As argued in the previous sections, despite a long sequence of unsuccessful reforms at the margin, the very high and persistent segmentation prevailing in the Spanish labor market since the late 1980s is the key factor behind its huge employment and unemployment volatility. Temporary contracts do not only bear the brunt of the adjustment during recessions but they also negatively affect the career developments and productivity of temporary workers (typically young, female, and low-skill), who face a low probability of advancing towards a long-term employment relationship.
Given these negative effects, clearly illustrated by the evolution of the Spanish labor market since the onset of the Great Recession, there is a growing consensus among academics that more reforms at the margin, like the one approved in 2010–2011, are bound to remain ineffective. On the one hand, timid attempts to reduce severance pay for some permanent contracts that are not available for all workers still leave a too high firing cost gap, as reflected by the scarce use of the new employment-promotion contracts . On the other, moving back to the labor market of a few decades ago by severely penalizing the use of temporary contracts while keeping the current levels of EPL for permanent contracts is not a viable option either. This would just prevent job creation in the subsequent recovery and make the labor market uniformly much more rigid. Thus, a more radical approach is needed to reduce the firing cost gap between permanent and temporary workers, thus paving the way to a quality job-rich recovery and, foremost, to a better balance between flexibility and social protection. More specifically, new regulations need to be introduced so as to provide a viable alternative for firms to the overuse of temporary contracts, with the key goal of eliminating the detrimental effects of the excessive churning of temporary workers on job stability, training, and future career prospects.
A single open-ended contract
In parallel with similar policy initiatives in Europe, namely those of Blanchard and Tirole (2003) and Cahuc and Kramarz (2004) for France, Boeri and Garibaldi (2008) and Ichino et al. (cr33) for Italy, and Bentolila et al. (2008) for Spain, a manifesto signed by 100 academic economists, see Andrés et al. (2009), was launched in Spain, defending the suppression of the firing cost gap once and for all. To achieve this goal, a key policy advice in this proposal is the introduction of a single open-ended contract (SOEC hereafter) for new hires, at the same time that temporary contracts were abolished –with the exception of replacement contracts for maternity or sickness/disability leaves. The key feature of SOEC is that it has no ex-ante time limit (unlike fixed-term contracts) and that severance payments smoothly increase with seniority, instead of having the same indemnity per year of service applying from the start (unlike current open-ended contracts). In this fashion, and in contrast with the current regulation of permanent contracts, the SOEC provides a sufficiently long entry phase and a smooth rise in protection as job tenure increases. The rationale for the gradually increasing severance pay is that the longer a worker stays in a given firm, the larger are her/his loss of specific human capital and the psychological costs suffered in case of dismissal (Blanchard and Tirole 2003).
A substantial advantage of SOEC over the current dual EPL regulation is that it drastically reduces the marginal cost, in term of expected severance pay, faced by employers when deciding whether to upgrade expiring temporary contracts into permanent ones. The large reduction in the marginal cost of contract extensions (of 2 or 3 days’ wages p.y.o.s. until a reasonable steady value is reached after 10 years, say) would prevent massive redundancies and the huge turnover of temporary workers, which have taken place in the last two recessions. The reason is that the entry phase with low firing costs would encourage job creation and reduce inefficient churning of temporary workers, while the very gradual increase in severance pay will foster longer job durations without necessarily harming employers, as uncertainty about the quality of job matches would entail a much lower cost. As discussed below, even if the expected compensation p.y.o.s. turned out to be to be lower under the SOEC than under current EPL, it is quite plausible that the longer job tenure induced by the fall in the firing cost gap would increase the total expected compensation received by dismissed workers, echoing a Laffer curve effect.
