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Employment Protection Reform in European Labor Markets: The Collective Bargaining Regime Matters

Abstract

Policy advisers repeatedly call on Western European countries to reform their employment protection legislation (EPL) by switching to a layoff tax model of unemployment insurance (UI) funding. This new design, partly based on the existing “experience-rating” (ER) system in the U.S., should induce firms to internalize layoff fiscal costs and hence reduce unemployment. However, its success remains uncertain in economies with a collective wage-setting system, as do those of many Western European countries. Using a matching model with endogenous job destruction, we provide an ex-ante evaluation of this policy reform’s effects on labor market outcomes and aggregate welfare in firm-level and sector-level bargaining economies. Our numerical analyses yield two main results. First, compared to simply increasing firing/dismissal costs, implementing an ER system improves labor market outcomes in both types of economies. Second, the design of the reform has to be adapted to the level of wage bargaining in the economy. Because firms can adjust most of the terms and conditions of employment (including wages) in decentralized negotiations, adding ER to existing EPL yields the largest reduction in unemployment under firm-level bargaining, while with sector-level bargaining, ER is better implemented with a relaxation of existing EPL. However, if the aim is to increase aggregate welfare, it is better under both bargaining regimes to relax existing EPL when implementing ER.

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Notes

  1. 1.

    The OECD (2013) defines EPL as the set of norms and procedures that employers have to follow when dismissing employees, including notification procedures, delays and lengths of notice periods, severance pay, definitions of justified and unfair dismissal, the length of trial periods, compensation or the possibility of reinstatement in cases of unfair dismissal, the definition of and additional requirements for collective dismissals, and the regulation of fixed-term contracts and temporary work agencies.

  2. 2.

    See Cazes and Nesporova (2003), Postel-Vinay and Saint-Martin (2004), OECD (2013) , Boeri and Garibaldi (2009), Clark and Postel-Vinay (2009), Martin and Scarpetta (2012) and Bassanini and Garnero (2013)

  3. 3.

    For a description of the ER system in the U.S., see Fath and Fuest (2005) and section 2. in Ratner (2013).

  4. 4.

    More information about European collective bargaining systems and their economic implications are available in “Appendix A”.

  5. 5.

    As we are not interested in the insurance aspects of ER, risk neutrality for workers and firms is a reasonable assumption. This is widely accepted in the literature on matching models moreover (see Pissarides 2000; Rogerson et al. 2005).

  6. 6.

    Although workers are risk-neutral in the model, and therefore UI is not necessary, we include it to assess the effect of ER on labor market outcomes.

  7. 7.

    See Mortensen and Pissarides (1999).

  8. 8.

    As in Pissarides (2000). We assume a fixed bargaining power to ensure it does not alter the effects of the reforms under study. Moreover, the consequences of union bargaining power in a right-to-manage model are already well known, and in this paper, the bargaining power affects the magnitude/extent but not the nature/direction of the results. Thus, for the sake of simplicity, we do not consider the effects of bargaining power when setting up the ER reform.

  9. 9.

    Full details of the derivations are provided upon request by contacting the authors.

  10. 10.

    Full details of the derivations are provided upon request by contacting the authors.

  11. 11.

    Full details of the derivations are provided upon request by contacting the authors.

  12. 12.

    Full details of the derivations are provided upon request by contacting the authors.

  13. 13.

    The job creation condition means that there is a single solution for \(\theta\). Indeed, the left-hand side (LHS) of Eq. 27 is increasing in \(\theta\) (because \(q(\theta )'<0\)) while the right-hand side (RHS) is decreasing in \(\theta\).

  14. 14.

    Full details of the derivations are provided upon request by contacting the authors.

  15. 15.

    Full details of the derivations are provided upon request by contacting the authors.

  16. 16.

    Proof. \(n_{o}^{b} = (1-u^{b})-n_{e}^{b} = (1-u^{b}) - (1-u^{b})(1-G(\epsilon _{d}^{b})) = (1-u^{b})(1-1+ G(\epsilon _{d}^{b})) = (1-u^{b})G(\epsilon _{d}^{b})\)

  17. 17.

    This expression comes from calculating the average of a set of continuous functions over an interval: \(m=\dfrac{1}{b-a}\int _{a}^{b} f(x) {\mathrm {d}}x\). In our case: \(\overline{w_{e}^{f}}=\dfrac{1}{G(\overline{\epsilon })-G(\epsilon _{d}^{f})}\int _{\epsilon _{d}^{f}}^{\overline{\epsilon }} w_{e}^{f}(x) {\mathrm {d}}G(x) = \dfrac{1}{1-G(\epsilon _{d}^{f})}\int _{\epsilon _{d}^{f}}^{\overline{\epsilon }} w_{e}^{f}(x) {\mathrm {d}}G(x)\)

  18. 18.

    Full details of the derivations are provided upon request by contacting the authors.

  19. 19.

    Full details of the derivations are provided upon request by contacting the authors.

  20. 20.

    \(\theta q(\theta )=\dfrac{m(u,v)}{u}=\dfrac{Au^{\alpha }v^{1-\alpha }}{u}=A(\dfrac{v}{u})^{1-\alpha }=A(\theta )^{1-\alpha }.\)

  21. 21.

    \(A=\dfrac{\theta q(\theta )}{(\theta ^{*})^{1-\alpha }}\) with \(\theta q(\theta )=0.135\) the target value of the job-finding rate and \(\theta ^{*}=0.562\) the target labor market tightness, we obtain: \(A=0.180\).

  22. 22.

