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Graded security from theory to practice

A new labour law in Italy aims to protect dismissed employees and offer firms greater incentives for human capital investment. This column explains the significance of the change, what it means for firms in Italy and its potentially positive effect on post-crisis job-creation. 

Since 1 March 2015 all new open ended contracts in Italy offer graded security, that is, severance payments in case of dismissals (see Lexology 2015), which are gradually and steadily increasing with tenure without any major discontinuity. These new contracts also reduce the range of compensations that judges may impose on employers in the context of judicial procedures on the fairness of the layoff, thereby reducing the uncertainty associated with the actual costs of dismissals. This particular design of employment protection for open-ended contracts largely draws on proposals developed by labour economists in Italy (Boeri and Garibaldi 2006 and 2008), France (Cahuc and Carcillo 2006, Blanchard and Tirole 2008), and Spain (Bentolila et al. and Le Barbanchon 2012) in order to reduce contractual dualism, improve incentives for human capital investment in the workplace, and reduce inefficient layoffs.

The Italian experience with the new open-ended contract can be very relevant in improving the quality of jobs created in the aftermath of the Great Recession. New jobs in Europe are mostly temporary jobs. According to data from the EU-SILC, the share of fixed-term contracts in new hirings has increased on average by 15 base points in the EU from 2006 to 2012, and it has been as high as 90% in countries with strict employment protection of permanent (open-ended) contracts. There is a lot of churning in these jobs, and job-to-job shifts from one temporary contract to another are intermediated by frequent spells of unemployment. Moreover, these jobs usually pay lower wages, and are subject to a lower incidence of on-the-job training than the average job (OECD 2014). In other words, firms do not invest in most of the new jobs that are been created. In addition, the flight away from tenured jobs is visible also in sectors and occupations requiring significant on-the-job training (such as, for example, professional services and other occupations for which there is more growth potential in advanced economies) and where the initial human capital investment of the worker can be poorly monitored. Thus, understanding the spread of temporary employment and the reasons of the under-investment in training on-the-job is very important to improve the quality of job creation in the years to come.

Why graded security?

In a recent paper (Boeri et al. 2014) and a new CEPR Policy Insight, we evaluate whether graded security contracts are optimal. We show that, under a rather broad set of circumstances, a severance pay increasing with tenure improves productivity, reduces inefficient layoffs and induces an efficient allocation of labour. Severance pay is efficient in dealing with opportunistic behavior of workers (moral hazard) whose investment in firm-specific human capital is imperfectly monitored by employers. It has to be mandated by governments to avoid adverse selection: in case firms did not at all set the same level of severance, poorly motivated workers would all go to the firms offering the highest severance. Severance should be increasing with tenure, when the costs of training for the individual worker are increasing with tenure (and age) and when judges are more protective of older workers. An optimal severance involves payments increasing with tenure also in presence of fiscal externalities associated to layoffs. For instance when unemployment benefits are also tenure-related and/or job finding rates declining with age.

Incentive reasons, notably deterrence of shirking (Shapiro and Stiglitz 1984), also suggest that severance for disciplinary dismissals (motivated on the basis of workers’ misconduct) should be lower than for economic dismissals. At the same time, this difference, especially when at least part of the burden of proof falls on the worker, induces employers to play strategically. Severance in case of unfair dismissals should be set at even higher levels to deter firms from taking the disciplinary dismissal route even in case of dismissals that are actually motivated on purely productivity reasons. These differences in severance pay levels by nature of individual dismissals, and the associated informational asymmetries enhance the discretion of judges, hence the unpredictability of the costs of dismissals stressed by many employers. By digging into the legal system, we can establish a link between the efficiency of the judicial procedures in detecting opportunistic behaviour of employers or employees, and the optimal levels of severance pay for disciplinary, economic and unfair dismissals.  Finally, problems in monitoring rationalise why small firms are typically exempted from the strictest employment protection legislation regulations. It is easier for employers in small firms to prove opportunistic behaviour of workers before courts as they can better monitor and document the effort made by their workers in increasing the productivity of a job.

The above findings are important in assessing employers’ incentives to hire under contracts that are severed and (dual) contracts that are not severed at termination. This choice involves a trade-off between low productivity, low wage’ and ‘high wage, high productivity’ job creation. The mechanism operates as follows – consider an employer who has to choose between two alternative contractual regimes for new hires:

  1. Offering open-ended contracts involving high and uncertain costs of dismissals;
  2. Offering temporary jobs that are not severed at termination.

