1. The Political Economy of Flexicurity Advanced Political Economics Fall 2011 Riccardo Puglisi

2. 2 OBSERVATION Two common ways of protecting individuals against the risks of being unemployed are: – to provide unemployment insurance (UI) – to impose legal restrictions against dismissals (EPL) In a cross-section of European and OECD countries there exists a clear trade-off between the use of EPL and the use of UI. –Countries (Italy, Greece, Portugal and Spain) which adopt stronger dismissal restrictions, tend to enjoy smaller unemployment insurance programs, and viceversa.

3. 3 The Trade-off

4. 4 EPL correlated withWorking-age population Male prime- age (25 to 45) a. UB coverage-.63**-.71** b. UB net replacement rate -.34* a * b-.55**-.66** ** significant at 99* significant at 95 nr of observations =14

5. 5 EPL for regular workers: late 2002 vs. 1980s A Stable Trade-off

6. 6 Explain the existing trade-off between Unemployment Insurance (UI) and Employment Protection Legislation (EPL). Why do countries resort to different combinations of firing protection (EPL) and UI to protect individuals against the risk of being unemployed? THEORETICAL EXPLATION

7. 7  Pissarides, 2001: If severance payments and notice periods (EPL) are chosen optimally to maximize welfare of risk-adverse agents no role for UI  Blanchard and Tirole, 2003, recognize some substitutability between UI & EPL. They suggest to use layoff taxes (EPL) to finance experienced-rated UB and to reduce the use of judicial system in layoffs.  Acemoglu and Shimer 1999 suggest that there may be efficiency gains in substituting EPL with UB. EXISTING ECONOMIC EXPLANATIONS

8. 8 Employment Protective Legislation. According to the OECD (1994) the measure of EPL can be classified as: procedural inconveniences, which characterize the complexity of the procedures needed to issue a dismissal notice; notice and severance payments requirements, that assess the time between the decision to layoff a worker and its effective dismissal as well as the cost of dismissal; difficulty of dismissal, which measures the relevance of litigation costs and any possible bias in the judicial enforcement process. What’s EPL?

9. 9  Red tape matters the most: OECD (1999) and Cazes, Boeri and Bertola (2000) suggest that the difficulty of dismissal, accounts for most of the reduction in the dismissal rate associated with a more strict EPL  Political Economics explanations along two degrees of heterogeneity:  Insiders and Outsiders  Low and High Ability Workers  Political Equilibria with different combinations of UB and EPL. The key role of redistribution in EPL and wage compression. POLITICAL ECONOMIC EXPLANATION

10. 10 1.Economic Environment 2.Labor Market Institutions 3.Voting Game 4.Politico-Economic Equilibria and the trade-off EPL-UI 5.Empirical Implications 6.Conclusions and further research ROAD MAP

11. 11 Infinitely lived agents with logarithmic preferences No savings Two types of agents: low (l) and high (h) ability, ρ l > ρ h with different wages, w l < w h = w l (1+A) Labor supply: Inelastic for Low ability; Elastic for the high ability l h = (w h -  ) 1/  with  degree of redistribution of the UB scheme and  the elasticity ECONOMIC ENVIROMENT

12. 12 Agents may be employed (Insider) or unemployed (Outsider). Unemployment Flows: in-flow rate (Firing): F j (s) and out-flow rate (Hiring): H j (s) where s is the degree of EPL ECONOMIC ENVIROMENT

13. 13 –Program taxes, , the insiders and provides a transfer, b l,b h. –Balanced budget every period –Degree of redistribution from high to low ability,  Unemployment Insurance LABOUR MARKET INSTITUTIONS

14. 14 –Replacement rate: Unemployment Insurance LABOUR MARKET INSTITUTIONS –Redistribution:

15. 15 Employment Protective Legislation  EPL as deadweight cost (litigation cost)  Severance Payment Component of EPL is Disregarded  Redistributive Aspect: EPL is a fixed cost, protecting mainly the low ability  HP: No effect on high ability LABOUR MARKET INSTITUTIONS

