The Political Economy of Flexicurity Advanced Political Economics

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

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. 2

The Trade-off 3

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

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

THEORETICAL EXPLATION 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? 6

EXISTING ECONOMIC EXPLANATIONS Ø Pissarides, 2001: If severance payments and notice periods (EPL) are chosen optimally to maximize welfare of risk-adverse agents no role for UI Ø 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. ØAcemoglu and Shimer 1999 suggest that there may be efficiency gains in substituting EPL with UB. 7

What’s EPL? 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. 8

POLITICAL ECONOMIC EXPLANATION Ø 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 Ø Political Economics explanations along two degrees of heterogeneity: Ø Insiders and Outsiders Ø Low and High Ability Workers Ø Political Equilibria with different combinations of UB and EPL. The key role of redistribution in EPL and wage compression. 9

ECONOMIC ENVIROMENT ü Infinitely lived agents with logarithmic preferences ü No savings ü Two types of agents: low (l) and high (h) ability, ρl > ρh with different wages, wl < wh= wl(1+A) ü Labor supply: ü Inelastic for Low ability; ü Elastic for the high ability lh= (wh-f)1/e with f degree of redistribution of the UB scheme and e the elasticity 11

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

LABOUR MARKET INSTITUTIONS Unemployment Insurance – Program taxes, , the insiders and provides a transfer, bl , bh. – Balanced budget every period – Degree of redistribution from high to low ability, f 13

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

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

LABOUR MARKET INSTITUTIONS Employment Protective Legislation 0<s<1 Low Ability Unemployment Flows HP: Firing: Fl(s) > Fh HP: Hiring: Hl(s) < Hh 16

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

INDIVIDUAL PREFERENCES 18

THE VOTING GAME • The degree of EPL (s) the level of UB (t) and its degree of redistribution (f) 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, f), s( , f) and f(s, ); Equilibrium ( *, s*, f*) when they cross. 19

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

INDIVIDUAL PREFERENCES 21

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

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

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

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

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

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

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

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

EMPIRICAL RELEVANCE: The Assumptions 30

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

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 32

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