    In this scenario, the ER tax \(\phi\) is used as an instrument, implying that the ER index \(\rho\) is endogenous. In the post-reform situation, the values are as follows: \(c=0\), \(\phi =1.7739\) and \(\rho =0.41\).

  23. 23.

    For example: if in the addition scenario, a given ER index \(\rho\) yields an ER tax \(\phi\) equal to X, we increase c by X in the ‘EPL only’ scenario, \(\rho\) and \(\phi\) remaining equal to 0.

  24. 24.

    Table 6 compares the absolute changes between the pre-reform position and the post-reform position (\(\rho = 0.41\)) for the three scenarios and two bargaining regimes.

  25. 25.

    The ER-related layoff cost is not taken into account since it funds the unemployment benefits and is therefore not a loss cost.

  26. 26.

    Even if some exceptions laid down in the law are allowed in extreme cases.

  27. 27.

    Wage dispersion is lower in economies with more centralized bargaining structures. See OECD (1997), Aidt and Tzannatos (2002), Rycx (2003), OECD (2004, (2018).

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Acknowledgements

We would like to thank Bernardo Fanfani (University of Torino) for his helpful discussion during the IAAEU workshop on Labour Economics 2018. The paper also benefited from the comments of the participants at the Labour market workshop at the Central Bank of Luxembourg, the 30th European Association of Labour Economist (EALE) 2018, the 1st CESifo EconPol Europe Ph.D. Workshop 2018 and the 2nd ERMEES Macroeconomics Workshop 2017. We also thank François Fontaine (PSE), Anne Bucher, Mathieu Lefebvre and Thierry Betti (University of Strasbourg) for their insightful comments.

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Appendix A: Description of European Collective Bargaining Systems and Their Economic Implications

Appendix A: Description of European Collective Bargaining Systems and Their Economic Implications

The model we present in Sect. 2 aims to reflect institutional wage-setting arrangements in many European countries, namely wage bargaining predominantly at the sector level with procedures for extending sectoral agreements to all workers. This is the case in Austria, Belgium, France, Finland, Iceland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia and Spain. This section aims to describe the main features of these arrangements to justify our modeling choices. We also briefly present the main macroeconomic effects of collective bargaining systems to provide a comprehensive overview and outline why it is important to take these systems into account when choosing how to reform other labor market institutions.

The collective bargaining systems in Western European labor markets are characterized by two main features: the predominant level where wage bargaining takes place and the worker coverage rate of collective agreements. Wage negotiations between parties can take place at the firm level, the sector/industry level or the cross-sectoral/national level, and the agreements can be binding for lower level negotiations. In most cases, lower level agreements can only offer more favorable terms for workers.Footnote 26 The coverage rate of a negotiated agreement is the percentage of workers whose contract is framed by the agreement out of the total number of workers with a right to bargain. Generally, in countries where wage negotiations take place mainly at the industry level, with binding minimum wages set by type of occupation, the coverage rate exceeds the rate of unionized workers because collective agreements are mandatorily extended to non-organized employers. This is the case in a number of Western European countries, as shown in the Fig. 4 and the classification in Table 7. This contrasts with the situation in more liberal economies, in particular the U.S., where wage bargaining takes place mainly at the firm level and with very low worker coverage.

This institutional arrangement for wage negotiations has several economic implications. The extension mechanisms, by setting occupation-specific minimum wages throughout an industry, lead to a compression of the wage distribution.Footnote 27 This has positive and negative effects (Villanueva 2015). On the positive side, it reduces wage inequality, and also gender wage gaps at the bottom of the wage distribution. On the negative side, it increases labor costs for all covered firms, reducing employment growth, chiefly because the sector-specific minimum wages are not necessarily appropriate for all firms (Martins 2014). As a corollary, this creates wage rigidities that limit the ability of firms to adapt to economic shocks by aligning wages with productivity (Gnocchi et al. 2015; OECD 2016; Izquierdo et al. 2017). Theoretical models predict that if collectively bargained wages are higher because of sector-wide agreements and if they cannot be adjusted to changes in job-specific productivity, this weakens the sector’s competitiveness, as reflected by a higher unemployment rate due to more job destruction and less hiring (Jimeno and Thomas 2013). Ronchi and di Mauro (2017) support these theoretical insights and empirical observations by showing that firms’ responses to the Great Recession in the EU were shaped by wage negotiation setups: economies with more centralized bargaining systems with high coverage rates because of automatic extension have experienced worse downward wage rigidity, job destructions and falls in profit than have those with decentralized bargaining systems.

Fig. 4
figure4

Bargaining coverage and level of wage-setting in 2018 Notes: Data from ICTWSS (Version 6.1). The coverage rate (% ) corresponds to employees covered by valid collective (wage) bargaining agreements as a proportion of all wage and salary earners in employment with the right to bargain. Wage bargaining takes place: 5 = predominantly at the central level; 4 = between the central and industry levels or alternately between the two; 3 = at the sector or industry level; 2 = between the sector and firm level or alternately between the two; 1 = at the local or firm level

Table 7 Mandatory extension of collective agreements to non-organized employers (0-3) in 2018

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De Palma, F., Thommen, Y. Employment Protection Reform in European Labor Markets: The Collective Bargaining Regime Matters. De Economist 168, 541–575 (2020). https://doi.org/10.1007/s10645-020-09370-1

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Keywords

  • Search and matching models
  • Collective bargaining
  • Experience rating
  • Employment protection

JEL Classification

  • E10
  • J48
  • J50
  • J60