The Third Way: Welcome to the Third World
Unemployment Consequences of Unfair Dismissal Laws
Economic reasoning tells us that making certain behaviour more
costly is likely to discourage the said behaviour. This simple
insight has found fruitful applications in many areas of human
action and one would think that its application to a straightforward
area of commercial, profit maximising activity like hiring practices
would be relatively straightforward. Yet those who close their
eyes to the employment disincentive effects of unfair dismissal
laws clearly think not.
The problem with proving that unfair dismissal laws have employment
disincentive effects is that it is very difficult to quantify
the costs which employers have to incur because of these laws.
Quantifications have been made in various small business surveys
of the costs of other non-wage award provisions such as workers
compensation, superannuation and parental leave provisions, usually
referred to as on-costs. In the case of these entitlements, the
cost comprises the addition to the total wages bill by having
to provide for these entitlements as well as the costs of complying
with the provision of these entitlements. The latter component
usually involves time spent in documentation and can be converted
into a dollar amount by noting the equivalent hourly wage that
has to be paid by the business owner to fulfill this task.
Quantification of the compliance costs of unfair dismissal
laws is made difficult because complying with such laws is a more
ongoing process than one more characterised by discrete periods
when documentation has to be filled in, as is the case with on-costs.
Additionally, the psychological costs incurred by the employer
at the prospect of complying with these laws is arguably just
as relevant in terms of its effects on whether, at the margin,
an employer decides to hire more workers or not. This is more
likely to be true for small business employers who have to do
most of the paperwork and human resources management themselves
than in the case of large employers who can afford to offload
these tasks to well-trained experts.
In the case of business taxation regulations, these psychological
costs take the form of fear of incurring strong penalties if returns
are lodged incorrectly. A similar brooding anxiety undoubtedly
envelops the mind of the hapless small business employer who is
trying to ensure that he or she does not fall foul of the unfair
dismissal laws, given the absurd results of some unfair dismissal
cases and the nitpicking intricacies of the law. This is confirmed
by a survey by Australian Business Ltd in December 1998 which
found that 84 per cent of small business employers were concerned
about the potential for an unfair dismissal action when hiring
Later I will survey some recent research which has risen to
the considerable challenge of trying to quantify the effects of
unfair dismissal laws. Before that I wish to explain exactly how
unfair dismissal laws involve a continuous process of compliance
and monitoring and describe its consequential chilling effect
on hiring, especially by the less well-resourced small business
The Unfair 'Unfair Dismissal' Laws
Laws at federal and state level, as well as common law interpretations
of the employment contract and award provisions have made termination
of employment extremely complex. The first act of compliance of
an employer is to look at the different layers of the law and
work out which applies in which situation. As a general rule,
where more than one layer of law deals with the same subject,
the federal law prevails but not always. Given this, I will focus
on the federal law.
There is little reason to assume that most employers treat
their employees unfairly. Such bad management practices, by undermining
workplace morale, would be against an employer's interests. Yet
unfair dismissal laws starting with those contained in the Industrial
Relations Reform Act 1993 seem to work on this assumption,
laying down strict procedures which need to be followed when terminating
The Workplace Relations Act 1996 does little to remove
this assumption, although the onus of proof placed on employers
has been removed. The Act prohibits sackings that are 'harsh,
unjust or unreasonable' or on prohibited grounds. These prohibited
grounds include such things as temporary absence from work or
union membership. The Industrial Relations Commission can order
up to six months' remuneration for unfair dismissal, with a $10,000
maximum additional penalty for termination for a prohibited reason.
In determining whether a dismissal was 'harsh, unjust or unreasonable',
the Industrial Relations Commission must look at whether:
- there was a valid reason related to the capacity or conduct
of an employee or operational requirements;
- whether the employee was notified of the reason and the employee
had an opportunity to respond to the reason offered;
- if the employee was warned where the termination was due
to unsatisfactory performance;
and other matters the Commission considers relevant.
The first consideration, where the Industrial Relations Commission
is charged with evaluating the 'valid reason' posited by the employer
requires it to examine business judgements about operational and
employee requirements, and where it thinks necessary, overrule
the judgement of the employer.
The argument for this, assuming that we accept the objectives
of unfair dismissal law, is presumably that we should not allow
unfair employers to get away on ex-post facto rationalisations.
