The Changing Paradigm: Freedom, Jobs, Prosperity

Employment Protection Laws and Worker Welfare

Geoff Hogbin

Introduction

In recent years, economists throughout the world have devoted much effort in an attempt to better understand the functioning of labour markets, especially the reasons for persistently high unemployment in many countries including, of course, Australia. Part of this research has focused on the consequences of employment protection laws (EPL) or, alternatively, job security provisions, for the welfare of people of working age. This research has created a debate about EPL which, in broad terms, has two parts:

  • the effects of EPL on labour market "flexibility"[1] and, ultimately, on employment and unemployment; and
  • the relationships between labour market flexibility and productivity, economic growth and living standards.

This paper outlines arguments, based on this research, which challenge the view that employment protection laws serve the interests of workers. In particular, there are reasons for believing that EPL contribute substantially to the persistently high rates of unemployment that have plagued most OECD countries over the last two decades-or-so, and especially to the problem of long-term unemployment. EPL also tend to reduce rates of productivity improvement, thereby reducing rates of increase of real incomes of workers, and eroding living standards generally. The paper also outlines the reasons for believing that EPL processes systematically produce labour market outcomes that are not consistent with generally accepted tenets of fairness.

 

Employment Protection Laws

Roughly speaking, Employment Protection Laws (EPL) are:

  • the laws, regulations and administrative decisions that constrain the contractual conditions under which a worker can be dismissed;
  • the laws and regulations relating to the compensation an employer is obliged to pay when a worker is dismissed; and
  • the laws and regulations determining remedies for wrongful or unfair dismissal.

Laws and regulations determining eligibility for unemployment benefits and unemployment insurance payments might also be considered part of EPL, because of their interaction with other components of EPL. However, there is only passing reference to these in the paper.

Employment protection laws and the processes for administering them vary widely across countries. At one extreme is the US, where many workers are employed on the basis of "at-will contracts" which permit employers to discharge employees for "good reason, bad reason or no reason at all". Even in the US, however, many states have one or more of three main restrictions on at-will contracting:

  • laws which prohibit employers from dismissing employees who refuse to act contrary to public policy;
  • court-defined "implied terms" and requirements for "fair dealing" in employment contracts; and
  • scope for tort action for wrongful discharge.

These restrictions are becoming more pervasive and severe over time---especially the last two, which provide wide scope for court "construction". Towards the other extreme are the countries of continental Western Europe (for example, France, Germany, Italy and Spain) where grounds for dismissal are difficult to establish, procedures are costly, and compensation and penalties are generally severe. Australia, Canada, New Zealand and the UK sit between these groups, with (perhaps surprisingly), the UK probably considerably less restrictive than Australia. Note, however, that because there are so many dimensions to job security measures and because the rigorousness of enforcement is difficult to assess, ranking countries according to degree of severity of EPL is difficult and such rankings are likely to exhibit some inconsistencies. Recognition that EPL may contribute to persistent unemployment has led some European countries over the last 15 years-or-so to relax some measures, but the UK and New Zealand (prior to the current government) aside, the reforms fall well short of "radical". For example, some countries have relaxed restrictions on forming fixed term and temporary employment contracts.

Two other points should be noted:.

  • in most countries, if not all, employees can and do quit an employment relationship "for good reason, bad reason, or no reason at all"; and
  • in most countries, if not all, there are contractual arrangements that allow parties in labour supply relationships to escape EPL restrictions (for example, initial review periods; fixed-term contracts; independent contracting; the black market; and so on). In many cases, however, resorting to these escape routes imposes costs of various kinds on contracting parties.

 

Job Security and the demand for EPL

The growth of market economies is driven both by innovation in products, and innovation in techniques and organisation of production, combined with competitive selection of those enterprises which deliver the best value for dollar---in Joseph Schumpeter's immortal phrase "creative destruction". The expansion, contraction and reorganization of enterprises that this inevitably entails implies continual reallocation of people to jobs. In addition, young people are continually entering the workforce, while others are leaving, either temporarily or permanently (retirement). Characteristically, those in the early stages of their working lives tend to change jobs frequently to acquire information that will help to match their abilities and aptitudes with the characteristics of jobs they move to later in their working lives. Similarly, many hirings and firings are manifestations of attempts by both parties to employment relationships to increase the values of those relationships by improving matches between job requirements and the abilities and aptitudes of job holders.

