Replacing dual employment protection with a single labour contract

Juan J. Dolado, Etienne Lalé, Nawid Siassi 30 January 2016

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One of the main rationales for having employment protection legislation is that, through fostering job stability, it can insure workers against job losses in the absence of perfect capital markets. In addition, employment protection legislation reduces moral hazard by employers who fail to internalise the cost of unemployment imposed on taxpayers.

Both issues are particularly relevant in the dual labour markets of Southern Europe and France. It is well known that the dysfunctional performance of these labour markets has not been due to the coexistence of permanent and temporary contracts. After all, the use of temporary contracts to accommodate for the fixed-term nature of many seasonal activities is widespread in most countries. What really matters is the so-called employment protection gap, which is the difference between stringent employment protection laws (defined as days of wages per year of service) applied to longer-tenured workers and the very low compensation (if any) that other workers receive at the end of their short-term contracts (Cahuc and Postel Vinay 2002, Dolado et al. 2002, Bentolila et al. 2012a, García-Perez and Osuna 2014).

As noted by Blanchard and Landier (2002), through increased flexible job creation and job destruction, a sizeable employment protection legislation gap reduces the conversion of temporary contracts into permanent contracts. This happens when wages are not flexible enough to offset the transfer from employers to employees implied by severance pay per se, and when uncertainty regarding litigation is large. As a result, dual employment protection legislation creates a ‘revolving door’ through which workers rotate between dead-end jobs and unemployment. Plenty of evidence documents that this gap has negative consequences on unemployment, wage pressure, human capital accumulation and innovation (see Dolado 2016 for a review of this evidence).

Regrettably, the financial and sovereign debt crises have confirmed all of these predictions in the olive belt countries, with Spain having become the epitome of a dysfunctional dualism. Indeed, despite suffering a similar cumulated fall in GDP as in other large EU economies during the Great Recession, the Spanish unemployment rate has rocketed to above 20%, as also happened in the early 1990s when the European Monetary System collapsed.

This poor performance, also shared by similar countries like Greece, Italy, Ireland, Portugal, Spain, and France, has triggered a policy debate on how to redesign employment protection legislation in those countries. Several proposals have been made advocating the replacement of dual employment protection by a single/unified open-ended contract applied for new hires or even retroactively (see Bentolila et al. 2012b, Cahuc 2012 and OECD 2014 for overviews and discussion of these proposals).

The key features of a single/unified open-ended contract are that it has no ex ante time limit (unlike temporary contracts) and mandatory severance pay increases smoothly with seniority, rather than abruptly. In this fashion, a single/unified open-ended contract would avoid the damages inflicted by dual employment protection contract by providing a sufficiently long entry phase to discern the quality of job matches and a rather smooth rise in protection as job tenure increases. A gradually raising redundancy pay-tenure profile would be justified by the larger losses of specific human capital and the difficulties of finding new jobs that dismissed older workers face, as well as to enhance employer-sponsored training.

However, despite being high on the European political agenda, so far most proposals on a single/unified open-ended contract have been rather vague on their specific recommendations regarding design and implementation.

To help filling this gap, in a recent paper (Dolado et al. 2015) we propose a methodology to evaluate the following pending issues:

  • A precise definition of the tenure profile that a single/unified open-ended contract should have depending on several relevant labour-market characteristics;
  • An assessment of the allocation and welfare gains that would result from a reform replacing dual employment protection legislation by a single/unified open-ended contract;
  • An evaluation of the political support to such a policy change; and
  • An analysis of how the transition towards the new steady state would limit losses and enhance gains.

For tractability, we develop a search-and-match model for a labour market where there is only one type of contract which is characterised by a large employment protection legislation gap after a few (two) years of job tenure. In this fashion, the first stage of this contract mimics temporary contracts, except that there is no pre-specified termination date. Likewise, the later periods become akin to permanent contracts. This simplifying assumption allows us to focus on the role of employment protection legislation gap as the main culprit of dysfunctional dual labour markets.

A distinctive feature of our model is that workers are risk averse (while firms are risk neutral) and therefore demand insurance to smooth out consumption (see Lalé 2015 for a forerunner of this model). This enables us to compute the optimal tenure profile of severance pay according to some pre-specified welfare criterion (see below). Other relevant features in our setup are that unemployment benefits (the other source of insurance) are financed by a payroll tax and that redundancy costs may have in part a layoff tax nature due the existence of red-tape cost associated to litigation procedures. In this fashion, our analysis is related to Blanchard and Tirole’s (2008) discussion of the relationship between layoff taxes and unemployment benefits to minimise the moral hazard problem affecting redundancies.

More specifically, our model has a life-cycle structure where young and older workers differ in the way they use severance pay and in their search intensity for jobs. On the one hand, while younger workers are hand-to-mouth because they are subject to binding credit constraints, older workers can use severance pay to buy actuarially fair annuities which help them smooth out consumption after becoming unemployed. On the other hand, whereas laid-off young workers search actively for jobs, unemployed older workers stop searching to capture the difficulties that these workers often face in re-entering the labour market. In this fashion, job security is allowed to play a key role in bridging the gap in consumption, and for this reason forward-looking young workers and very keen on accumulating job tenure to access to the annuities markets. Yet, wage-setting systems prevent them to fully achieve this goal, leading to the detrimental revolving-door effect.