But how certain can we be that the Commission will not err significantly
in the direction of overruling legitimate dismissals such that
it has a chilling effect on the hiring practices of fair-minded
The possibility of many errors being made is boosted once we
take account of the substantial risk and uncertainty involved
in litigation. This risk and uncertainty is likely to translate
in the minds of employers, especially small business employers
who do not have sufficient resources to continue litigation, into
a corresponding probable dollar amount of loss. Weighting this
factor in their minds, they might then opt to settle with the
complaining employee even if the small business has a legitimate
Dismissing employees according to the procedures laid down
in legislation presupposes detailed record keeping and documentation
and extensive counselling.
As an example of the detailed record-keeping involved, the
Workplace Relations Act 1996 prescribes the period of notice
which must be given to employees before termination of employment.
For instance a period of continuous service of more than 1 year
but not more than 3 years requires a period of notice of at least
2 weeks. It is at least 3 weeks for employees who have been in
continuous service for more than 3 years but not more than 5 years.
The amount of pay in lieu of notice is also prescribed. Formulae
for working out the term of continuous employment must factor
in the leave taken.
To give notice, the longest period prescribed by either the
award the employee is covered by, the Workplace Relations Act
or the term of contract of employment, must be chosen.
Returning to the 'harsh, unjust or unreasonable' test, the
consideration that the Commission must give to whether the employee
had sufficient warning of unsatisfactory performance imparts further
documentation requirements. The NSW Employers Federation advises
members in its Employers' Handbook that it is best to follow
a four step counseling procedure as follows:
- counseling and verbal warnings to bring to the attention
of the employee the undesired behaviour;
- a counseling session and written warning;
- a counseling session and final written warning; and
- termination only as the final resort.
As was previously argued, the prescriptiveness of the laws
means that those employers who feel the need to dismiss employees
who are genuinely incompetent or insubordinate will have to expend
resources to ensure compliance and thus minimise the risk of a
lawsuit. The alternative is possibly expensive litigation if they
get things wrong.
The possible conflicting obligations between unfair dismissal
laws and anti-discrimination laws may also prove to be a problem
in some cases. For example, if a firm employs a worker who has
persistently exhibited discriminatory conduct, it may attract
an anti-discrimination suit from other workers for failing to
maintain a non-discriminatory workplace. If the firm decides it
best to dismiss the offending employee as promptly as possible
in order to avoid a complaint being lodged, this may conflict
with the requirements of the unfair dismissal law.
The NSW Department of Industrial Relations reports that the
number of unfair dismissal cases in NSW has fallen from an average
of 384 a month in 1997 to 340 a month in 1998. This trend is encouraging
but still means that more than 4000 cases a year. In NSW, 94 per
cent of matters were conciliated by the NSW Industrial Relations
Commission or otherwise settled. The average time of settlement
was 90 days. This imposed a very large cost on small businesses.
The average 2400 cases went to arbitration on an average processing
time of 180 days.
In 1996-97, the median amount of time it took for a case to
be finalised by a hearing in the Court after being filed with
the Commission varied from 130 days in South Australia to 234
days in Tasmania, with a national median of 185 days (see Table
Streamlining under the Workplace Relations Act has reduced
the number of dismissal cases filed to the Commission. In the
first six months of 1998, the total of
State and Federal applications regarding dismissals was 8310,
18 per cent less than for the same period in 1996 and two per
cent less than in 1997.
There were 2694 cases filed before the federal Industrial Relations
Court in 1996-97, compared with 9080 in 1995-96. This decrease
is due to changes in filing procedure and the introduction of
the Workplace Relations Act, which has reduced recourse
to the court system.
From January 1996, over 300 new cases per month were referred
from the Commission to the Industrial Relations Court. There were
1200 claims a month filed with the Court or, following the change
of procedure, to the Court and the Commission, from October 1995
to December 1996 (Industrial Relations Court of Australia Annual
By making dismissals more costly in terms of both time and
money, unfair dismissal laws reduce the demand for labour. The
higher the costs of firing, the more akin the act of hiring a
worker becomes to making an irreversible investment (such as buying
a new machine), and consequently the more cautious the employer,
particularly the small business employer, becomes in making this
This has particularly severe impacts on the long term unemployed.
Workers who have been out of the labour market for a long time
may turn out not to have the necessary skills for performing the
job they were hired for. Thus there is a higher probability that
they may later have to be dismissed than is the case with other
job-seekers. Given the added risks introduced by the unfair dimissal
laws, employers might decide it is simply not worth the trouble
and avoid long-term unemployed job-seekers altogether. A similar
argument might be made for young job-seekers and workers from
socially disadvantaged minority groups, especially those without
Theoretically it is possible to sidestep the high adjustment
costs of unfair dismissal laws by changing other work conditions
such as wages or working hours. However in Australia, at least,
these other aspects of the labour market are also subject to close
regulation and are therefore relatively inflexible compared to
countries like the US.
