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European Economic Review 49 (2005) 2057–2077 www.elsevier.com/locate/econbase

The effects of employment protection: Learning from variable enforcement
Tito Boeria, Juan F. Jimenob,Ã
b

` Universita Bocconi-IGIER, Milan, Italy ´, FEDEA and Universidad de Alcala Jorge Juan 46, 28001 Madrid, Spain Received 12 June 2003; accepted 29 September 2004 Available online 23 November 2004

a

Abstract Employment protection legislation (EPL) is not enforced uniformly across the board. There are a number of exemptions to the coverage of these provisions: firms below a given threshold scale and workers with temporary contracts are not subject to the most restrictive provisions. This within-country variation in enforcement allows us to make inferences on the impact of EPL which go beyond the usual cross-country approach. In this paper we develop a simple model which explains why these exemptions are in place to start with. Then we empirically assess the effects of EPL on dismissal probabilities and on the equilibrium size distribution of firms. Our results are in line with the predictions of the theoretical model. Workers under permanent contracts in firms with less restrictive EPL are more likely to be dismissed. However, there is no effect of the exemption threshold on the growth of firms. r 2004 Elsevier B.V. All rights reserved.
JEL classification: J63; J65 Keywords: Efficiency wages; Employment protection and job loss

ÃCorresponding author. Tel.: +34 91 4350 401; fax: 34 91 5779 575.

E-mail address: jimeno@fedea.es (J.F. Jimeno). 0014-2921/$ - see front matter r 2004 Elsevier B.V. All rights reserved. doi:10.1016/j.euroecorev.2004.09.013

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1. Introduction The purpose of this paper is threefold (i) to extend standard models of employment protection legislation (EPL) allowing for disciplinary as well as economic dismissals, (ii) to explain why EPL is typically not enforced in the case of small units and (iii) to provide new evidence on the relationship between strictness of EPL and job loss as well as EPL thresholds and growth of firms. Unlike previous studies drawing on cross-country variation, in this paper inferences are made by exploiting the within-country variation in the enforcement of EPL. Regulations on dismissals typically allow for a threshold scale (generally defined in terms of the number of employees) below which the most restrictive EPL provisions (e.g., the compulsory reintegration in case of unjustified dismissal) are not enforced, the legal procedures for firings are eased, or severance payments are diminished. In this paper we develop a simple theoretical model to illustrate the rationale for these exemptions, and use this discontinuity in regulations (as well as the divide between fixed-term and permanent contracts) to infer the effects of EPL within a double-difference approach. The vast theoretical literature on EPL does not take into account that legal restrictions to dismissals affect both economic and disciplinary dismissals. In an ` efficiency wage environment a la Shapiro and Stiglitz (1984), this observation is very important because the likelihood of disciplinary layoffs deters workers from shirking, whilst the probability of economic layoffs affects positively the efficiency wage the employer has to pay in order to induce workers not to shirk. This is because a higher risk of being dismissed per any given level of effort reduces the penalty associated with the fact of being caught shirking. Hence, insofar as EPL negatively affects disciplinary layoffs, it increases the efficiency wage; when EPL instead acts mainly on economic layoffs, it reduces the efficiency wage. As monitoring effectiveness is decreasing in firms’ size, this simple intuition explains the presence of threshold plant levels below which EPL is only mildly enforced. It would just make it too costly for small units to operate. The vast empirical literature on EPL (surveyed in OECD, 1999, 2004) typically uses a cross-country approach in assessing the effects of EPL on labour markets. However, cross-country (and often pair-wise) correlations of indicators of the strictness of EPL with measures of labour market performance cannot disentangle the effects of EPL per se from the effects of EPL when interacted with other institutions. Previous work— i.e., Bertola and Rogerson (1997), and Layard and Nickell (1999)—suggests that the effects of EPL on labour market performance interact with other institutional features, such as wage compression induced by collective bargaining, unemployment benefits and statutory minimum wages or the effects of early retirement and ‘‘soft’’ landing schemes. In a cross-country and multivariate regression framework it is not possible to take into account all of the relevant institutional interactions, owing to the few degrees of freedom available (there are no time-series for many institutions), and measurement problems, which are particularly serious having mainly to do with ordinal measures (country rankings) of institutions, developed out of qualitative information on regulations. In this paper—as in Garibaldi et al. (2004) and Kugler and Pica