People are aware of these processes in a general way, but until the publication, in 1996, of a pioneering study by US economists Steven Davis, John Haltiwanger and Scott Schuh , Job Creation and Job Destruction, most had little appreciation of what "creative destruction" entails in practice. A few pieces of data from a recent US Bureau of Labor Market study (Pivetz et al. 2001)---one of the vary large number of recent publications inspired by the work of Davis et al.---help to provide a perspective on creative destruction in practice.

  • More than one in seven jobs in the US were either created or destroyed over the year between September 1999 and December 1999.

The following US data (rounded to the nearest whole number) refer to just one quarter in the US---the fourth quarter of 1999.

  • Employment in the retail industry grew by 4 per cent during the quarter. However, this was the net result of creation of 11 per cent of the jobs existing at the end of the quarter and destruction of 7 per cent of the jobs existing at the beginning of the quarter. In the same quarter, 36 per cent of retail trade establishments expanded or opened during the quarter (that is, took on extra workers) while 30 per cent contracted or closed.
  • During the quarter, a net change of minus 3 per cent in employment in the construction industry was the result of an 11 per cent job-creation rate and a 14 per cent job-destruction rate.
  • During the quarter, 31 per cent of establishments in the construction industry expanded or opened, while 35 per cent contracted or closed.
  • Manufacturing had the lowest rates of job creation and destruction---4 per cent and 5 per cent respectively. And of all 10 industry groups, manufacturing had the lowest quarterly opening and closing rates (both 3.3 per cent).

We can gauge the relative importance in job creation and destruction of establishment openings and closings versus establishment expansions and contractions by looking at the following data for 1999 Q4.

  • The proportion of jobs created by establishment openings ranged from 13 per cent in manufacturing to 24 per cent in agriculture.
  • The proportion of jobs destroyed by establishment closings ranged from 15 per cent in manufacturing to 25 per cent in the retail trade.

In short, job creation and destruction are dominated by enterprise contractions and expansions, but establishment openings and closings are also substantial contributors.

High rates of job creation and destruction are not peculiar to the US.

  • Research shows that rates of job creation and destruction in Australia are similar to those in the US.
  • Job creation and destruction rates in the "sclerotic" major European economies are about the same as those in the US, but this should not be interpreted as showing that European sclerosis is a myth---far from it.
  • Over the course of a business cycle, job destruction rates exhibit greater variation than job creation rates.

In considering the labour market processes underlying creative destruction, it is helpful to consider the reasons why people change jobs. Australian data show the following.[2]

  • Of the 9.25 million people in Australia who were employed at some time in the year to February 1998, 21 per cent (1.98 million people) gave up a job within that year. (Roughly 700,000 of these were people who changed the location of their job but not their employer; people retrenched from, or who left, temporary jobs; and people who lost their jobs because of ill health or injury.)
  • Of the remaining 1.3 million who gave up a job (for reasons other than those listed above) in the year, almost a million (69 per cent) quit their jobs voluntarily compared with 400,000 (31 per cent) who were retrenched. Thus, quits outnumbered redundancies/dismissals by more than two to one.
  • Of the 0.92 million who left their jobs voluntarily, 20 per cent (about 185,000) left because they regarded their work conditions as unsatisfactory.

Similar data from other countries show that volumes of employment flows in all OECD economies are high. As emphasised by Arnold Harberger in his 1998 Presidential address to the American Economic Association, the processes of creative destruction which underlie economic growth are such that, even in booming industries, there are both insolvencies and contractions and, conversely, in declining industries, some firms expand and new firms enter. (Harberger, 1998)

 

Implications of labour flows for EPL

High rates of job mobility are the inevitable consequence of three central features which are the essence of economic growth and improvements in living standards within modern economies. They are:

  • First; continuous changes in patterns of demand for goods and services resulting from rising household incomes; development of innovative goods and services, and goods and services with superior price/quality characteristics; the phasing out of goods and services that can no longer be produced profitably; and changes in demographic structures and migration.
  • Second; continuous innovation in production techniques and in the organization of production processes; and
  • Third; the continuous process of searching for information needed to better match people and jobs thereby forming more productive and higher-valued employee--employer relationships.

