Efficient labor markets match workers with the most suitable jobs for their skillset. Efficient labor markets also incentivize both employees and employers to act in ways that promote the productivity of human capital: workers to work as efficiently as possible and employers to provide the right incentives.

The first way in which efficient labor markets promote productivity—allocating a country’s human resources to its most productive sectors—points to the importance of labor market flexibility. Employment protection policies, such as rules and regulations for firing workers, have been shown to lead to a decrease in employment, consumption, and productivity.⁶⁶ Flexible labor markets allow workers to shift from declining firms and enable companies and the economy as a whole to respond to external shocks.⁶⁷

Greater labor market flexibility also increases the ability of a country to reallocate production to emerging segments and adapt the workforce to the new needs of high-tech sectors.⁶⁸ As technology advances, firms that fall behind the technological frontier have to reduce their workforce—and if firing costs are high, entrepreneurs will be more inclined to invest in sectors with a slower pace of technological change.⁶⁹ This implies that countries with more flexible labor market legislation would tend to specialize more in industries with a faster pace of technological change.

Flexibility works best when complemented by some form of unemployment insurance, because workers who benefit from unemployment insurance are more patient in their job searches and tend to look for riskier, more productive, and higher-wage jobs; employers also tend to create more of these good-quality jobs. Acemoglu and Shimer (2000) find that, while moderate levels of unemployment insurance benefits—such as those in the United States—may slightly increase the level and duration of unemployment, they could boost productivity overall by improving the quality of jobs. Recent research has also pointed to active labor market policies as a means to improve the matching between workers and vacant jobs and reduce long-term unemployment.⁷⁰ The importance of these policies is not captured in the current Index but will be taken into account in the updated GCI.

The second way in which efficient labor markets can stimulate productivity is by promoting the accumulation of human capital and the use of talent at its full potential. This means attracting and retaining the best talent in the country, increasing workers’ efforts, and increasing employers’ willingness to train employees. Performance-related pay is one policy with proven benefits for productivity.⁷¹

Beyond monetary rewards, dualities in labor markets—when some permanent employees enjoy strong labor protection, while others are on flexible temporary contracts—have been shown to reduce productivity in two ways: by demotivating workers and by reducing firms’ investments in training.⁷²