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(2003)—we exploit within-country variation in the enforcement of EPL. This is a clear improvement with respect to the above literature insofar as the different institutions interacting with EPL are invariant across observations or, at least, do not have the same cross-sectional variation as EPL. Firstly, we model the exemptions and EPL rules, and then develop our empirical framework. The model sheds light on the rationale and political support to these exemptions. It extends the standard models of adjustment costs for labour used by most of the EPL literature, allowing for imperfect monitoring of workers’ effort. To keep things simple we rule out adverse selection and assume that workers are homogeneous, so that in equilibrium there is no shirking. Our main theoretical results can be summarised as follows. From a theoretical perspective, EPL has ambiguous effects on wages: on the one hand, employment protection reduces the likelihood of exogenous (economic) dismissals thereby reducing the wage levels which can deter shirking; on the other hand, EPL also makes it difficult to dismiss undisciplined workers, and this reduces the credibility of the threat of dismissal for those shirking, forcing employers to pay higher wages in order to discourage opportunistic behaviour by their workers. The first effect tends to dominate in large units, whilst the wage enhancing effect dominates in small organisations that can monitor workers’ performance better. Thus, exempting small firms from EPL reduces the negative employment effects of employment protection. From a political economy perspective, EPL can only be accepted in large units, as in small firms EPL stabilises employment at levels which can be lower than in a flexible regime under the bad state of the world. Empirically, we show that the Italian EPL threshold scale does not significantly affect employment growth of firms while it affects the distribution of dismissal rates by plant size. More precisely, exemptions from EPL induce a discontinuity in the relation between size of firms and likelihood of being dismissed, but not in the yearto-year probability that units increase their work-force. Our results are obtained by taking a double-difference approach. We compare the estimated dismissal probabilities along two dimensions: firstly the coverage of EPL (workers in units with less than 15 employees are not covered by EPL); secondly, the fact of having a permanent or a temporary contract (as workers under temporary contracts are not covered by EPL, independently of firm size). In estimating the effects of EPL on employment growth we once again use the 15-employees threshold as well as the fact that in 1990 some regulations were tightened exclusively for establishments with less than 15 employees. The plan is as follows. Section 2 reviews the literature. Section 3 develops a simple model rationalising exemptions from EPL of small units. Section 4 provides details of exemptions from EPL in Italy, describes the data and displays our estimates. Section 5 concludes.

2. (Cross-country) empirical ambiguities Fig. 1 reviews the empirical literature on the effects of EPL on the labour market. A few studies found significant effects of employment protection (generally

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STOCKS Employment Unemployment ? ? + ? ? ? ? ? ? ? ? ? ? ? ? ? + ? + ? + FLOWS Unemployment -

Authors(s) Emerson (1988) Lazear (1990) Bertola (1990) Grubb & Wells (1993) Garibaldi, Konings, Pissarides 1997) Addison & Grosso (1996) Jackman, Layard, Nickell (1996) Gregg & Manning (1997) Boeri (1999) Di Tella & McCulloch (1999) OECD (1999) Kugler &Saint-Paul (2000)

Employment -

?

-

Fig. 1. Survey of empirical evidence on EPL from cross-country data. [Emerson, 1988; Lazear, 1990; Bertola, 1990; Grubb and Wells, 1993; Garibaldi et al., 1997; Addison and Grosso, 1996; Jackman et al., 1996; Gregg and Manning, 1997; Boeri, 1999; Di Tella and McCulloch, 1999; OECD, 1999; Kugler, 2000].

measured using the OECD cross-country ranking) on employment and unemployment stocks, while a robust finding of this literature is that EPL negatively affects unemployment inflows and outflows. No unambiguous result is obtained concerning the impact of EPL on labour (the sum of hirings and separations) and job (the sum of job creation and destruction) turnover, although economic theory unambiguously predicts a negative effect of the strictness of employment protection on labour market flows. Explanations of this discrepancy between theory and facts—e.g., Bertola and Rogerson (1997) and Boeri (1999)—typically call into play the interaction of EPL with other institutional features as well as measurement error. For instance, it is argued that institutions compressing wage structures tend to counteract the negative effects of EPL on labour market flows because they reduce the scope of price-driven adjustment mechanisms. These potential interactions with other institutional features question the relevance of many findings, which are all based on pair-wise correlations. Measurement problems stem from the fact that there is quite a substantial within-country variation in the actual enforcement of regulations, which is not captured by cross-country analyses. From the above it follows that empirical work should preferably use data referred to the same country and exploit any time-series available for regulations. No reform of EPL was carried out on a stock basis, adjusting regulations for all workers with regular contracts. The type of reforms of EPL which have been implemented have only been enforced at the margin, adding new flexible contractual types to the existing ‘‘rigid’’ ones. These asymmetric reforms yield dual labour market regimes in which a flexible segment of the work-force coexists with a rigid one. Contrasting the behaviour of the two segments is not sufficient to identify the effects of EPL because there are rather obvious links between the two components of the work-force, investigated by the literature. In particular, Bentolila and Dolado (1994) argue that flexible contracts provide a buffer stock to firms, insulating permanent workers from employment adjustment in response to exogenous shocks. Studying the effects of

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EPL under dual regimes may then induce one to overstate the impact of these regulations. However, dual regimes can be used in difference-in-differences policy evaluation studies.1 Another dimension of within-country variation is the exemption of small units from the strictest EPL provisions. These exemptions are present in all countries with otherwise very restrictive EPL. In order to empirically exploit this within-country variation in EPL we first need to understand why these exemptions are in place. This is important for defining a suitable empirical framework and for interpreting the results from difference-in-differences analyses. Previous studies using firm-size thresholds to make inferences as to the effects of employment protection on labour market outcomes—e.g., Bauer et al. (2004), Garibaldi et al. (2004), Kugler and Pica (2003) as well as Schivardi and Torrini (2003)—found hardly any effect of EPL on employment dynamics. However, the above-mentioned studies did not investigate the rationale for these exemptions, which may well be defined in such a way as to minimise undesirable effects of EPL on labour market outcomes. Studies not acknowledging the role played by exemptions of small firms may be looking for the ‘‘wrong’’ type of effects or give little guidance on interpreting results obtained in a neighbourhood of the exemption thresholds. Hence, the task set out for the next section is to provide a rationale for the firm-size thresholds in the enforcement of EPL.