One obvious limitation of legislating to prevent job losses in economies characterised by creative destruction is that it is somewhat akin to legislating to prevent tides from rising---job destruction is the essence of a growing economy. Excluding those who leave seasonal and temporary jobs, in any given year probably something like 5 per cent of the workforce lose "their" jobs because establishments close or contract in response to changes in the economic environment (that is, for what are referred to as "economic reasons").[3] The numbers of employees terminated by their employers for "economic reasons" probably exceed those terminated for other reasons, such as unsatisfactory performance, by a substantial margin. Although many countries make explicit provisions that permit employment contracts to be terminated for economic reasons, the often futile attempts to distinguish between economic and other reasons for termination tend to be costly and unsatisfactory.

Nevertheless, since losing a job often (but not always) entails an unexpected loss of wealth, there is a natural demand for insurance against it---just as there is demand for insurance against fires and vehicle collision. Accordingly, satisfying the demand for unemployment insurance is desirable, provided it can be done without creating negative side-effects that outweigh the benefits. Commercial insurers cannot profitably provide unemployment insurance, because the problems of moral hazard and adverse selection (roughly, insurance fraud) are insurmountable. Much employment protection regulation seems to derive from attempts to satisfy workers' demands for unemployment insurance. The problem is that, like so much other ad hoc regulation cobbled together to meet the exigencies of particular circumstances, EPL measures in many countries appear not only to have failed to deliver effective unemployment insurance, but also to have produced negative side-effects which outweigh any benefits they might confer.

Finally, it should be obvious that a very effective way of ameliorating the problem of losses of wealth associated with job loss is to reduce the size of the losses by adopting policies that minimise unemployment (i.e. reduce the average time taken for a dismissed worker to find a new job).

 

Negative consequences of EPL

Research shows three broad kinds of negative effects of EPL on the welfare of workers and living standards generally.

1. EPL, employment and unemployment

For many years, people have argued that heavy-handed EPL and other regulations have contributed to the persistently high unemployment rates experienced in many continental European countries over the last two decades or so. Probably the main reason why this argument was not widely accepted was that the regulations which were supposed to cause the problem were in place many years before unemployment levels rose. A related reason is that some countries with strong EPL have not experienced persistently high rates of unemployment (for instance, Austria, Norway). And, there are other respectable theoretical arguments why EPL should not cause higher unemployment.

Over the last 5 years, however, a growing body of theory and evidence has been developed, based on international studies, which greatly strengthens the argument that EPL has been a substantial cause of the persistently high rates of unemployment in continental Europe. Most of this has been produced by a new generation of continental European economists, although US and UK economists have also contributed. Briefly, the broad argument is that industrialized countries have been subject to a series of macroeconomic shocks since the early 1970s, including a marked slowing of the rate of technological progress, as measured by Total Factor Productivity (TFP); two large increases in oil prices; high real interest rates since the early 1980s; and an apparent reduction in the demand for labour relative to supply, especially unskilled labour.[4] The research points to the interaction between these shocks and economic "institutions" (labour market regulations, including EPL and wage-setting procedures; welfare payments, product market regulations) as the cause of persistently high unemployment in much of Western Europe. With economic conditions much less turbulent, the relatively minor adjustments needed to maintain full employment in the 1950s and 1960s could be accommodated within these restrictive institutions.

To sketch the flavour of the arguments, wage increments more appropriate for the 1950s and 1960s continued to be granted in the regulated labour markets of Europe in the 1970s and 1980s because the wage-setters, failed (not unreasonably) to take proper account of the marked slowdown in rates of increase in Total Factor :Productivity TFP. Consequently, real wages in the later period rose faster than was consistent with maintaining full employment. This contrasts with the US, where wage changes depend on the capacity of firms to pay and must inevitably reflect the underlying changes in TFP. However, since the slowdown in TFP did not become obvious in official data for a decade or more, the Europeans continued blithely granting wage increases, assuming the earlier TFP increases were being maintained. Importantly, EPL contributed to the problem of excessive real wages in Europe by strengthening pressures on regulators to grant wage increases for the majority of employees---whose jobs were protected by regulations---(that is, regulations that raised firing costs).

Apart from raising real wages above market clearing levels (and thereby causing higher unemployment) institutional factors have contributed to the related problem of creating a division in the workforce between "insiders" (those with secure, well-paid jobs, well represented in wage-setting processes) and outsiders (the unemployed and those filling the insecure and relatively low-paid jobs). Half-baked "regulatory reforms" exacerbated this division by giving employers more scope and incentives to hire people for temporary and fixed-term jobs that were less costly to create. Also, there are convincing arguments and evidence that EPL increase the proportions of unemployed people experiencing long-duration unemployment (spells of unemployment exceeding, say, a year).

