Employment protection and labour market turnover

Winfried Koeniger , Julien Prat

29 August 2007



Employment protection legislation (EPL) is a set of mandatory restrictions governing the dismissals and recruitments of employees. The stated purpose of these restrictions is to improve job security. According to dynamic models of labour demand (Bertola and Bentolila, Review of Economic Studies, 1990, Ljungqvist, Economic Journal, 2002), EPL fulfills its purpose: more stringent regulations reduce both firing and hiring of workers and thus employment flows. The predictions for employment stocks, as well as unemployment, are ambiguous instead. They depend on whether EPL lowers the recruitment activity more than the number of layoffs (Cahuc and Zylberberg, Labor Economics, 2004, MIT Press, chapter 12.2, give a simple exposition)

What is the empirical evidence?

The ambiguity of the relationship between EPL and aggregate employment is supported by cross-country data. Regressions based on panels of OECD countries typically find that the correlation between EPL and unemployment has an ambiguous sign and is not significant, as suggested by the theory. Evidence for the negative impact of EPL on job flows, however, remains more elusive. OECD measures for aggregate job flows are only loosely correlated with the stringency of EPL. A set of papers contained in the feature of the Economic Journal (June 2007) sheds new light on these issues.

New evidence based on micro-data

Autor, Kerr and Kugler, MacLeod and Nakavachara, Messina and Vallanti use recently available worker and firm level data for the US and European countries to measure the effect of EPL on employment changes, job turnover, firm dynamics as well as productivity of skilled and unskilled workers.

Messina and Vallanti find that stricter EPL reduces job turnover, but this effect is smaller in faster-growing sectors as theory would predict. Most importantly, EPL makes job turnover less counter-cyclical. This is also in accord with theory if job destruction is immediate but hiring takes time so that, in the absence of EPL, job turnover is higher in recessions. As stricter EPL reduces firing in recessions, job turnover becomes less counter-cyclical.

The negative effect of dismissal protection on job flows is confirmed by Autor, Kerr and Kugler who exploit time variation in legislation on wrongful discharge protections across US states. The good-faith exception in that legislation prevents employers from firing workers for “bad cause”. The implied-contract exception instead applies if an employer implicitly promises not to terminate the contract of a worker without “good cause”. Autor, Kerr and Kugler find that the good-faith exception has a negative effect on employment flows. Part of this negative effect can be attributed to less firm entry. Moreover, the good-faith exception seems to increase firms’ capital intensity. This raises labour productivity but reduces total factor productivity. The stronger use of capital as production input is accompanied by a shift of employment towards non-production workers.

One may attribute this employment shift to substitution of low-skilled workers if the wrongful discharge laws imply larger costs for low-skilled workers. MacLeod and Nakavachara offer an alternative interpretation for this result. If contracts between workers and firms are incomplete, wrongful discharge laws may enhance employment in occupations which are characterised by high levels of human-capital investment. MacLeod and Nakavachara find that both the good faith and the implied-contract exception have a larger negative employment effect for occupations characterised by small levels of specific investment in the employment relationship. The estimates for the good faith exception suggest even a positive employment effect but no significant effect on wages for occupations which involve high human-capital investment.

This empirical evidence gives some interesting first clues about the effect of EPL at the worker and firm level. In particular, it shows that there are substantial differences across worker skill-types and firms. This raises another important question. Since the types of firms which operate in the market may depend on the structure of product and financial markets, a broader perspective on the effects of EPL may be called for. Our paper on the interactions between Product Market Regulation (PMR) and EPL takes a first step in this direction (Koeniger and Prat, Economic Journal, 2007).

Interactions of EPL with regulation in product markets…

Recently compiled indicators on PMR by Nicoletti and Scarpetta (Economic Policy, 2003) reveal that the same OECD countries which have strict EPL also have much more regulated product markets. Since larger entry costs or administrative burden imply that a different selection of firms operates in countries with strict EPL, it is important to account for this selection effect when comparing the impact of EPL across countries. In our paper, we show how selection can generate opposite and countervailing effects of firing costs, sunk entry costs and bureaucratic flow costs on firms as well as job turnover. This helps to explain why both firm and job turnover rates are so similar across OECD countries with very different regulation in labour and product markets.

…and financial markets

Finally, it is important to bear in mind that financial-market development matters for the welfare effects of labour market deregulation, such as a relaxation of EPL. Since turnover and income insecurity is all the more painful for workers if they lack access to consumption-smoothing instruments (Bertola, Review of Economic Studies, 2004), labour market deregulation need not improve the economy’s ability to deliver welfare to its citizens unless accompanied by reforms aimed at easing borrowing constraints. Accordingly, it is not surprising to witness heavy resistance to labour market liberalisation in countries in which credit supply remains relatively constrained, such as Italy, while the United Kingdom’s financial market development may well have allowed that country to drastically reform its labour market in the 1980s. Interestingly enough, international opinion-survey data reveal that younger and lower-income individuals express stronger support for government intervention in countries where consumer credit is less easily available (Bertola and Koeniger, European Economic Review, forthcoming). This evidence is suggestive since such individuals are more strongly affected by tighter credit supply, in that expectations of higher incomes in the future increase their propensity to borrow.


Recent research shows that EPL has quite different effects across worker and firm types. The results suggest that less skilled individuals bear most of the adverse consequences of EPL in terms of a lower quality and quantity of employment. Similarly, EPL seems to drive small or less efficient firms out of the market. Policy makers trying to reform EPL should therefore strive to take these differences and the interactions with the structure in product and financial markets into account.



Topics:  Labour markets

Tags:  employment, Employment Protection Legislation

Professor of Economics, University of St. Gallen; Research Fellow, Center for Financial Studies and IZA; Research Affiliate, CEPR

Assistant Professor at the Economics Department of Vienna University