Theoretical and empirical studies conducted on macroeconomic indicators and, more generally, the role of institutions in economic development have left their mark on the literature of economics in recent years. The corporate tradition is based on the work of Thorstein Veblen in the United States at the end of the 19th century. The German Historical School, represented by authors such as Schmoller, also contributed greatly to the work of the institution. It is possible to see explanations about the role of institutions in the early works of development economists (Hirschman, 1970). On the other hand, institutional economists, unlike mainstream economists, base their economic analysis on “institutions” rather than “individuals” (Miçooğulları & Değirmen, 2019). According to these economists, achieving various macroeconomic goals such as ensuring growth and development, ensuring income justice in the economy, and increasing employment to desired levels could only be possible through conducting institution-based analyzes (Adams, 1994; Demir, 1996; Hodgson, 2000; North, 2010). The representation of institutional quality using numerical data initiated the analysis of the relationship among economic performance indicators. North’s (1990) major contribution to the literature was that he integrated and formulated the role of institutions within the analytical framework of mainstream economics using aspects inherent to mainstream economics such as transaction costs, imperfect information and path dependence. North’s (1990) contributions made institution and institutional change an indispensable part of economic analysis. In this way, studies examining the dynamic relationships between institutional quality, employment and income distribution that shape the socio-economic structure and processes have gained a place in the literature despite their limited number (Chong and Calderon, 2000; Chong and Gradstein, 2007; Kotschy and Sunde, 2017).
It is crucial to examine the above-mentioned role of institution and institutional change for Central and Eastern European countries for it is a well-known fact that these countries have undergone a radical institutional change in the 1990s. Following the collapse of the Union of Soviet Socialist Republics, the reconstruction and modernization of economies towards sustainable market economies necessitated a systemic change. The main aim here was to eliminate the barriers to the market economy. The shift to the market mechanism and the change of the political-economic system accelerated the steps towards deregulation of the economy, such as privatizations, liberalizations, and flexibility of the labor market in Central and Eastern European countries. Thus, the institutional framework of the transition to a market economy was constructed, which was expected to be followed by growth and development (Burger and Stare, 2010; Grusevaja and Pusch, 2015). At this point, investigating whether this new institutional framework affects employment in the aforementioned countries as well as analysing income inequality may contribute to the literature. According to the current literature, the relationship between institutional quality and employment can be positive, negative or unrelated. However, it is possible to reduce the positive or negative effects of institutional quality on employment with a third modulating variable to be defined. Therefore, the income inequality variable was included in the study as a modulating variable to examine its impact on the institutional quality-employment relationship regarding the 19 Central and Eastern European countries for current empirical research shows that income and wealth inequalities have increased significantly in Central and Eastern Europe since the dissolution of the Union of Soviet Socialist Republics. Taking the Gini coefficient as a general and common measure, the value of the index in Eastern Europe is about 3% higher than that of the rest of Europe. This increase in inequality was initially driven by the reforms of privatization, liberalization and deregulation, as mentioned above, and more recently reinforced by policies of redistribution of wealth along with technological change and globalization (Brzezinski and Salach, 2022).
Theoretically, inequality may have a positive or negative impact on employment. To start with the negative impact, high income inequality can lead to the deterioration of employment levels through various channels. First, it could result in political instability and social unrest which adversely impacts employment (Alesina and Rodrik, 1994; Alesina and Perotti, 1996; Keefer and Knack, 2002). Secondly, high income inequality can be a barrier to employment of the poorer segments of society due to their insufficient investment in human capital. For example, as a result of high income inequality, if the poorer segment of the society cannot meet their education expenses, leaving their education unfinished may have a negative impact on the accumulation of human capital. This channel, known as the theory of “human capital accumulation”, has a direct effect on the level of employment (Cingano, 2014). Thirdly, the negative impact of income inequality on employment may be observed in economies where advanced technology is driven by domestic demand. In this channel, in the case of high income inequality, the domestic demand dynamics of the economy will not be strong which will also be reflected in the demand for high-tech products. This may cause a failure in achieving the targeted economic growth; thus, negatively affect employment (Cingano, 2014).
Regarding the positive impact of inequality on employment, higher income inequality could boost economic growth, thus employment if it encourages individuals to work hard, invest and take risks associated with higher rates of return (Mirrlees, 1971; Lazear and Rosen, 1981 Cited by Cingano, 2014). Nevertheless, if high income inequality encourages total savings and thus capital accumulation which would reduce the tendency of the rich to increase their consumption, it can positively affect growth and employment (Kaldor, 1956; Bourguignon, 1981).
There are few studies in the literature that have examined the direct linkage between institutional quality and employment for Central and Eastern European Countries. Furthermore, there is almost no study investigating the role of income inequality in modulating the impact of institutional quality on employment in these countries. In this sense, the current study fundamentally differs from the previous studies conducted on Central and Eastern European Countries and aims to fill this gap in the literature. First of all, unlike some previously conducted studies, this study examines not only the impact of institutional quality on employment, but also whether income inequality acts on this impact. Secondly, three institutional quality indicators, namely corporate governance, economic governance and political governance, were used to examine whether the impact of institutional quality on employment depends on the institutional quality indicator used. Thirdly, three indicators of income inequality, namely the Gini coefficient, Atkinson index, and Palma ratio are used; thus, providing three different specifications for each institutional quality indicator. Fourthly, to examine the modulating effect of income inequality on the institutional quality-employment relationship, three interaction terms were calculated for each of the institutional quality indicators. Thus, a total of nine interaction terms regarding institutional quality and income inequality indicators were obtained. The regulatory impact of income inequality on the relationship between institutional quality and employment will provide policmakers with information on whether income inequality plays an important role in the relationship between institutional quality and employment. The study will also provide information on whether both income inequality and institutional quality improvement should simultaneously be targeted in the long run. Furthermore, by using an interaction model, this study aims to estimate income inequality threshold levels that should not be exceeded in order to sustain the beneficial effects of institutional quality improvement on employment. As far as is known, this study may be listed among the few pioneering ones to present a detailed examination of the dynamic relationship between institutional quality, income inequality and employment using the interaction model for Central and Eastern European Countries. The rest of the paper is structures as follows: Section 2 provides a summary of previous empirical literature on the relationship between institutional quality, income inequality and employment in various countries and country groups. Section 3 presents the methodology used in the study, while Section 4 presents the empirical analysis. Finally, Section 5 summarizes conclusions and offers policy recommendations.