To illustrate these ideas, let us consider a Spanish worker with a prototypical job tenure of 10 years, where the first 2 years are under a temporary contract and the remaining 8 years under a permanent one. Figure9 depicts the marginal severance pay in case of dismissal up to 10 years working at the same firm under current EPL regulations with the rights that would be provided by a conceivable specification of a SOEC. The latter (labeled as SOEC 12–36 hereafter) starts with 12 days’ wages p.y.o.s. and grows by 2 days per year to a maximum of 36 days’ wages, so that compensation is incremental, with a maximum of 24 months’ wages. Under current regulations, since firing costs for a temporary contract entails 8 days’ wages p.y.o.s., while those of a permanent contract typically amount to 45 days’ wages p.y.o.s. (after Law 45/2002), the expected total dismissal cost to the firm would be 376 days’ wages (=2×8 + 8×45). The alternative option for the firm would be to use five temporary contracts in sequence (offered to different workers) instead of converting the temporary contract into a permanent one after the first two years. In this case, the firm would pay 80 days’ wages (=8×10). Thus, the gap in expected firing costs for the firm of contract conversion amounts to 296 days’ wages (=376-80), i.e. slightly more than 80% of a yearly wage. In contrast, under SOEC 12-36, the expected total severance pay would be 210 days’ wages (=12+14+..+30), so that the firing cost gap would fall to only 130 days’ wages (=210-80). This amounts to a reduction of 56% vis-à-vis the current regulation, which is bound to increase job creation and job duration significantly, as well as to reduce job destruction. The combined effect of these favorable outcomes should lead to a noticeable reduction in unemployment.
Evaluating the effects of introducing a single open-ended contract in Spain
There have been a few papers quantifying the above-mentioned implications of the SOEC proposal that we summarize in what follows. The first strand of this literature relies on calibrating search and matching models of the labor market, along the lines of Mortensen and Pissarides’ (1994) classical model with endogenous job creation and job destruction, but extended to allow for the existence of temporary and permanent contracts entailing very different dismissal costs.11
Bentolila et al. (2012) estimate the proportion of the much larger increase in Spanish than in French unemployment during the Great Recession that is due to the larger firing cost gap in Spain than in France. They focus on a comparison of these two neighboring countries not only because they share quite similar labor market institutions, including the use of temporary contracts, but also because their unemployment rates just before the crisis were almost identical (around 8% in 2007). Yet, while the unemployment rate in France has only increased by about 2 percentage points (pp.) by the end of 2009, it shot up to 19% in Spain over that period (23% nowadays). As discussed earlier, the fact that both countries exhibit similar overall indexes of strictness in EPL in the well-known OECD (2004) rankings is due to how these indexes are constructed, i.e. on the basis of legal regulations and not on their implementation. Indeed, when discussing the enforcement of the legislation, they argue that de facto EPL of temporary jobs is much weaker in Spain than in France, whereas the opposite holds for regular permanent jobs.
Further, to estimate the relevant EPL gap in each country, they adopt the conservative view that what affects employment is not legal severance pay per se, which is a transfer from the firm to the worker and may therefore be compensated for in the wage bargain (Lazear 1990). Rather, what matter are other costs generated by third agents, like labor courts and labor authorities, which cannot be appropriated by firms and workers and therefore cannot be neutralized through wage bargaining. These are the so-called red tape costs, which they estimate to be 50% higher in Spain than in France. In view of this large gap, the research question they address is by how much would Spanish unemployment have been reduced during the Great Recession, relative to its actual rise, had Spain adopted the lower French EPL gap before the start of the slump, instead of keeping its own EPL regulations.
Their strategy is to calibrate the above-mentioned analytical model to match the main stylized facts (average flows and stocks) in the French and Spanish labor markets before the recession (2005–2007). Then, keeping invariant the calibrated parameters in this first stage, they proceed to match the new stylized facts during the recession (2008–2009), by allowing only for an adverse aggregate productivity shock and, in Spain, a negative reallocation shock. These two shocks are meant to capture, respectively, the severity of the recession and the increase in mismatch induced by the collapse of the construction industry as a result of the credit crunch. Once the model is well calibrated in both the good and bad state, they run a counterfactual simulation during the recession (imposing the same adverse shocks estimated before) where the Spanish EPL gap is replaced by the much lower French gap.
Their main finding is that, with the French EPL gap and taking into account its indirect, mismatch-reducing effect, Spanish unemployment would have increased by 45% less than what it actually did (i.e. from 8% to 14%, rather than to 19%). Further, a similar counterfactual simulation during the preceding expansionary period yields that unemployment would have been 2 pp. lower during 2005-2007, i.e. 6% rather than 8%. Overall, these results indicate that, due to the inefficient turnover they induce, facilitating the widespread use of temporary contracts is likely to raise average unemployment over the business cycle in labor markets with already rather stringent permanent job security provisions.