3. Why are small firms exempted from EPL? In this section we extend models of EPL disentangling economic from disciplinary layoffs. This extension is essential to understand why EPL has asymmetric effects on small and large firms. Our theoretical framework is a partial equilibrium and dynamic efficiency wage model, inspired by Saint-Paul (1998). We distinguish between layoffs justified on economic grounds and firings for disciplinary reasons. Firm size is relevant for monitoring and, hence, for the probability of being fired. EPL applies to both types of dismissal, as the burden of proof rests on the firm and it is generally much easier to support layoffs on economic rather than on disciplinary grounds. 3.1. The model without EPL 3.1.1. No-shirking condition All workers are alike. Their utility is linear in earnings and effort: ut ¼ wt À et ; (3.1)

where w is the wage and e is effort, which, for simplicity, is assumed to be a discrete variable ðe ¼ 0; 1Þ: Effort is imperfectly monitored by firms. If a worker chooses to
1

See, for example, Kugler (1999) as well as Kugler et al. (2003).

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exert effort, her value function is given by V ns ¼ wt À et þ d½ð1 À pns ÞE t V tþ1 þ pns U tþ1 Š; t t t (3.2)

where pns is the probability of being dismissed for economic reasons, d is the discount t factor and U t is the asset value of unemployment, notably U t ¼ b þ d½rE t V tþ1 þ ð1 À rÞU tþ1 Š (3.3)

being b the (flat) unemployment benefit and 0oro1 the (exogenous) outflow probability from unemployment into employment.2 The asset value of being employed and shirking is given by V s ðlÞ ¼ wt þ d½ð1 À ps ðlÞÞE t V tþ1 ðlÞ þ ps ðlÞU tþ1 Š; t t t (3.4)

where ps ðlÞ4pns is the probability of being laid-off if not exerting effort in a firm of t t size l: Detection technologies are dependent on the size of firms. In particular, let ¯ dodðlÞp1 be the probability of being caught shirking (the detection-cum-firing probability) in a firm of size l; where dð0Þ ¼ 1; so that no self-employed worker shirks, d 0 o0 and d 00 40: This captures the fact that in large firms monitoring is more difficult, but not impossible. The total probability of being dismissed for a shirker is therefore given by ps ðlÞ ¼ pns þ ð1 À pns ÞdðlÞ: t t t The no-shirking condition ðV ns ¼ V s ðlÞÞ is given3 by t t E t V tþ1 ðlÞ À U tþ1 ¼ 1 1 ¼ : dðps ðl t Þ À pns Þ ddðl t Þð1 À pns Þ t t t (3.6) (3.5)

In words, the expected surplus of employment over the reservation wage is decreasing in the detection probability. Now, using Eqs. (3.4) and (3.6), we solve for the wage to obtain4 E t wtþ1 ðlÞ ¼ ð1 À dÞðU tþ1 Þ þ 1 À d½1 À dðl t ފð1 À pns Þ t : ddðl t Þð1 À pns Þ t (3.7)

2 One may think of unemployed being randomly ‘‘assigned’’ or ‘‘referred’’ to jobs in firms of a given sector-region. If that post is vacant, then workers would find a job. Otherwise they would remain unemployed. Separations are always initiated by the employer in this setup. Job finding rates are independent of firms’ size as we only explore equilibria where the no-shirking condition holds. 3 Both for a shirker and a non-shirker we have that E t V tþ1 ¼ maxðE t V s ; E t V ns Þ: Since workers are tþ1 tþ1 homogeneous E t V tþ1 should be independent of the decision at t; provided that there is infinite horizon and there is no serial correlation in the parameters conditioned on decisions at t: The detection probability is an exogenous parameter in our model, which does not depend on the worker’s past shirking behaviour. 4 In addition to the no-shirking condition, the value of being employed and exerting effort should exceed the value of being unemployed, so that wages must also satisfy

wt 4b þ e À dð1 À r À pns ÞðE t V tþ1 À UÞ: t By appropriate choice of b; we can make sure that this is not binding.

