Abstract
We analyze the effects of mandated severance payments in an economy with search and matching in the labor market, risk-averse individuals and imperfect insurance against shocks. Our model emphasizes a tension between efficient worker-firm bargains and consumption smoothing: a well-designed contract dictates a downward shift in entry wages to offset expected severance payments, and thus goes against having a smooth consumption path. As a result, we find that severance payments produce mostly negative welfare effects. There are large allocation and welfare effects in the absence of savings which limits the response of wages to severance payments. With savings, the impact on equilibrium allocations is considerably dampened, but the welfare losses remain substantial.
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