For illustrative purposes, the model is calibrated to Spain just before the Great Recession, at a time when its unemployment rate was close to the EU average rate, namely 8.5%. Once the calibrated parameters reproduce a set of targets prior to the crisis and under the employment protection gap prevailing at that time, we compute the optimal tenure profile of redundancy pay. In this computation, optimality refers to maximization of the steady-state lifetime utility of new labour market entrants. We can then analyse how the new employment protection legislation scheme affects welfare across the current population at the time of the single/unified open-ended contract reform. In particular, during the transition phase from dual employment protection to a single/unified open-ended contract we consider two alternative scenarios for workers under existing matches:

  • Reform 1, where they retain their accrued-to date employment protection legislation rights until the date of the reform and subsequently become subject to new single/unified open-ended contract regulations; and
  • Reform 2, where they also keep previous employment protection legislation rules after the reform.

Using conventional values for the coefficient of risk aversion, unemployment insurance replacement rates, quit rates (not entitled to protection) and share of red-tape costs, our main findings can be summarised as follows:

Figure 1

Note that, for example, the solid line in Figure 1 indicates that a worker suffering an unfair dismissal after 10 years (40 quarters) of job tenure in a firm, would get a severance package of 1.23 annual wages (=45x10/365). By contrast, using five contracts of two years each in sequence implies a severance pay of 0.22 annual wages (=16x5/365).

By removing the revolving door, the optimal single/unified open-ended contract raises welfare by 1.7% relative to the status quo. Job destruction of short-tenure jobs decreases, overall job creation increases and the payroll tax goes down (the proposed single/unified open-ended contract is fairly robust to changes in the key parameters of the model). In addition, while there is a rise of young workers’ wages since they are no longer threatened by the employment protection legislation gap, older workers’ wages become more flexible since, as a result of the flatter slope of single/unified open-ended contract, they accept wage cuts more often (than with dual employment protection) to save their jobs when hit by adverse productivity shocks. The net effect of lower dismissal costs and higher wage flexibility is that job losses among older workers become fairly small. Since this is accompanied by hefty job gains for young workers, unemployment declines substantially (Figure 2).

Figure 2

Reform 1 brings in positive effects much earlier that Reform 2. Foremost, 87% of workers support it (almost 100% of young/prime age workers and 27% of older workers).

When comparing the effects of the single/unified open-ended contract to the employment protection legislation reform implement by the Spanish conservative government in 2012 welfare gains are twice as large under the former (1.7% vs. 0.86%).

To limit the uncertainty stemming from a permanent contract worker’s appeal to labour courts (something that temporary workers are not entitled to), we argue that, as in the recent Italian Jobs Act, combining single/unified open-ended contract compensations exempted from income taxes with higher but taxed severance pay for unfair dismissals could be a fruitful employment protection design to eliminate the scourge of high employment protection legislation gaps in dual labour markets.

References

Bentolila, S, P Cahuc, J Dolado, and T Le Barbanchon (2012a), “Two-tier labour markets in the Great Recession: France versus Spain”, The Economic Journal 122(562): F155–F187.

Bentolila, S, T Boeri and P Cahuc (2012b), “Ending the Scourge of Dual Labour Markets in Europe”, VoxEU, 12 July.

Blanchard, O J and A Landier (2002), “The perverse effects of partial labour market reform: Fixed-term contracts in France”, The Economic Journal 112(480): F214–F244.

Blanchard, O J and J Tirole (2008), “The joint design of unemployment insurance and employment protection: A first pass”, Journal of the European Economic Association 6(1): 45–77.

Cahuc, P (2012), “For a unified contract”, European Labour Law Journal 3(3): 190–205.

Cahuc, P and F Postel-Vinay (2002), “Temporary jobs, employment protection and labor market Performance”, Labour Economics 9(1): 63–91.

Dolado, J (2016), “EU Dual Labour Markets: Consequences and Potential Reforms”, in R Blundell (ed.) Economics without Borders. Economic Research for European Policy Challenges. COEURE project, Cambridge University Press.

Dolado, J, C García-Serrano, and J F Jimeno (2002), “Drawing lessons from the boom of temporary jobs in Spain”, The Economic Journal 112(480): F270–F295.

Dolado, J, E Lalé and N Siassi (2015), “Moving towards a Single Labour Contract: Transition vs. Staedy State”, CEPR Discussion Paper 11030.

García Pérez, I J and V Osuna (2014), “Dual labour markets and the tenure distribution: Reducing severance pay or introducing a single contract”, Labour Economics 29: 1–13.

Lalé, E (2015), “Penalty vs. insurance: A reassessment of the role of severance payments in an economy with frictions”, University of Bristol DP No. 15/648.

OECD (2014), Employment Outlook 2014

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Topics:  Labour markets

Tags:  employment protection, Contracts, contract law

Professor of Economics, EUI and Universidad Carlos III de Madrid; and CEPR Research Fellow

Assistant Professo, Dept. of Economics, University of Bristol

Assistant Professor of Economics, University of Konstanz

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