In contrast to continental Europe, the more flexible US labour market has permitted the real wage adjustments needed to accommodate the macroeconomic shocks of the 1970s and 1980s with relatively small and temporary effects on unemployment rates, albeit with a fall in real wages for unskilled workers over an extended period, and a widening dispersion of income. (In recent years, for predictable reasons, real wages at the lower end of the US labour market have again shown substantial, steady increases over time.)

In summary, the argument, supported by a substantial and growing body of evidence (albeit not yet conclusive evidence) is that EPL, interacting with other labour market institutions and macroeconomic shocks, has been a factor contributing to:

  • persistently high unemployment in Europe;
  • the large numbers of people experiencing long-duration unemployment in Europe, to which should probably be added the large numbers who chose premature retirement;
  • the increasingly wide gap between pay and conditions for labour-market insiders and labour-market outsiders.

The issue of whether these negative effects on employment will be ameliorated in the longer term by market processes or whether they are more permanent is a controversial one.

2. EPL, productivity and living standards

To the extent that EPL reduce employment (as argued in the preceding sub-section), it reduces aggregate production of goods and services relative to potential output, thereby eroding living standards for all in society, including those workers who have jobs. Beyond this, the research shows that EPL, especially unfair dismissal laws, can be expected to impede productivity growth and living standards generally by:

  • impeding the job-matching process (the matching of workers' skills and aptitudes with job requirements);
  • constraining employers and employees from negotiating terms of contracts that are conducive to greater productivity; and
  • encouraging shirking (defined as opportunistic reductions of physical and mental effort to assigned tasks).

3. EPL and fairness

There are several reasons for reasons for believing that EPL processes systematically produce labour market outcomes that are inconsistent with generally accepted tenets of fairness. First, since employers cannot easily detect shirkers and may be prevented from discriminating against them, the various costs associated with increased scope for shirking created by EPL tend to be passed on to the more conscientious workers. Second, unfair dismissal laws tend to create scope for other forms of opportunistic behaviour that are costly to deal with (for example, pilfering) and, again, these costs tend to be passed on to more conscientious workers in the form of wages lower than would otherwise be the case. Third, in a world of creative destruction, substantial numbers of workers will be forced out of jobs for economic reasons. EPL cannot reduce these job losses without damaging productivity. Fourth, unfair dismissal processes have inherent defects which systematically produce unfair outcomes.

One reason for this is that employment contracts, like marriage contracts, are relational contracts that are based largely on implicit terms and understandings. Since performance in relation to such contractual terms cannot be monitored reliably by a third party, those responsible for implementing EPL simply cannot obtain the information required to adjudicate disputes fairly. This is reflected in the emphasis on procedures leading to a disputed dismissal rather than on the substance of the reasons for the dismissal in unfair dismissal cases. This problem seems to be exacerbated by a tendency for adjudicators to give the employees the benefit of any doubt about performance in relation to contractual terms. The problem of dispensing "fairness" is compounded by the impossibility of taking into account the effects of judicial decisions in unfair dismissal cases on third parties. Dismissing an underperforming employee does not destroy a job but rather creates an opening for another person who might well be better suited to the job and, indeed, might be more needy than the dismissed employee. However, such considerations simply cannot be taken into account in decisions to reinstate a dismissed employee, despite the obvious implications for the overall fairness of labour market outcomes.

It is worth noting that because of similar difficulties in evaluating contractual performance, regulators no longer attempt to determine the fairness or otherwise of dissolution of marriage relationships. Thus, either party to a marriage relationship is permitted to "dismiss" the other "for good reason, bad reason or no reason at all" and, in the process, to inflict wealth losses that frequently far exceed the expected wealth loss inflicted by an employer on a dismissed employee. Another asymmetry between regulators' attitudes to the breakdown of marriage relationships and the breakdown of employment relationships is that, whereas an employee is free to dissolve an employment relationship "for good reason, bad reason or no reason at all", an employer is not. Such considerations are central to the case for exempting small businesses from EPL. The owner of a small business may spend more waking hours with her employees than with her spouse. Given this, even if friction in the personal relationship between the employer and an employee does not erode the economic value of the employment relationship (which it very often does) it is far from clear that preventing the employer from breaking the relationship is consistent with fairness.