More inflexibilities could be introduced if courts expand their
reach to catch practices amounting to 'constructive dismissals'.
A 'constructive dismissal' could be found where some employees
are hired for shorter hours or assigned simpler and lower paying
tasks. In these cases, the reasons for the employer's decisions
may be more subtle and it would be harder to differentiate between
a legitimate decision and an unfair one.
Unfair dismissal laws ultimately affect the employment prospects
of all job-seekers. In the long term, the
climate of legal uncertainty created by the unfair dismissal laws
will mean that instead of responding to increased demand by hiring
more workers, employers will increase their capital intensity
and use more careful and begrudging selection procedures.
Recent Research on the Effects of
Unfair Dismissal Laws
There have not been many empirical studies on the effects of
job security provisions like the unfair dismissal laws on unemployment.
This partly owes to the difficulty of quantifying the inflexibility
introduced by job security provisions.
In the case of job security provisions like unfair dismissal
law, a further ambiguity is introduced by the fact that such laws
will also have the obvious effect of reducing the inflow into
unemployment. That is, such laws may increase long term unemployment,
but they also achieve their aims of affording some protection
to labour market insiders, at least to the extent that business
flexibility is not so compromised as to lead to more business
failures later on, to the detriment of all. This will then show
up in the statistics as lower short term unemployment and higher
long term unemployment. This explains why results of past studies
have not been that clear cut.
Bearing these caveats in mind, we can turn to some important
quantitative studies. A 1990 study by Lazear used data on severance
pay and periods of notice required before employment termination
from 22 developed countries from 1956 to 1984.
One problem with this data, as Lazear acknowledges, is that
these two specific provisions are used as a proxy for an entire
system of employment regulation. Severance pay and periods of
notice are prescribed in Australian unfair dismissal law, but
do not form the whole of its obligations. However to the extent
that data on these two obligations, like the others, increase
firing costs and are more quantifiable than other obligations,
they can be of some use. Another weakness acknowledged by Lazear
is that the rules covered in the data changed once or twice during
the period in each country.
Lazear found that after an econometric regression analysis
against the employment rate, the number of hours worked per week
and labour participation rate that there was a significant negative
relationship between severance pay and these three variables i.e.
the higher the severance pay, the lower the employment rate, numbers
of hours worked per week and labour participation rate.
A more recent study by Di Tella and MacCulloch tries to overcome
some of the inadequacies in data encountered by the Lazear study.
It uses data based on surveys of businesspeople in 21 OECD countries
from 1984 to 1990. In the survey used, an average of 1531 top
and middle managers were asked to evaluate the flexibility their
enterprises enjoyed in 'adjusting job security and compensation
standards to economic realities'. They were asked to rank this
flexibility from 0 to 100 where 0 signified none at all and 100
a great deal. The 1990 survey question was changed slightly to
'Flexibility of management to adjust employment levels during
difficult periods.' Note that, henceforth, when I refer to labour
market flexibility, I mean flexibility as defined above.
The data used in the study is unavoidably subjective. However
the benefit is that unlike the Lazear study which uses some measurable
aspects of employment regulations as a proxy for the complete
regulatory system, this subjective data can take better account
of the immeasurable aspects of the regulatory system. This includes
dimensions like the degree of enforcement of different aspects
of employment law which is otherwise ignored in more objective
data. Businesspeople should be in a better position to judge the
net effect of the regulatory system on their hiring decisions
and incorporate that into their evaluations of prevailing laws.
Australia's average score of labour market flexibility is recorded
as 38.45. This is the third lowest ranking of flexibility of the
21 OECD countries surveyed, lower even than the Scandinavian countries
usually cited as bastions of collectivised labour relations. This
may seem counterintuitive but not surprising when it is remembered
that the spirit in which the law is enforced may be more important
than the letter of the law.
The authors of the study caution that a lower ranking in one
country may simply reflect the fact that people in other countries
use a different cardinal ranking system i.e. they have different
expectations. They also note that their data set of seven years
is considerably less than Lazear's data from 29 years.
