^*Helge Berger is a professor of Monetary Economics in the Department of Economics, Free University Berlin. Stephan Danninger is an economist in the European Department of the IMF. The authors are indebted to Alfonso Arpaia, Jörg Decressin, Marcello Estevão, Andy Hughes-Hallet, Giuseppe Nicoletti, Werner Schule, Marcel Thum, Bob Traa, and participants at the European Commission's Workshop on Sequencing and Incentives of Reforms and the IMF European Department's research seminar for insightful comments. Jair Rodriguez provided excellent research assistance.

Abstract

This study explores the effects of labor and product market deregulation on employment growth. Our empirical results, based on an Organization for Economic Cooperation and Development country sample from 1990 to 2004, suggest that lower levels of product and labor market regulation foster employment growth, including through sizable interaction effects. Based on these findings, the paper discusses a theoretical framework for evaluating deregulation strategies in the presence of reform costs. Optimal deregulation takes various forms depending on the deregulation costs and the strength of reform interactions. Compared with the first-best policy, decentralized decision making can lead to excessive or insufficient deregulation.