Academic journal article Contemporary Economic Policy

Turning Pink Slips into Red Tape: The Unintended Effects of Employment Protection Legislation

Academic journal article Contemporary Economic Policy

Turning Pink Slips into Red Tape: The Unintended Effects of Employment Protection Legislation

Article excerpt

This article presents evidence on the link between employment protection legislation (EPL) and the rate of unemployment in a cross-country panel dataset of Organisation for Economic Co-operation and Development countries from 1985 to 2013. We use both a traditional panel specification with lags of the policy variable, and also a unique structural panel vector autoregression (PVAR) method to determine the long-run dynamic interaction between EPL and unemployment. We confirm that more restrictive EPL for permanently employed workers causes a significant and persistent increase in unemployment, but the effect is only apparent at long-lag lengths, some 2-5 years after the law has been implemented. (JEL J68, J65, J63)

I. INTRODUCTION

Over the past 5 years, there has been a considerable effort on the part of many developed countries including Spain, Estonia, the United Kingdom, Italy, and Portugal, to reduce the costs imposed on employers associated with hiring workers. While labor legislation debates typically revolve around the use of unemployment benefits and their distortionary effects on workers' labor-leisure allocation, relatively less attention is paid to the effects of employment protection legislation (EPL), which is designed to protect the worker from losing his or her job by imposing additional costs on employers who fire their workers. These policies include state-mandated severance packages for firing workers, lengthy prior notice to terminated employees, and other administrative costs associated with dismissal.

The purpose of this article is to determine whether the passage of additional EPL increases the rate of unemployment in a country, an effect that the prior literature has had difficulty confirming. To address this question, we present a fixed-effect panel model with lags of the policy variable and a panel vector autoregression (PVAR) specification which, to our knowledge, has not been used to address this question. The reason for the policy lag is that the choice of policy is not independent of the unemployment rate. Policymakers will base their legislative decisions in part on the current unemployment rate, thus any model that estimates the contemporaneous relationship between EPL and unemployment will have estimates that are biased and inconsistent due to simultaneity bias. The choice of policy, however, will be unrelated to the future unemployment rate because it is unobserved at the time the choice of policy is made. The policy lags also allow us to construct the basis for a long-run adjustment mechanism.

Even though we could conceivably identify a contemporaneous effect through the use of instrumental variables, focusing on the contemporaneous effect obscures much of the total effects of employment protection. For example, consider the passage of an employment protection law. In the short run, it is improbable that firms would immediately begin firing workers because of the costs of immediately changing output decisions, in addition to the additional penalties resulting from firing workers under the new legislation. Thus in the short run, we should expect very little increase in unemployment, even if the effect is correctly identified. Instead, we expect that any interesting structural change in the unemployment rate will occur in the long run, and perhaps very far off into the future. This is because firms will more likely wait for workers to leave their positions voluntarily and then simply close the vacancy if they do not want to incur the cost of potentially firing the new worker. This means that previous research that focuses on the contemporaneous effect underreports the true impact on unemployment, even if the effect is correctly identified and estimated. In fact, if the effect is strong enough, we may even observe a temporary drop in the unemployment rate if businesses find it too costly to fire workers in the short run leading to an incorrect assessment of the policy's effects. …

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