12 Reforming Labor Market Institutions: Unemployment Insurance and Employment Protection

Abstract

Abstract This chapter explores the characteristics of both optimal and actual unemployment insurance and employment protection. It then sketches potential paths for reforms in both rich and middle-income countries. There is a role for both state-provided unemployment insurance and employment protection. In rich countries, one challenge is to combine unemployment insurance with strong incentives for the unemployed to take jobs. The other challenge is to redefine employment protection by reducing administrative constraints and judicial intervention, and relying more on financial incentives. In middle-income countries, the main challenge is to move from the current system of high severance payments and employment protection to a system of state-provided unemployment benefits and lower severance payments. Modern economies are characterized by high levels of job creation and job destruction: such reallocation is central to productivity growth. Job destruction risks unemployment. Private markets, left to themselves, do a poor job of protecting workers. This suggests a potentially welfare-improving role for state intervention, through the joint design of unemployment insurance and employment protection. Designing and putting in place the right institutions is a complex task. The evidence is that many rich countries, particularly in Europe, have done a poor job. The mistakes they made have led both to poorly functioning labour market, and high unemployment. It is therefore essential to take a step back and think about the optimal design of labor market institutions. European countries already have a complex set of labour market institutions; reforms mean transforming existing institutions. Poorer countries, such as those in Latin America have more embryonic labour market institutions to start, and more limited institutional capability; reforms mean putting in place new, potentially simpler, institutions. The goal of this chapter is to explore these themes.