must end by May 2010 regardless of when the worker was hired Did not require them to formally register worker for taxes. Interviewed worker, and did occasional spot checks to ensure worker working there

Supplementary interventions To test if effectiveness of wage subsidy varies with access to other inputs, also had supplementary treatment groups: Savings group: Matched savings, to build up capital before wage subsidy offered 297 get savings program + wage subsidy; 112 get just savings Training group: Get ILO improve your business training, to improve skills before hiring worker 297 get training + wage subsidy; 141 get just training

Surveys and Timeline Context: 2008 GNI per capita: 7,598 April 2008 Round 1 - Screening Survey and Baseline I October 2008: Round 2- Booster Sample and Baseline II April 2009: Round 3 August 2009: Wage Subsidies Begin October 2009: Round 4 (During Intervention) April 2010: Round 5 (During Intervention) May 2010: Wage Subsidies End October 2010: Round 6 April 2011: Round 7 October 2011: Round 8 April 2012: Round 9 October 2012: Round 10 April 2013: Round 11 April 2014: Round 12   Supplementary Treatments: Savings Treatment began November 2008, ended August 2009 Business Training Treatment: June-July 2009 Context: 2008 GNI per capita: 7,598 May 2009: civil war ends 2014 GNI per capita: 10,396 Year 1 after Year 2 after Years 3 and 4 after

Low attrition

Take-up 24% of firms offered wage subsidy took it up Conditional on using the subsidy, the median firm used it for 7/8 possible months and received a total of 24,000 Rs. in subsidy. 68% used it for 6 months or more. Correlates of take-up: Lower in Colombo (wages higher there, so subsidy covers less of wage) Little correlation with firm characteristics (age, assets, formalization, already having a worker) Skills of owner matter – higher take-up for more educated owners, and owners with better business practices to begin with.

Who did they hire? hired workers are 31.5 years of age and have 9.8 years of schooling on average. 31.3% of hired workers are related to the owner in some way; 15.6% are female. Most (83.4%) were known to the owner before the hiring, and almost half (48.4%) say they live within 1 kilometer of the business. Workers report being paid 1,860 LKR per week. Control group firms: 33.6 years, 9.4% female, 9.4% related to owner, paid average of 3,217 LKR per week Workers hired post-subsidy: 32.6 years, 10% female, 10% related to owner, 71% known to owner before hiring, 36% live within 1km, paid 3,350 LKR per week.

Who are the firms induced to hire workers?

Results

Impact on Survival

Impact on Employment

Employment Churn

Churn in the Number of Workers

Impact on Profits

Quantile Treatment Effect on Profits Effect during subsidy: 95% CI OLS unconditional profits is (-1766, 3118), 50th percentile it is (-1208, 3140). This is relative to a control mean of 16603 SLR, so represents a range of -11% to +19%.

Quantile Treatment Effects on Sales

Return to Additional Labor Estimate during intervention, instrumenting labor (L) with assignment to treatment Compare to subsidy of 4000 SLR (not included in profits)

Mechanisms

Using heterogeneity of treatment effects to see possible channels If the subsidy is allowing firm owners to learn about their management type, θ, then we would expect the impacts to be greater for younger firms (where the owners have had less time to learn their type), and for firms whose owners have never hired a worker before. See no significant heterogeneity in treatment effect with either variable Heterogeneity with respect to management ability A one standard deviation improvement in baseline practices is associated with a 0.19 additional worker increase during the intervention, which is significant at the five percent level Effect dissipates over time, no long-term effect Consistent with labor non-convexity story

Using heterogeneity of treatment effects to see possible channels If firms need capital to make new workers productive, then the theory predicts that treatment effects should be higher for firms which have more access to capital. We see no heterogeneity with respect to either baseline capital stock, nor to household wealth at baseline.

Supplementary Treatments Treatment no more effective if coupled with business training or saving Suggests lack of long-term effect is not driven by lack of capital or lack of business skills.

Survey evidence Did owners learn about their types, for example, did they learn about their ability to manage workers? We asked which among several reasons the worker left. One option was that the owner had come to realize he was not able to properly manage the worker. Across several rounds and more than 30 such cases, this reason was only ever given once Only 13.3 percent of the owners said concern about their ability to manage an employee was a reason for not hiring. The far more common responses for not hiring related to a lack of demand for labor, including that the additional employee would not be profitable (43.4 percent), that the enterprise does not require an additional employee (26.5 percent, and that the subsidy is not large enough (13.3 percent). Together, these data suggest that learning about managerial ability is not a central issue among these firms; the lack of hiring appears mainly to reflect a lack of demand for labor

Survey evidence Role of capital 27.1% of those not taking up subsidy said they lacked capital to make employee productive Among those not hiring workers, responses from the October 2009 survey indicate that only 40 percent would need to make a capital investment to make the additional employee profitable. Among these 40 percent, a majority (56 percent) say that a lack of capital is an important reason they did not hire anyone under the program how much capital would be require to make a new employee “as productive as (s)he could be.” Only 7 percent of respondents said “zero” to this question, but 43 percent said 15,000 LKR or less, a level which is approximately one month’s profit for the average firm.

Survey evidence Is it that takes time for employees to become productive, and you can’t pay them a low wage in the meantime? In April 2010, we asked owners how long they thought it would take a hired worker to become fully productive. The mean response was 4.1 months; 86 percent said the period would be six months or shorter, suggesting that the subsidy was long enough to fully cover the learning period for the majority of the sample. Search costs? Jobs in these small firms appear to involve mainly physical labor rather than complex mental tasks. Employers say that the sex and physical strength of the worker are the two most important characteristics of workers they consider hiring, with education the least important of the characteristics listed. Most firms looking for workers say they can find worker in 2 months or less – median owner says 1 week.

Why was there a survival effect? Only long-term impact of the wage subsidies appears to be on firm survival, with no impact on paid employment, sales or profitability. Survival impact is not coming through relieving labor market constraints on firms. Most likely explanation for the survival effect appears to be that the subsidy provided firms with extra profits during the intervention period, and this small amount of additional capital allowed firms to survive shocks that would otherwise shut them down One-time grants of 10K and 20K helped micros survive (de Mel et al, 2012) If workers earn marginal product, max subsidy earned is 28,000 SLR, equivalent to two months profits. If this is channel, would expect effect for firms that are smaller to begin with.

The subsidy helps keep lower capital firms alive

Conclusions Several theoretical reasons why ex ante we might think labor market constraints prevent small firms from growing, and for which a short- term subsidy might have a lasting impact on firm employment Firms willing to take on extra labor when they are subsidized, but once subsidy ends, let some of this labor go, and no long-term effect (except on survival of low-capital firms) => Firms are not constrained by labor.