Labour Market Regulation, Flexibility and Employment

Chronic unemployment and slow employment growth in some countries have led to calls for more labor‐market “flexibility”. This paper defines the flexibility issue in terms of legally‐mandated “severance”, a generalized employment cost linked to seniority. A mandated severance benefit can stand for a variety of programs including employer‐provided employment guarantees, payments which must be made to laid‐off workers, and compensation for wrongful discharge. Such a mandated cost can be seen as a payroll tax on the employer, raising the issue of tax incidence. Employers often take the view that labor costs are given and that mandated costs are simply add‐ons to pre‐existing cost levels. However, the literature on tax incidence suggests that a significant portion of “employer‐paid” payroll taxes are shifted to labor in the form of lower wages. Such shifting should reduce the dis‐employment effects attributed to severance. A model is provided of a firm upon which a severance mandate is imposed. Even at the micro level, the firm can shift some of the cost of severance to employees by lowering wages — although at the expense of higher turnover costs associated with increased quit rates. At the macro level, to the extent that firms reduce employment, there could be still further downward wage adjustments which would shift the severance burden to labor and mitigate the dis‐employment effect. Ultimately, if the natural rate of unemployment is raised by severance mandates, the age‐old question is raised of why wages do not fall in the face of labor surpluses. The true inflexibility to be explained, therefore, is in wage determination.