A related paper is Costain et al. (2010), which addresses the issue of high unemployment volatility in strongly dual labor markets. Rather than focusing a single event, like Bentolila et al. (2012) do with the Great Recession, these authors study labor market dynamics over the business cycle following a sequence of auto-correlated, match-specific productivity shocks. After calibrating a similar search and matching model with permanent and temporary contracts to the Spanish labor market during 2001-2008, they compare the volatility of unemployment under two alternative scenarios regarding firing costs: under the current, dual EPL and under a unified labor market with a single contract where firing costs are equal to the average severance pay in the dual labor market (but where the firing cost does not increase with job tenure). Their main finding is that the unemployment rate in the dual labor market fluctuates 21% more than in the unified case.
The intuition behind this result is that while new permanent jobs must have relatively high productivity (to compensate firms for future high severance pay), in temporary jobs with low or no dismissal costs firms are instead willing to hire workers with lower productivity. Hence, the latter jobs become very fragile as soon as there is an adverse shock. In other words, the stock of fragile jobs accumulates rapidly in expansions and becomes immediately destroyed when a recession hits. According to these results, introducing a single contract would unambiguously reduce volatility but, by hampering the hiring of low productivity workers, it would also increase unemployment by 2 pp. (from 10% to 12% during the calibration period). Their simulations show that, in order to avoid this rise in unemployment, average firing costs would have to fall by 60% in their sample period. Interestingly, as discussed above, this reduction in average firing costs turns out to be quite similar to the one implied by the introduction of SOEC 12-36.
The quantitative evaluation of the effects of the SOEC 12-36 proposal is directly addressed in this type of search and matching models by García Pérez and Osuna (2011), which analyzes the transition between the existing dual EPL and this specific design of SOEC. They focus not only on simulating the effects of this change of regulations on unemployment but also on how this change would have affected workers’ job tenures over the period 1998–2009, which comprises both a long expansionary phase and the subsequent recession. Their strategy is similar to the one used in the previous two papers: calibrate the parameters of the model to match the main stylized facts of the Spanish labor market over the chosen period and then run counterfactual simulations under SOEC 12-36. Their results show not only that the unemployment rate would be 3 pp. lower under the single contract but, more importantly, that the number of workers with job tenure below one year would be almost 25% lower than under current EPL, while the number of workers with tenure longer than three years would become 15% higher under SOEC 12-36. The intuition for these results in again similar to the one discussed above: under the latter contract, the probability of being fired in contracts with tenure below four years is almost halved, because firms are much less reluctant than before to destroy jobs since they are costlier (12 days’ wages p.y.o.s. v. 8 days’ wages p.y.o.s.) and because the jump in severance pay (from 8 to 45 days’ wages) has been replaced by a much smoother gap (2 days for each year the contract is extended, up to an upper bound of 36 days’ wages).
A second strand of this literature uses a different simulation approach to evaluate other relevant consequences of the introduction of SOEC 12-36, as well as those of other alternatives, like a combination of a single contract and a capitalization fund for dismissals, in line with the so-called Austrian model. The idea behind this fund is that, rather than paying a statutory severance pay to the worker at the termination of a labor relationship, firms deposit every month a given (small) amount of days of salary for all their workforce into an individual fund for every worker, to be used in case of dismissal, relocation, engagement in educational activities or eventually upon retirement. The idea is that a worker’s fund does not disappear upon changing jobs –as happens with current EPL– and it therefore fosters worker mobility. In particular Conde Ruiz et al. (2011) focus on the effects of introducing two alternative single contract schemes on the expected average severance paid by firms and received by different types of workers after 10 years, relative to what they would respectively pay and receive under the status quo.