If the employer offers a temporary contract, it is hard for her to induce the worker to make an investment with uncertain returns, when effort can be imperfectly monitored. If she offers a higher wage to reward an investment in training, she creates a gap between the worker wage and the outside option. It will typically be very hard for her to commit not to fire workers who invest in job-specific human capital, but whose effort, for exogenous reasons, does not translate in sufficiently high productivity levels to match the increased wage levels. Nor does statutory employment protection provide this commitment device, as the contract is temporary, and hence does not involve any cost of dismissal. It follows that the employer hiring with temporary contracts cannot deal with the moral hazard associated with investment in training when workers’ effort can be poorly monitored. Consequently the choice of a temporary contract tends to involve a flat wage tenure profile (provided that the worker’s outside opportunity is constant over time) low human capital investments by workers, and firing whenever a negative productivity shock is experienced.

If instead the employer offers an open-ended contract, she can commit to a higher pay (hence a higher sanction for opportunistic behaviour) in the future and use statutory employment protection as a commitment device. In fact severance pay dents the gap between the higher wage paid to continuing workers and the outside opportunity, making it not convenient for the employer to fire ‘unlucky’ investors under a relatively large set of circumstances.

The practicalities

The Italian Graded Security Contract (‘Contratto a Tutele Crescenti’) has been effective since 7 March this year. The previous open-ended contract for firms with more than 15 employees involved the compulsory reinstatement of workers in the case of unfair dismissals.  This reinstatement, although rarely enacted (about 3,000 cases in a typical year), was a strong deterrent to hiring in open-ended contracts as it made the costs of dismissals very high (up to 36 months of pay) even for very short tenures. The reinstatement is a major deterrent also because there is a risk of a long trial and eventually a reinstatement, with the employer having also to pay back the worker during the trial period.

The new contract has been introduced on a flow basis (limited to new hires), but will be the only type of open-ended contract allowed in Italy henceforth. It will also involve all workers of firms growing above the 15 employees threshold. 

The new contract phases out the possibility of reinstatement for economic dismissals, and almost entirely also for disciplinary reasons. Basically, the protection is offered only in terms of a mandatory severance pay in case of unfair dismissal increasing steadily (by two months per year with a low threshold of four months and a maximum of 24 months) with tenure, as depicted in Figure 3.  Fair economic dismissals (as well as fair disciplinary dismissals) continue to involve no transfer to the worker at all tenures, while an option has been introduced that allows the employer to offer an intermediate level of severance (one month per year of tenure, starting from a threshold of two months and a maximum of 18 months) together with the notification of the dismissal. If the worker accepts the payment, then there is no possibility for the worker to sue the employer. This compensation is called ‘rupture conventionelle’ in Figure 2, as it mimics the French legislation in this respect.

Below the 15-employees threshold, compensation for dismissal amounts to one months’ salary per year of tenure for a minimum of two and a maximum of six months.

Figure 1. The Italian ‘Contratto a Tutele Crescenti’


Bentolila, S, P Cahuc, J Dolado, and T Le Barbanchon (2012), “Two-Tier Labour Markets in a Deep Recession: France vs. Spain”, Economic Journal 122: F155–F187.

Blanchard, O and A Landier (2002), “The perverse effects of partial labour market reform: Fixed-term contracts in France”, Economic Journal 112, F214–F244.

Blanchard O J and J Tirole (2008), “The Joint Design of Unemployment Insurance and Employment Protection: A First Pass”, Journal of the European Economic Association 6(1): 45-77.

Boeri, T and P Garibaldi (2006), “Un sentiero verso la stabilità”, available at www.lavoce.info, 8 May 8.

Boeri, T and P Garibaldi (2008), “Un nuovo contratto per tutti”, Chiarelettere.

Boeri T, P Garibaldi, and E Moen (2014), “Inside Severance Pay”, CEPR Discussion Paper.

Lazear, E (1990), “Job security provisions and unemployment”, Quarterly Journal of Economics 105(3): 699–726.

Lexology (2015), “Italy: new rules affecting terminations, mass redundancies, executives and mandatory severance (TFR)”.

OECD (2014), Employment Outlook, Paris: OECD.

Shapiro, C, and J E Stiglitz (1984), "Equilibrium Unemployment as a Worker Discipline Device", American Economic Review, American Economic Association 74(3): 433-44, June.

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