Employment protection legislation

Some economists have claimed that empirical evidence gives support to their theories, according to which EPL leads to a segmentation in the labour market between the so-called insiders, the workers with a protected job, and the outsiders, who are people that are either unemployed or employed with fixed-term, part-time or temporary contracts, or even in the black economy, and face big difficulties to find a job covered by EPL because of the firms’ reduced propensity to hire. This latter group is mainly constituted by youths, women, racial minorities and unskilled workers.[3]

Whether EPL has any effect on unemployment is an issue of contention between economists. On the one hand, assuming that the cyclical wage pattern is not affected by mandated firing costs, EPL reduces the propensity to hire by employers, since they fear that such decisions will be difficult to reverse in the future, in case of a recession. On the other hand, EPL also leads firms during downswings to keep more workers employed, than they would have otherwise done. Therefore, EPL reduces both job creation and job destruction, so that the net effects on average employment and unemployment are not identifiable a priori. What is instead agreed among economists, is that more stringent EPL lowers the fluctuations in the quantity of labour demanded over the business cycle, leading to smoother dynamic patterns of those aggregates.[3]

Economists considering that EPL has no effect on unemployment include Blanchard and Portugal (2000).[6] In their article they compare two opposite countries as regards their EPL stance: Portugal with one of the more strict legislations in the world and the US with one of the more flexible ones. In spite of these differences, both countries have similar unemployment rates which undermines the argument considering that EPL has any effect on unemployment. Instead, the authors claim that EPL does affect two other variables: job flows and unemployment duration. EPL would reduce job flows (from employment to unemployment: employers are less willing to fire, given that they must pay indemnizations to workers) therefore reducing unemployment but would increase unemployment duration, increasing the unemployment rate. These two effects would neutralize each other, explaining why overall, EPL has no effect on unemployment.

Nickell (1997)[7] arrived to similar conclusions when stating that labor market rigidities that do not appear to have serious implications for average levels of unemployment included strict employment protection legislation and general legislation on labor market standards.

Among those that have found evidence suggesting that EPL increases unemployment are Lazear (1990).[8] The author argued that mandated severance pay seemed to increase unemployment rates. His estimates suggested that an increase from zero to three months of severance pay would raise the unemployment rate by 5.5 percent in the United States.

Lazear (1990)[9] once again argues he has evidence suggesting that EPL reduces the employment-to-population ratio. In his article he claims that the best estimates suggest that moving from no required severance pay to three months of required severance pay to employees with ten years of service would reduce the employment-population ratio by about one percent. In the United States that would mean over a million jobs. Lazear argues that the young could bear a disproportionate amount of the burden.

To the contrary, Bertola and Bentolila (1990)[10] found evidence supporting the idea that firing costs have a larger effect on firms' propensity to fire than to hire, and therefore (slightly) increase average long-run employment.

Several authors have found that EPL has significant effects on wages. As stated by Lazear (1990),[11] in a perfect labor market, severance payments can have no real effects as they can be undone by a properly designed labor contract. Leonardi and Pica (2006) found evidence supporting this claim. They suggest that in the case of Italy an EPL reform in 1990 had as effect to reduce entry wages by 6 percent, implying that firms tend to transfer the increase in the cost of firing (due to EPL) onto workers. In fact, in their study they find that 25 percent of the firing cost was shifted onto lower wages in the case of Italy.[12] Similarly, Brancaccio, Garbellini, and Giammetti (2018) found that EPL reductions have no significant links with real GDP growth whereas they are significantly correlated with wage share reductions.[13]

In principle the effects on profits are ambiguous. Because of EPL, firms engage themselves in labour hoarding practices, which lead them to employ a lower quantity of workers during upswings, while keeping inefficient levels of employment in downturns. For a given level of wages, this loss of productive efficiency would result in lower average profits. On the other hand, if firms operated in a context of efficiency wages, by inducing more stable relationships with the workers and reducing their job and income insecurity, EPL could allow them to pay lower wages, without reducing the effort provided by the labour force employed, with beneficial effects on profits.[3]

There appears to be agreement among economists on the positive correlation between product market and employment regulation. Although employment protection legislation is only one aspect of the wide range of regulatory interventions in the labour market, Nicoletti et al. (2000) find evidence suggesting that, across countries, restrictive regulatory environments in the product market tend to be associated with restrictive employment protection policies. They claim that the indicators presented in their paper are closely related, with a statistical correlation of 0.73 (significant at the 1% level). In other words, according to these results, restrictive product market regulations are matched by analogous EPL restrictions to generate a tight overall regulatory environment for firms in their product market as well as in the allocation of labour inputs. The strong correlation between regulatory regimes in the product market and EPL also suggests that their influence may have compounded effects on labour market outcomes, making regulatory reform in only one market less effective than simultaneous reform in the two markets.[14]

Kugler and Pica (2003) find similar results in the case of the Italian economy. They present a matching model which illustrates how barriers to entry in the product market (product market regulation) mitigate the impact of labor market deregulation, (that is, mitigate the effects of a reduction in the strictness of EPL). In the author's opinion, this means that there are economic complementarities between labor and product market policies in their model, in the sense that the effectiveness of one policy depends on the implementation of the other policy. Thus, an important implication of their model is that labor market deregulation will be less effective in the presence of heavier regulations of entry.[15] Similar results are obtained by Koeniger and Vindigni (2003).[16]

Whereas EPL may have not a significant effect on unemployment, strict EPL gives incentives to the firms to resort to other sources of flexibility like overtime, which, as shown by Abraham and Houseman (1994),[17] indeed tends to be used much more in Continental European countries, where the variability of hours per worker is significantly higher than in the Anglo-Saxon labour markets.