16. 16 Employment Protective Legislation 0<s<1 LABOUR MARKET INSTITUTIONS Low Ability Unemployment Flows HP: Firing: F l (s) > F h HP: Hiring: H l (s) < H h

17. 17 where: and represents the discounted proportion of time that a type-j agent who is currently an outsider/insider spent unemployed. INDIVIDUAL PREFERENCES

18. 18 INDIVIDUAL PREFERENCES

19. 19 The degree of EPL (s) the level of UB (  ) and its degree of redistribution (  ) are determined through a political process which aggregates agents´ preferences. Multidimensional Voting Game may lead to Condorcet cycle and lack of equilibria. Solution: Issue-by-issue voting (Shepsle 1979, Conde-Ruiz & Galasso 2003 & 2005, Persson & Tabellini 2000). We restrict to steady state analysis and assume that the voting game takes place once and for all. (No dynamic aspects of the game). Intuition: Agents vote reaction functions  (s,  ), s( ,  ) and  (s,  ); Equilibrium (  *,s *,  *  when they cross. THE VOTING GAME

20. 20 VOTING OVER THE STRICTNESS OF EPL (s) Effects of EPL on Firing & Hiring Rate Unemployment Rate Voting on EPL High Ability Abstain Low Ability

21. 21 INDIVIDUAL PREFERENCES

22. 22 VOTING OVER THE STRICTNESS OF EPL (s) Effects of EPL on Firing & Hiring Rate Unemployment Rate Voting on EPL High Ability Abstain Low Ability The median voter is a low-ability insider Substitutability between UI and EPL: The higher is the UI the lower is EPL preferred by the low-ability insider

23. 23 VOTING OVER the SIZE of UI (  ) Wright (1986): The higher the proportion of time expected to be spent unemployed the higher is the demand for UI. the Median Voter is a Low-ability Insider Notice that is first decreasing and then increasing in s, but does not depend on 

24. 24 VOTING OVER the degree of REDISTRIBUTION of UI (  ) Low skilled maximize UB transfer from the high skills, who have elastic labor supply High skills choose the Median Voter is a Low-ability

25. 25 Issue-by-issue voting Equilibrium (SIE)  Low Ability Insider: Pivotal voter in EPL (s) and Size of UB (  )  Low Ability: Pivotal voter in Redistribution of UB (  ) Equilibrium Outcome:  Redistributive UB:  But large EPL:  And some UB POLITICO-ECONOMIC EQUILIBRIA

26. 26 SIE requires the reaction functions  (s,  ), s( ,  ) and  (s,  ) to cross POLITICO-ECONOMIC EQUILIBRIA A

27. 27 Wage Differential between high and low-skills workers –Other Labor Market Institutions (unions) –Technological Differences: Skill-biased Progress  With more Wage Differential a more Redistributive UI becomes more convenient to Low Ability:  Redistributiveness of UB, , increase  The size of the UB, , increase  But, EPL decreases What Explains the cross-country EPL-UI Trade off?

28. 28 An increase in the wage differential between high and low-skills workers shifts the equilibrium towards less EPL and more UB WHEN DOES A TRADE-OFF EPL-UI EMERGE? A B

29. 29 EMPIRICAL RELEVANCE  Test the hypothesis of our simplified model:  Does EPL reduce unemployment inflow rates? How? To whom?  Test of the key implication of our simplified model:  Is less wage compression associated with less EPL and to more UI?

30. 30 EMPIRICAL RELEVANCE: The Assumptions

31. 31 EMPIRICAL RELEVANCE: Determinants of the UB/EPL Trade-off. Wage Dispersion Returns to education estimated from Mincer-type earning equation

32. 32 EMPIRICAL RELEVANCE: Determinants of the UB/EPL Trade-off. Wage Dispersion Reforming countries experience a (previous) increase in income inequality and a contemporaneous increase in UB

33. 33 In this paper we have shown that different institutional configurations between EPL and UB can be interpreted as politico- economic equilibria. The trade-off between EPL & UI may be explained by the conflicting interests of Insiders-Outsiders & Low-High Skilled Agents. More wage inequality leads to more UB and less EPL Our empirical results are encouragingly in line with the implications of the model. SUMMING UP