The first scheme is SOEC 12-36, while the second scheme is a combination of a SOEC entailing lower firing costs, increasing from 12 to 24 days’ wages in 7 years, with a capitalization fund of three days’ wages per year (SOEC 12-24 +F3), both with a maximum entitlement of two years’ wages. To simulate these effects, they use information at the individual level on wages, hiring, firing, and contract conversion rates for unemployed, temporary, and permanent workers over their working life, using a 4% random sample of the Spanish social security registers for 2009.12 The paths arising from these rates are then projected over the next decade to evaluate the effect of alternative EPL regulations. Specifically, drawing from the endogenously determined job creation, job destruction, and contract conversion rates obtained by Costain et al. (2010) and García Pérez and Osuna (2011) in their counterfactual simulations of general equilibrium search and matching models, it is assumed that the firing rate under SOEC will be on average 60% lower than those observed for temporary workers with less than 4 years of job tenure and 35% higher for permanent workers with job tenure above 4 years. The latter is assumed to capture the potential adverse effect of a SOEC reform exclusively applied to new workers (i.e. not retroactively) on workers with old permanent contracts, through a replacement of these workers –entitled to high severance pay– by new contracts under the cheaper SOEC. The main finding of these (partial equilibrium) models is that SOEC 12-24+ F3 provides on average 15% higher severance pay for workers than under the status quo and 13% more than under a pure SOEC 12-36, while the average firing cost to firms over the 10 year period is approximately the same. Thus, the mixed proposal of a SOEC and a capitalization fund seems to be a more beneficial alternative in order to reduce the degree of segmentation in the Spanish labor market, through its effects on job duration, job mobility, and greater incentives to invest in human capital.
Other policy proposals
A SOEC would not be the cure-all for the Spanish labor market. The extremely high unemployment rates that have been reached are the result of a systemic failure, involving also the structure of collective bargaining, unemployment benefits, and active labor market policies. In this section we briefly review appropriate lines of reform in those areas.
Among the many government policies that can affect wage developments (public sector wages, minimum wages, labor taxation, etc.), the regulation of collective bargaining is probably the one having the strongest bearing on labor cost developments. The coverage of collective bargains, the level at which wages are set, the extension of bargained wages to workers and firms outside the scope of an agreement, the existence of coordination mechanisms or the application of wage indexation clauses are clearly determined by the social partners. But these features are very strongly influenced by both labor legislation and the intervention of governments in the social dialogue.
As indicated in Section 3, empirical studies reveal little real wage adjustment to unemployment or to productivity changes. This yields a significant increases in equilibrium unemployment, as has been argued by Jimeno and Thomas (2011), using a calibrated version of a Mortensen-Pissarides (1994) model with heterogenous firms. They also show that allowing for opting-out of industry-wide collective bargaining agreements would reduce unemployment to the same level achieved under efficient firm-level bargaining without major changes in either average wages or wage inequality. Real wage rigidity has two important consequences in the current situation. First, regarding the employment impact of the crisis, the lack of wage adjustment increases job destruction. Secondly, looking ahead, the requirements for restoring output and employment growth, namely nominal adjustment, the closing of the competitiveness gap, and the reallocation of resources from the non-tradable to the tradable sector, are all harder to implement.
Hence, regulatory reforms should affect collective bargaining practices in order to bring wages more in line with productivity changes. This requires giving more scope to firm-level bargaining, even for those firms within the coverage of industry-wide agreements, and limiting the use of wage indexation rules. As indicated in Section 3, the labor reforms of June 2010 and June 2011 eased the opt-out of industry agreements and established firm-level agreements as the default ones. However, by giving labor unions and the employers’ association an effective veto over this change, it is not clear whether these changes will deliver a significant increase in the degree of decentralization.
We strongly believe that the SOEC and making opting-out of sectorial collective bargaining truly operational would eliminate the insider-outsider divide, and that this would bring very positive consequences in terms of job creation, giving scope to most-needed productivity gains and, last but not least, reducing earnings inequality among Spanish workers. The two fundamental measures that we advocate would surely need further refinements and being complemented by others geared towards reducing long-term unemployment, such as introducing some degree of experience-rating in unemployment benefits and improving the effectiveness of active labor market policies, by means of proper evaluation of their effects with financial consequences for the agencies in charge of the administration of those policies (see Andrés et al. 2009 for other proposals).