Finally, there are undoubtedly bosses who treat employees unfairly, just as there are spouses who are treated unfairly by their partners. Since a low unemployment rate reduces the expected cost to workers of moving to another job, and consequently raises the expected cost of mistreating employees, labour-market policies that keep unemployment rates low are likely to be an effective way of curbing bosses who behave badly. To the extent that EPL contribute to higher rates of unemployment (as discussed above) it has the unfortunate consequence of tending to work against itself.

 

Conclusion

Recent overseas research has produced an increasingly convincing body of research showing, as many have long suspected, that institutions of EPL adversely affect the welfare of workers in several ways. This research provides theoretical arguments supported by empirical evidence that in an increasingly turbulent world economy and in conjunction with other labour market institutions:

  • EPL impede the creative destruction that improves productivity and living standards for all people in an economy;
  • EPL impede the process of job matching which helps to give workers productive and fulfilling lives and higher real wages;
  • EPL contribute to widening the welfare gap between insiders and outsiders; and
  • EPL increase unemployment rates and the duration of unemployment, thereby forcing the heavy costs of adjusting to shocks onto a relatively few, essentially disenfranchised people of working age.

The nature of the employment relationship makes it extremely difficult for third parties to determine the fairness or otherwise of a dismissal through unfair dismissal (or any other) procedures. The result is that EPL increase the cost of controlling various forms of shirking by opportunistic employees, and these extra costs tend to be passed on to more conscientious workers. Likewise, the costs of opportunistically negotiated redundancy payments tend to be passed on to more conscientious workers.

In a world of creative destruction the notion of "employment protection" seems somehow peculiarly inappropriate---thinking in terms of unemployment insurance is more helpful. In this respect, a recent piece of unpublished research by Daniel Cohen of the University of Paris-Sorbonne has come up with what may turn out to be the ultimate irony: despite the vast volume of EPL and generous unemployment benefits in France and the relative absence of EPL in the US, the average loss of wealth suffered by a person who became unemployed in France in the early 1990s (13 months' wages) was greater than the corresponding wealth loss for a person who became unemployed in the US at the corresponding time (9 months' wages).[5] EPL appears to be a very poor approach to provision of unemployment insurance.

Australia's unemployment record is little better than Europe's. Despite a decade of strong economic growth, the unemployment rate has remained stubbornly high (around 6 per cent) and some observes consider that because of "hidden unemployment" the true unemployment rate may be considerably higher. Although we cannot be certain that our EPL regulations have contributed to the problem, the conclusions from overseas research outlined above suggest that we should be examining carefully their effects on labour-market processes and labour-market outcomes. It may be tempting to think that, because Australia's labour market institutions differ substantially from those of other countries, the results of overseas research have little relevance for Australia. However, leading US labour economist Daniel Hamermesh thinks otherwise. In a recent US NBER paper he argues that it would be foolish for US economists not to attempt to use information about differences in labour markets and differences in labour market institutions across economies to learn more about ways in which differences in institutions affect the welfare of workers and living standards generally.



References

Pivetz, Timothy R.; Searson, Michael A.; and Spletzer, James R., 2001, "Measuring job and establishment flows with BLS longitudinal microdata", Monthly Labor Review, April, 13-20.

Davis, Steven J.; Haltiwanger, John C.; and Schuh Scott, 1996, Job Creation and Job Destructon, Cambridge, Massachusetts: The MIT Press.

Harberger, Arnold C., 1998, "A vision of the growth process", American Economic Review, 88(1) 1-32.



Endnotes

1.  Labour market "flexibility" can be thought of as relating to flow rates of workers between jobs and firms; into and out of employment and unemployment; and into and out of the workforce.
2.  Although these data (taken from earlier work) are outdated, there is little doubt that more recent data would tell essentially the same story.
3.  Pervasive illusions about the capacity of legislators to "do good" led King Canute, almost exactly 1000 years ago, to demonstrate by example reasons for thinking otherwise. Nevertheless, these days similar illusions seem to have reached epidemic proportions.
4.  Probably attributable to factors such as technological change, increased trade with developing countries and increased female participation in paid employment.
5.  Although the reliability of this research has yet to be tested, 2000 Nobel Laureate James Heckman apparently considers it good enough to cite it in a recent talk given in Germany.

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