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As we are interested in the steady-state properties of the model, we will focus on the case of static expectations ðV t ¼ V tþ1 ¼ V Þ; where from (3.7) we have wðlÞ ¼ ð1 À dÞU þ 1 À d½1 À dðlފð1 À pns Þ : ddðlÞð1 À pns Þ (3.8)

It is apparent from (3.8) that wages are increasing and concave in firm size via the d term. The economics behind this result is that a lower detection probability has to be compensated by higher wages: the penalty upon shirking, the wage loss, should be sufficiently strong so as to deter opportunistic behaviour. Furthermore, wages are increasing (and convex) in the exogenous (for the worker) probability of being dismissed for economic reasons, pns : This can be better appreciated by considering the t case where l is so small that d approaches one unit. In this case, Eq. (3.8) reduces to w ¼ ð1 À dÞU þ 1 : dð1 À pns Þ

While pns is exogenous for the individual workers, it is endogenously determined in t our model, as discussed below. The value of being unemployed is therefore given by U¼ b r þ : 1 À d ð1 À dÞð1 À pns ÞdðlÞ

3.1.2. Economic dismissals Firms produce using labour as the only input. Their instantaneous profits are given by pit ¼ yit f ðl t Þ À l t wðl t Þ where f 0 40; f 00 o0;

where yi is the market value of the good in region i: We model prices as a first-order, discrete-space, Markov process.5 In particular, we consider a two-state Markov process where prices can be either high ðyh Þ or low ðyli oyh Þ with a symmetric i i transition matrix, whose stayer coefficients are given by l4 1 so that there is some 2 degree of persistence. Realisations of yi are common knowledge. Whenever a shock occurs, firms revise employment levels accordingly. We will consider adjustment costs in labour later. Call the two optimal levels of employment l h and l li : they i maximise the value of firms in sector i when the states of the world are yh and yl ; respectively. Given the symmetry of the process, at a steady state, each plant will have for half of its time l h employees and for the other half l li : Thus, the economic i layoff probability at the steady state will simply be given by
h l 1 l i Àl i 2 lh i

¼ pns : i

3.1.3. Equilibrium Wages and employment levels prevailing in plants under good and bad demand conditions are depicted in Fig. 2. Under good times, both wages and employment
Generalisations to continuous time Markov processes (e.g., in continuous time and continuous state space) would not affect our results, while they would complicate algebra.
5

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W

w + w 'l w ( l , p ins ) wiH
wiL

f ' ϑH f ' ϑL

liL

liH

∆l
Fig. 2. Employment and wage adjustment without EPL.

L

levels are higher than under yi ¼ yli : Notice that the relative size of employment and wage variations depends on the curvature of the no-shirking condition in the relevant region: the steeper the curve, the lower the employment variation. Formally the two optimal employment levels are implicitly given by the first-order conditions f 0 yli ¼ wðl l Þ þ w0 ðl l Þl l and f 0i yh ¼ wðl h Þ þ w0 ðl h Þl h i which spell out the effect of employment adjustment on wages, hence on the marginal costs of labour, via changes in detection-cum-firing probabilities. In each industry-region there is a continuum of firms of mass 1, which draw on sector-specific unemployment pools ui opns ; so that job creation and destruction are i always demand determined. There is no entry nor exit of firms. 3.2. Introducing EPL We are now ready to introduce EPL. For simplicity, we model EPL as a cost on dismissals6 which makes it unprofitable for firms to dismiss workers in response to
6 Furthermore, our notion of EPL is one inflicting red-tape costs on employers rather than forcing them to implement transfers to the worker being dismissed. Red tape costs cannot be internalised in the employer–employee relationship, hence cannot be undone even under flexible wages.

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shocks. Under EPL the plant enters an ‘‘inactivity corridor’’ (Bertola, 1990) where it is optimal to keep employment unaltered over the ‘‘cycle’’. Inevitably EPL also constrains disciplinary layoffs. In the real world this happens via the costs of judicial procedures required to implement the dismissals. EPL usually establishes that either economic or disciplinary reasons have to be provided for the dismissal by the employer, who has the burden of proof. Layoffs are considered unfair in most countries when there are neither subjective (misconduct) nor objective (economic) grounds for the interruption of the relationship. Penalties applied to employers implementing unfair dismissals do not discriminate among the two types of justification (disciplinary and economic, see Bertola et al., 2000) and the employer finding it hard to prove the misconduct can always try to justify the dismissal on economic grounds. Thus, the costs of disciplinary layoffs are inevitably interrelated to those of economic dismissals. Summarizing, firms under a ‘‘rigid regime’’ do not implement economic dismissals, and choose employment by maximising average, as opposed to instantaneous, profits. They also face restrictions on enforcing disciplinary layoffs, so that the detection-cum-firing probability is also low for small units. 3.2.1. A geometric illustration ¯ For simplicity, suppose that d ¼ d; that is, it is at its lowest level for any possible employment level. In the presence of EPL, the wage schedule is flat as in the continuous lines depicted in Figs. 3 and 4. This flat wage schedule will lie somewhere below the asymptote of the no-shirking condition because EPL also reduces the probability of exogenous dismissals, depressing wages with respect to the flexible regime above a given level of employment. For lower employment levels, EPL pushes wages above the flexible regime as it prevents firms from using the disciplinary layoff deterrent to prevent shirking. Under a rigid regime, for any realisation of the shock, the optimal employment level satisfies the first-order condition
1 h 2 ½yi

f 0 ð¯ þ yli f 0 咞 w; lÞ lފ ¯

where variables denoted by a bar represent the rigid wage regime. As shown in Figs. 3 and 4, EPL has different implications in regions dominated by relatively small and relatively large units (with low and high y; respectively). Where large plants are operating, EPL implies a stabilisation of employment above l l : the larger the plant, the more likely that employment stabilises at a level which is close to l h ; the level attainable under good conditions in the flexible regime. Instead in regions with small units, EPL involves a decline of employment below the level prevailing in a flexible labour market under the bad state of the world. Clearly the nature of the shift in the wage function, hence of the change in equilibria related to EPL, will depend on the slope of the no-shirking condition, hence on the characteristics of monitoring technologies.

