Employment Protection Legislation (EPL) is a set of laws which rule the dismissal of employees. Many papers have studied the effect of changes in EPL on employment and job flows. This paper studies the effect of EPL on the distribution of wages.
The firing cost consists of a transfer from the employer to the employee (severance payment) and a tax (e.g. the trial costs). While the tax part of the firing cost cannot be part of the negotiations between employers and employees, it is known since the work of Lazear (1990) that the transfer part of EPL can be undone by changes in wages in a flexible wage framework. The firm reduces the entry wage of a worker by an amount equal to the expected present value of the future severance payment and leaves the cumulative wage bill unchanged. Thus the theory predicts a wage decrease for new entrants. Unlike new entrants, insiders should gain from the introduction of stricter EPL, in fact in a bargaining framework a higher EPL improves the bargaining power of the insiders while worsening the outside option of the firm.
We test this theoretical result jtypically named Vbonding critiqueV jusing a natural experiment from Italy. In 1990, Italy introduced a labour market reform which increased employment protection for workers employed under permanent contracts in firms with fewer than 15 employees relative to those in firms with more than 15 employees. The reform increased the severance payment (i.e. the transfer part of firing costs) of workers in firms below 15 employees from zero to between 2.5 and 6 months of pay. Although EPL is still stricter in firms with more than 15 employees, the reform narrows the gap between employment security provisions guaranteed in firms above and below 15 employees.
Figure 1 considers all workers and shows evidence of a smooth relation between wages and firm size both before and after the 1990 reform. Figure 2 focuses on new entrants and shows that around 1990, the year of the reform, a discontinuity appears in the relation between wages and firm size at the 15 employees threshold. The discontinuity seems to vanish in later years. We identify the effects of employment protection legislation on wages through a Regression Discontinuity Design (RDD). We essentially compare wages in firms just below the 15 employees threshold with wages in firms just above the 15 employees threshold, before and after the reform. Exploiting the temporal variation in EPL which affected differentially small and large firms, we are able to control for time invariant unobservable differences in the two groups of firms.
One natural concern is the endogeneity of the treatment status. One may think that both firms and workers sort above and below the threshold according to their preferences. In fact, if there are benefits to receiving the treatment, it is natural to expect those who gain the most to select themselves into the treatment group. In the course of the empirical analysis we try to address the sorting of workers and firms into the treatment status. To address the latter, we instrument firm size in 1990 (the year of the reform) with firm size in year 1988, when the reform was arguably unexpected. To try and (partially) address the sorting of workers we plan to look at exogenously displaced workers in the hope that their allocation in firms below or above the threshold is Vmore randomV than the allocation of those who voluntarily change firms.
Our empirical analysis uses administrative data from the Italian Social Security Institute (INPS). The dataset is an employer$employee panel reporting, among other information, the firm yearly average number of employees, the workers yearly wage and the number of paid weeks as well as other individual characteristics. Following the indication of Lazearis theory we distinguish two groups, the insiders i.e. those workers who were continuously employed in the same firm (in the text VSample of StayersV) and the sample which of workers who changed firm in the current year (in the text VSample of MoversV).
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