Nonetheless, a further strength of the Di Tella and MacCulloch
study is that it adjusts for the differences in the unemployment
compensation system of the countries surveyed to ensure that the
effects of labour market flexibility are better isolated in their
The main findings of the study are as follows:
- Countries with flexible labour markets have higher employment
rates. For example, it was found that if French labour markets
were as flexible as those in the US, the employment rate in France
would increase by 1.6 per cent. This means that flexibility accounts
for almost 14 per cent of the different employment rates of the
- The employment effects of increased flexibility on the female
employment rate are larger than for the male employment rate
in the short run but less so in the long run;
- There are positive and significant effects of flexibility
on labour force participation rates. Paradoxically, this increased
participation rate may lead to a less strong result on employment
rates initially as more outsiders enter the labour market. However
to regard this as a bad thing is to be guilty of a serious statistical
fetish usually attributed to economic rationalists, considering
the demoralising effects of non-participation in the labour market.
- There is also evidence of a positive relationship between
flexibility and the average number of hours worked per week,
something which would probably be of little comfort to those
who think that those in jobs are overworked as it is. However,
when combined with increased opportunities for the unemployed,
this should not be easily dismissed.
- The researchers are cautious to point out that when the data
is adjusted to take account of factors not considered inside
the model, the correlation between unemployment and flexibility
is indeed negative but insignificant. Nonetheless the raw results
are quite compelling. For instance, it was found that labour
market flexibility explained 47 per cent of the different unemployment
experiences of the US and France.
- A similar relationship between the proportion of long term
unemployed and flexibility (negative but insignificant) holds
when the data is adjusted for outside factors. Nonetheless a
similar adjustment also yields a significant relationship between
unemployment persistence and labour market inflexibility.
It was found that unemployment is more persistent in countries
with less flexible labour markets.
- Another finding which is especially relevant to debate about
the sequencing of microeconomic reform has to do with the effects
of openness. It was found that the effects of openness to trade
on wages is lower, the greater the flexibility of the labour
markets. That is, a country that opens up to trade should make
its labour market more flexible if it wants to experience a smaller
reduction in real wages. Given the commitment of most major parties
today to free trade and the infeasibility of maintaining a Fortress
Australia mentality in any case, this should give greater impetus
to labour market reform, especially to those concerned about
increasing disparities of income in Australia.
Unfair dismissal laws are not a costless exercise in compassion.
They are seen by employers as a potential source of compliance
costs and litigation risks which attach onto each new employee.
Thus they are likely to discourage hiring of new workers if other
alternatives are available such as buying more machines. This
is likely to be more so to the extent that unfair dismissal laws
render labour hiring decisions into virtually irreversible investment
decisions. The first people to fall by the wayside as the result
of such laws are those who most need to be given a chance to enter
the labour market, namely the young, unskilled and long term unemployed.
Though the effects of job security provisions like unfair dismissal
laws are difficult to measure, recent attempts at quantifying
these effects have yielded some statistically significant evidence
that such provisions decrease employment rates and increase the
average duration spent in unemployment.
Table 1: Number of cases filed to the Industrial
Source: Australian Industrial
Relations Commission and Australian Industrial Registry Annual
Table 2: Whole of process waiting times for claims
the Industrial Relations Commission which go on to be
by an Industrial Relations Court hearing for 1996-97.
Source: Industrial Relations Court
of Australia Annual Report 1996-97
Australian Industrial Relations Commission and Australian Industrial
Registry, Annual Report 1997-98.
Bertola, G. and R. Rogerson 1997, 'Institutions and Labour
Reallocation', European Economic Review 41: 1147-1171.
Bierhanzl, E. and J. Gwartney, 'Regulation, Unions and Labour
Markets,' Regulation 21(3): 40-53.
Birmingham, Amanda 1997, 'A Guide to the Workplace Relations
Act 1996', Australian Bulletin of Labour 23(1): 33-47.
DiTella, R. and R. MacCulloch 1998, 'The Consequences of Labour
Market Flexibility: Panel Evidence Based on Survey Data,' email
Industrial Relations Court of Australia, Annual Report 1996-97.
Lazear, E. 1990, 'Job Security Provisions and Employment,'
Quarterly Journal of Economics 55: 699-726.
Nickell, S. 1997, 'Unemployment and Labour Market Rigidities:
Europe versus North America,' Journal of Economic Perspectives
NSW Department of Industrial Relations 1998, Industrial
Relations in NSW, June 1998 Report.
Siebert, H. 1997, 'Labour Market Rigidities: At the Root of
Unemployment in Europe,' Journal of Economic Perspectives
Soon, J. and H. Hughes 1999, 'Why Small Business is not Hiring,'
Issue Analysis No. 6, 10 February, Centre for Independent