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w

w +w' l

w f 'ϑ
H

f'ϑ L

l
L

∆l
Fig. 3. Employment and wage adjustment with and without EPL: large firms.

w

w + w' l

w

f ' ϑL
1 H θ f '+θ L f ' 2 f ' ϑL

[

]

l

∆l

L

Fig. 4. Employment and wage adjustment with and without EPL: small firms.

3.2.2. Enforcement rules Suppose that workers, in each region, decide on whether or not to have EPL. They will be ex-ante favourable to the introduction of EPL insofar as
1 ½wðl l Þ þ wðl h ފ À e þ dpns U wÀe b ¯ i þ ð1 À fi Þ 42 ; (3.9) 1Àd 1 À dð1 À pns Þ 1Àd i   2¯i l where fi ¼ min l h þl l ; 1 and we dropped time subscripts as we are only interested

fi

i

j

in steady state comparisons. For small firms fi tends towards zero so that condition

[

1 H [θ f '+ θ L f ' 2

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(3.9) reduces to
1 ½wðl l Þ þ wðl h ފ À e þ dpns U b i 42 ; 1Àd 1 À dð1 À pns Þ i

which is never satisfied because boU: For large firms, instead, fi ¼ 1; as EPL will stabilise employment at a level which is higher than average employment under the flexible regime. In this case, support for EPL implies that w À e 1 ½wðl l Þ þ wðl h ފ À e þ dpns U ¯ i 42 ; 1Àd 1 À dð1 À pns Þ i which, after some algebra, and using pns ¼ 1 i 2 dðl h À l l Þ ð1 À dÞl h w À ðe þ bÞ À ¯ 4rl h ðl h þ l l ½dðl l Þ þ dðl h ފ
l h Àl li i lh i

; reads as follows: ! 4ðwðl l Þ À wÞ þ ðwðl h Þ À wÞ: ¯ ¯

In between these two extreme cases, both, the left-hand side and the right-hand side of (3.9) are monotonically increasing in size. It follows that the two value functions will cross only once. This unique crossing point represents the optimal threshold scale for the exemption from EPL. Firms whose long-run equilibrium employment level is below this threshold are exempted from EPL, which is consequently confined to the largest units. A corollary of this result is that an EPL threshold chosen according to the preferences of workers does not reduce the average size of plants in an industry. This is because EPL is only supported by workers when the threshold is equal or higher than average employment in the flexible regime. Insofar as EPL makes it unprofitable to adjust labour in response to shocks, it will, however, reduce employment turnover, that is, hiring and separations, in any firm subject to these regulations.

4. Empirical evidence The model above suggests that EPL can be politically supported by workers only when it involves firms with a relatively large equilibrium size. In these firms EPL reduces dismissal rates. Thus, we should observe a discontinuity in dismissal probabilities at the threshold defining the range exempted from EPL. This discontinuity should not arise in plant-level net growth rates, as exemption thresholds chosen according to the preferences of workers do not reduce the average size of plants which would prevail without EPL. In this section we test these implications of the model drawing on individual data on labour market flows and plant-level growth rates in Italy, a country with strict EPL and exemptions for small firms. Italian employment protection regulations and the data are briefly described below.

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4.1. Italian thresholds Individual, no-fault, dismissals of workers with a permanent contract in Italy are regulated by the norms of the Statuto dei Lavoratori, approved in 1970. The employer is required to give a written noticification to the employee who can also request a communication of the detailed reasons for the dismissal and the start of a conciliation procedure by the provincial employment office or through conciliation committees set up under collective agreements. The length of the statutory notice period depends on the tenure of the worker. The worker can appeal to a court against the dismissal within 60 days from the communication of the reasons of the dismissal, but first has to start a conciliation procedure with the firm. The consequences of the judge’s decision to overrule the firm’s decision depend on the size of the firm. Workers in firms employing more than 15 employees in a single plant (or 60 overall) are protected by the so-called ‘‘tutela reale’’, i.e., they can choose either reinstatement in the firm, plus a compensation equal to foregone earnings between the date of the dismissal and the legal settlement of the case (with a minimum of 5 months), or a financial compensation of 15 months and the foregone earnings. Workers in smaller units are instead covered by the so-called ‘‘tutela obbligatoria’’: in this case it is up to the employer to choose between reinstatement and a compensation ranging between 2.5 and 6 months depending on seniority and the size of the firm. Thus, EPL on individual dismissals is much stricter for units with more than 15 employees.7 4.2. Data We use data from two sources. The first is the national Labour Force Survey, a quarterly survey with a large rotating panel. Using the LFS for three years (1993–1995), at yearly frequencies, we can track histories of about 40 per cent of the LFS sample, that is, about 80,000 individuals. The size of the firm is stated by the employees. This gives rise to problems of ‘‘heaping’’; indeed the distribution of the stated employment levels reveals marked peaks at discrete intervals (e.g., 10 employees, 20 employees, etc.), as seen in Fig. 5. There is no simple method to correct this. Hence, we used sensitivity analyses to check the robustness of our results to marginal changes in the location of the threshold dummy. We combine information from matched records across LFS waves (enabling us to identify separations) and from retrospective sections of the survey allowing us to measure the size of the firm the worker was attached to and the nature of the separations. Unfortunately we cannot disentangle disciplinary from economic dismissals. The second statistical source is a sample of firms drawn from the Italian social security records (Inps archives), covering all private employees. It is the same data set used by Garibaldi et al. (2004), Schivardi and Torrini (2003) and Kugler and Pica
7 Workers under temporary contracts are covered by EPL during the duration of the contract but not upon termination. All workers, permanent or temporary, are considered for the EPL threshold (with the exception of workers under part-time contracts, temporary or permanent, who are counted as half).

