The Employment Effects of Severance Payments with Wage Rigidities∗

Firing costs due to employment protection legislation have two separate dimensions: a transfer from the firm to the worker to be laid off and a tax paid outside the firm-worker pair. We document that quantitatively transfers are a much larger component than taxes. Nevertheless, to avoid the “bonding critique” most of the existing literature overlooks the transfer component by making the implicit assumption that, in the presence of wage rigidity, mandatory severance payments have the same real effects as firing taxes. This paper shows, in the context of a search model with insider and outsider workers, that this presumption is in general misplaced: the impact of severance payments on unemployment is qualitatively different from that of firing taxes, and it varies according to the bite of the wage rigidity. When the wage rigidity is endogenously determined by a centralized monopoly union of insiders, severance payments are either neutral or they increase unemployment, depending on the union’s coverage of outsiders’ contracts. This prediction finds empirical support in a panel data-set of OECD countries.