Reforming employment protection

Olivier Blanchard Professor of Economics Massachusetts Institute of Technology (MIT) Project Syndicate

There may be no labor market institution more controversial than employment protection regulation -- the complex set of laws and procedures that govern how firms hire and fire workers.

Firms complain not only about the direct cost, but also about the complexity and the uncertainty introduced by such regulation. They argue that regulatory constraints make it difficult for them to adjust to changes in technology and product demand, and that this in turn lowers their efficiency, raises their costs and, as a result, deters job creation.

Workers, on the other hand, focus on the pain of unemployment, and argue that such pain should be taken into account by firms when they consider closing a plant or laying off a worker.

Under pressure from firms to decrease protection, and from workers to maintain it, European governments have navigated carefully, looking for politically acceptable reforms. In most countries, reforms have included extending the scope for temporary contracts.

This would seem like a smart solution, both politically and economically. Politically, it maintains high protection for those workers who are already protected. Economically, easier recourse to temporary contracts gives firms more flexibility in adjusting to changing market conditions.

But the evidence on the effects of these reforms is mixed. The existence of two classes of workers -- those on permanent versus temporary contracts -- has led to an increasingly dual and unequal labor market.

Firms are typically reluctant to keep workers on when their temporary contracts end, as this would imply giving them high employment protection. So new entrants to the labor market go through a long period of dead-end jobs and stretches of unemployment before they eventually get a stable job -- not the best way to start their working life.

From a political point of view, the fact that the majority of workers remains highly protected, and that firms have more flexibility than before, decreases the pressure for coherent, across-the-board reform.

Ignore political feasibility for the moment, and ask what "good employment protection" should look like. The answer is actually simple. When deciding whether to lay off a worker, a firm should take into account the social costs of doing so.

This means taking into account the benefits that the unemployment insurance fund will have to pay the worker. At least for workers with seniority in a firm, it also means taking into account the psychological costs associated with losing a long- held job.

How can such "social accounting" be done? Again, simplicity rules. If a firm lays off a worker, it should pay a layoff tax that is equal, at least on average, to the unemployment benefits that will be paid to the laid-off worker; to compensate for psychological costs, it should pay severance payments that increase in line with workers' seniority.

If, under these conditions, a firm decides to layoff a worker, it should be free to do so. Simply put, if firms find it more profitable to close a job or a plant even after paying the social costs of their decision, then it does not make sense to keep that job or plant open.

How does this answer compare to the way employment protection is currently designed? The answer varies from country to country, but the case of France is representative.

In France, unemployment contributions are collected through a payroll tax, not a layoff tax. This means that firms that lay off more workers do not pay more. But firms that lay off more workers should pay more.

At the same time, the judicial process is such that judges have a substantial say in deciding whether a layoff decision is justified. This is also wrong: Not only does it lead to a long, uncertain process, but there is no reason for judges to be involved in the first place.

So employment protection reform should involve a shift from a payroll tax to a layoff tax, accompanied by a reduction in the role of judges. Judges should make sure that rules are followed, but if a firm is willing to satisfy administrative requirements, pay the layoff tax, and make severance payments, they should not be able to second guess the firm's decision.

How complicated would it be to shift from a payroll tax to a layoff tax? Ironically, the answer comes from America, where the financing of unemployment insurance is indeed done through layoff taxes. The generosity of the U.S. system -- and hence the burden of layoff taxes -- is limited. Benefits and taxes would be higher in Europe, but America's system indicates that it can be done.

This forces us to return to the question of whether such a reform is politically feasible. I believe it is. Higher layoff taxes, which force firms to think twice before laying off, would be welcomed by workers, while lighter and more predictable regulation of employment relations would surely be welcomed by firms. The political road is narrow, but it may exist, and the economic and social rewards of finding it would be very high.