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0.3

2069

0.25

0.2

0.15

0.1

0.05

0
6 7 8 9 12 19 25 26 -5 51 0 ov -10 er 0 10 0 10 11 13 14 15 16 17 18 20 21 22 23 le 24 ss 5 or

Fig. 5. Size distribution of firms in the LFS sample.

(2003) who also investigated threshold effects on employment growth. It allows to estimate yearly transition matrices for employment size classes over the period 1986–1995. Clearly only firms surviving from one year to the next are recorded in this sample. This leads to a slight over-representation of large firms. Based on this data source we could evaluate growth and persistence of firms below and above the 15 employees threshold, exploiting the ‘‘natural experiment’’ of a reform implemented in 1990. It should be stressed that in this case there are not the ‘‘heaping’’ problems, which are present in the Labour Force Survey data. 4.3. Dismissal and hiring rates Using the LFS sample, we identify dismissed workers as those who experienced a transition from employment to either unemployment, non-employment or employment in another job, and declare that the reason for the loss of the previous job was either a dismissal or the termination of a fixed-term contract.8 Fig. 6 plots the dismissal rates for temporary and permanent employees in establishments of different sizes. As temporary workers are not covered by EPL provisions upon termination of the contract, their dismissal rates are expected to be higher than those of permanent employees, which is confirmed in our data. Since EPL provisions are stricter in establishments above 15 employees, we expect dismissal rates of permanent employees to decrease above this threshold. In fact, dismissal rates of
Transitions are observed at annual frequency. Employment to employment transitions are identified by observing the tenure in the current job being less than 12 months.
8

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Fig. 6. Dismissal rates by establishment size. Note: DimðiÞ refers to establishment size below i employees.

permanent employees decrease with establishment size. Also, since dismissals of permanent employees are more costly, we would expect firms to hire and dismiss more temporary employees. As seen in the figure, dismissal rates of temporary employees increase with establishment size. These stylised facts are robust for different partitions of the sample, e.g. by industry, region, gender, age and skills. In addition to EPL, there are clearly other factors, related to the characteristics of both employers and employees, which affect dismissal probability and the relationship between job turnover and establishment size.9 In order to identify the true effect of EPL, one needs to compare the dismissal rates for workers covered

On the relationship between firm size and turnover, see Winter-Ebmer (2001) and Anderson and Meyer (1994).

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0.01 0 -0.01 -0.02 -0.03 -0.04 -0.05 -0.06 Below 5 employees Below 10 employees Below 15 employees Between 16 and 25 employees Between 26 and 50 employees More than 50 employees

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Fig. 7. Effect of EPL coverage on the dismissal rate. Note: The figure plots the point estimates of the marginal effect of permanent contract on the probability of dismissal and the corresponding 95% confidence band.

(permanent workers) and not covered (temporary workers) by the legislation in establishments below and above the thresholds. Thus, we estimate E½l ijt ¼ 1jX it ; Zjt ; tt ; Permit ¼ 1; S j pDŠ À E½l ijt ¼ 1jX ijt ; Zjt ; Permit ¼ 0; Sj pDŠ; where l ijt ¼ 1 if worker i in firm j at time t is dismissed, tt is a time effect, X it is a set of individual characteristics, Z jt is a set of firm characteristics, Permit ¼ 1 for permanent workers and Permit ¼ 0 for temporary workers, Sj stands for the establishment size, and D is some size threshold. We perform this estimation for different values of D and compare the marginal effect of a permanent contract (covered by EPL) on the dismissal rate of establishments of different sizes. This estimation is in the spirit of a difference-in-differences strategy in which the ‘‘treatment’’ is coverage of EPL, the ‘‘control group’’ is temporary workers (not covered by EPL), and the treatment differs by establishment size. The estimated marginal effects of EPL coverage on dismissal rate, and their 95% confidence band, are plotted in Fig. 7. The covariates used for the estimation are gender, age, educational attainments, region of residence, industry, and establishment size entered both linearly and with a quadratic term. According to our results, EPL coverage only reduces the dismissal rate in establishments above 10 employees, the estimated effect for establishments below 15 employees is statistically significant but smaller than for establishment above 15 employees.10 Given the ‘‘heaping’’
10

The full set of results are available from the authors upon request.

