Firing costs have two separate dimensions: a transfer from the firm to the laid-off worker and a tax paid outside the firm-worker pair. To avoid the 'bonding critique' most of the existing literature implicitly assumes that, in the presence of wage rigidity, transfers have the same real effects as taxes. This paper shows that this presumption is in general misplaced, especially so when the degree of wage rigidity is endogenous. The predictions of our theory find empirical support in a panel data-set of OECD countries. Job security provisions are a set of rules and restrictions governing the dismissals of employees. A careful look at the employment protection legislation (EPL) throughout developed countries shows that such provisions impose a 'firing cost' to the firm that has two separate dimensions: a transfer from the firm to the worker to be laid off, and a tax to be paid outside the job-worker pair.1 Since the classical work of Lazear (1988, 1990), it is well known that, in the absence of contractual and market frictions, a government-mandated pure transfer (e.g., a severance payment) from the firm to the dismissed worker can be neutralised by an appropriately designed wage contract: the firm reduces the entry wage of the worker by an amount equal to the expected present value of the future transfer, so as to leave the expected cumulative wage bill arising from the employment relationship unchanged. This powerful theoretical result - typically named the 'bonding critique' has led the vast majority of researchers to conceptualise firing costs as taxes.2 Taxes represent real costs on labour shedding paid outside the firm-worker pair and, as such, cannot be undone by side negotiations. Ljungqvist (2002) provides a comprehensive overview of the various models studying the effects of layoff taxes on unemployment. Some firm conclusions have been established in this literature. Notably, a firing tax reduces the layoff rate and unemployment incidence by making firing more costly to employers, and increases unemployment duration because the larger labour * The article was started when Violante was a visiting scholar in the IMF's Research Department. We are particularly indebted to Pietro Ichino, Alessandro Lizzeri and Chris Pissarides for useful discussions, and to the Editor and three anonymous referees for suggestions that greatly improved the paper. We thank Guilio Fella, Michele Belot and Jan van Ours for allowing us to use their dataset. Violante acknowledges the support of the CV Starr Center at NYU. 1 The transfer component includes institutions such as the requirements to provide the worker with advance notification, with severance payments for no-fault dismissal, and with other monetary compensations for unfair dismissal. The tax component is a set of administrative restrictions and procedures that the firm has to obey if it wants to lay off. It includes pure red tape costs, legal expenses in case of a trial and any financial penalties imposed by a ruling judge. See OECD (1999) for a recent survey of the literature and an update of the EPL indicators. 2 Bertola and Rogerson (1997, p. 1149) call it the 'standard view of firing costs'.
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Jan 1, 2022
Mikael Carlsson + 1
Open Access
