DP3636 Firing Tax and Severance Payment in Search Economies: A Comparison

Author(s): Pietro Garibaldi, Giovanni L. Violante
Publication Date: November 2002
Keyword(s): firing tax, severance payment, unemployment, wage rigidity
JEL(s): E24, J64, J65
Programme Areas: Labour Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3636

Employment Protection rules have two separate dimensions: a transfer from the firm to the worker to be laid off and a tax paid outside the firm-worker pair. It is well established that with full wage flexibility statutory severance payments (pure transfers) between employers and dismissed employees are neutral (Lazear 1988, 1990). Most of the existing literature makes the implicit assumption that, in the presence of wage rigidity, such mandatory transfers have the same real effects as firing taxes. This Paper shows, in the context of a search model, that this presumption is in general misplaced. It is only correct in the case of extreme wage rigidity, whereas when some (but not full) flexibility in the wage setting at the level of an individual employer-worker match is allowed, the impact of severance payments on unemployment duration and incidence is qualitatively different from that of firing taxes (and its sign depends on the nature of the wage rigidity).