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hiring rates by firms' size (hirings as a % of total emplyees)

T. Boeri, J.F. Jimeno / European Economic Review 49 (2005) 2057–2077
hiring rates

0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1 -5 6 -1 0 1 1 -1 5 1 6 -2 0 2 1 -2 5 2 6 -3 0 3 1 -3 5 >35
firms' size

Fig. 8. Hirings by establishment size in the LFS sample. Note: Standard deviations: from 1 to 5 employees (0.07), 6–10 (0.04), 11–15 (0.06), 16–20 (0.05), 21–25 (0.13), 26–30 (0.24), 30–35 (0.24), more than 30 (0.03).

problem commented above, we take these results as evidence of EPL threshold effects on dismissal rates.11 Our model predicts that EPL should not only reduce dismissals, but also hirings above the threshold scale. In the LFS sample we observe the individual employment status, but we do not have establishment-level data on accessions. Hence, we can only observe the proportion of employees of a given tenure in establishments of different size. Thus, we estimated a monthly proxy-hiring rate defined as the proportion of the work-force declaring to have a tenure lower than one month in each cell of establishments. Unfortunately, the data at hand do not allow us to perform analyses of the type of those carried out in the case of dismissal rates. Nevertheless, as shown in Fig. 8, we observe that the hiring rate declines in a neighbourhood of the 15 employees threshold, while above the threshold, it starts rising again, although to reach a lower level than below the threshold. This finding suggests that the EPL threshold also affects inflows into employment. 4.4. The size distribution of firms, persistence and growth The Italian size distribution of firms does not point to a marked discontinuity around the 15 employees threshold (Istat, 2001). In order to formally test whether EPL affects the equilibrium size distribution of firms, we now use data from the Inps
Bauer et al. (2004), using matched employer–employee data for Germany, do not find any effect on separations of changes in the threshold scale exempting small establishments from dismissal protection. However, their measure of separations, the total outflow of employees from an establishment, includes both dismissals and voluntary quits.
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T. Boeri, J.F. Jimeno / European Economic Review 49 (2005) 2057–2077 Table 1 Effects of the EPL reform on ‘‘stayer’’ and ‘‘mover’’ coefficients 1986–1990 (a) Yearly persistence Initial sizep14 n ¼ 126 Initial sizeX15 n ¼ 144 D Initial size ¼ 14 n¼9 Initial size ¼ 15 n¼9 D 1991–1995 D 2073

38.18 (14.69) 21.92 (19.56) 16.26 23.37 (1.95) 24.10 (3.19) 0.73

40.80 (15.51) 21.87 (19.51) À18.93 26.46 (0.98) 23.36 (2.57) À3.1

2.62 À0.05 2.67 3.09 À0.74 3.83

(b) Yearly growth by one employee Initial sizep14 18.05 n ¼ 126 (1.92) Initial sizeX15 16.33 n ¼ 144 (9.49) D À2.78 Initial size ¼ 14 17.68 n¼9 (1.50) Initial size ¼ 15 14.66 n¼9 (2.13) D À3.02

16.27 (1.86) 15.17 (9.17) À1.00 16.39 (1.20) 14.20 (2.61) À2.19

À1.78 À1.06 À0.72 À1.29 À0.46 À0.83

Non-parametric estimates. Italy, services, 1986–1995. Sample: Inps Archives data 1986–1995. Standard errors displayed in brackets.

archives, covering the period 1986–1995, and a double-difference approach. The first difference is represented by the 15 employees threshold. The second difference is represented by a reform which, in 1990, made severance pay (up to 6 months of pay) mandatory for firms with less than 15 employees in the case of unfair dismissals. Before that date, small firms were not obliged to obey the ‘‘just-cause’’ rule. Thus the reform, by tightening regulations for small units, confined the asymmetry between firms with more or less than 15 employees to the so-called ‘‘reintegra’’. There was yet another reform, in 1991, making it easier for large units to dismiss workers in the context of ‘‘group layoffs’’, but this reform involved only manufacturing firms with more than 15 employees and units in services with more than 50 employees. Thus, firms operating in services with more than 15 and less than 30 employees represent the ‘‘control group’’ for our natural experiment.12 From the Inps archives we were able to obtain transition matrices of firms across different levels of employment and use one-year maximum likelihood estimators of transition probabilities as a test of our theory. Table 1 displays
Kugler and Pica (2003) also use this reform to estimate the effects of product market regulations and labour market institutions on turnover.
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difference-in-differences in the stayer coefficients (persistence) of this transition matrix as well as in the one-step-upward mobility coefficients (growth) for firms having more or less than 15 employees in the base year. As there are large standard deviations in growth and persistence above and below the threshold, we also display the difference-in-differences estimator when the focus is on units located just below or above the threshold. The annex contains grouped logit estimates of the probability of persistence and growth, which can capture the effects of covariates. Both parametric (see Appendix A) and non-parametric (see Table 1) difference-indifferences estimators suggest that EPL increases persistence, albeit mildly, but does not affect the growth of firms. Schivardi and Torrini (2003) who had access to richer data than us, estimated the ergodic distribution implied by (stationary) transition matrices evaluating the effects of the EPL threshold dummy on persistence by comparing stayer coefficients above and below the diagonal, as done also by Garibaldi et al. (2004). They concluded that ‘‘average firm size would increase by less than 1 per cent when removing the threshold effect’’. Garibaldi et al. (2004) estimated a linear probability model on stayer and mover coefficients finding that the EPL threshold mildly affects persistence, but not growth of firms. We take all this as evidence supporting the implications of the model: EPL affects the turnover of workers and firms’ persistence at given employment levels, but not the equilibrium employment-size distribution of firms.

5. Final remarks There are a few institutional features of the labour market which have been as thoroughly investigated as employment protection. Despite the attention devoted by applied economists to this issue, we still know very little about the impact of these regulations on the employment adjustment of firms. Above all, it is difficult to isolate the effects of EPL from those of other institutional features of the labour market. This is because most of the work has been carried out in terms of cross-country and pair-wise correlations between EPL and various measures of labour market performance. In this paper we take a different approach in that we focus on within-country variation in the enforcement of EPL. In particular, we draw inferences from the exemption clauses which exonerate small units from EPL. To this end, we develop a theoretical model which extends standard models of EPL by disentangling disciplinary from economic layoffs and provides a political economy rationale for these exemption rules. Our empirical results are in line with the predictions of the model: the small firm (15 employees) threshold does matter in conditioning layoff and hiring probabilities. It also mildly increases firms’ persistence, i.e., the probability that a firm does not change the number of employees from one year to the next. But there is no evidence of any significant discontinuity in the size distribution of firms in correspondence with these thresholds. In future work we plan to consider other exemption rules in

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T. Boeri, J.F. Jimeno / European Economic Review 49 (2005) 2057–2077 Table A.1 Effects of the EPL reform on ‘‘stayer’’ and ‘‘mover’’ coefficients (a) Persistence Logsize Dummy 6 employees Dummy 15 employees Dummy 1990 Dummy 1990 n dummy 15 Constant (b) Growth Logsize Dummy 6 employees Dummy 15 employees Dummy 1990 Dummy 1990 n dummy 15 Constant 2075

À0.79 0.02 0.18 À0.01 0.14 0.81

12.80 0.46 3.80 0.28 2.73 4.36

À0.33 À0.14 0.05 À0.10 0.03 À0.92

4.46 2.38 0.93 1.77 0.57 4.20

Grouped logit estimates. Italy, services, 1986–1995. Sample: Inps Archive data 1986–1995. The first column is the marginal effect and the second column is the corresponding unsigned t-statistics.

the enforcement of labour laws, notably those related to regulations on group layoffs.

Acknowledgements We are grateful to Pietro Garibaldi for sharing with us the transition matrices of firms employment levels, which he reconstructed from the Inps archives, to Juan ´ Ramon Garcı´ a, Virginia Hernanz, Mario Izquierdo, and Mauro Maggioni for excellent research assistance, and to two anonymous referees for comments. Juan F. Jimeno acknowledges financial support from the Spanish Ministry of Science (Grant SEC 2001-0061).

Appendix A Table A.1 reproduces estimates from a grouped logit model of the probability of persistence and growth for the firms in the Inps archive, operating in services and having between 1 and 30 employees in the base year. In the persistence equations, the mii dependent variable is given by lnð1Àmðt;tþ1Þ Þ where mii ðt; t þ 1Þ ¼ nii ðt;tþ1Þ and n is the ni ðtÞ ii ðt;tþ1Þ number of firms in each size cell, indexed by the subscript i: The set of regressors includes a nonlinear function in size,13 as well as dummies for units lower than the
13

We tried with several specifications: 1=l; l 2 and lnðlÞ: The latter provided the best fit.

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mean size of firms in the sample (6 employees) for firms with less than 15 employees (our threshold dummy), the 1990 reform as well as the reform interacted with the threshold dummy. The latter two variables are crucial to our analysis: we expect the tightening of EPL to increase the persistence of firms with less than 15 employees, but not to exert spillover effects on the larger firms. We find that the 1990 dummy is indeed significant only when interacted with the threshold dummy, and in this case, it mildly increases the probability that a firm does not change size from one year to another (the log-odds ratio associated with this variable is 0.94). mii þ1 In the bottom panel of Table A.1, the dependent variable is lnð1Àmii Þ; where we omitted time subscripts for expositional ease. In other words, we focus on probabilities to increase size by one employee from one year to the next (marginal net hirings as we cannot identify workers within each establishment). In this case, there is evidence of regression to the mean: the 6-employees dummy is significant and negative. More importantly, neither the reform dummy, nor the reform interacted with the threshold dummies, is significant in this case.

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