During the last decade, fixed-term contracts have taken center stage in the economic debate over European labour market reform as the number of temporary contracts has steadily risen. While some analysts suggest that temporary contracts may act as stepping-stones towards permanent employment (Booth, Francesconi and Frank, 2002), there is increasing evidence that such contracts only serve to deepen the rift between insiders holding permanent contracts and outsiders who find themselves confined to the margins of the labour market, trapped between alternating spells of unemployment and temporary work (for the Spanish case, some recent studies are Güell and Petrongolo, 2007 or Rebollo, 2007). In an attempt to prevent such negative results, some governments have both restricted the conditions under which temporary employees can be hired and sought to entice employers with incentives for increasing the hiring under permanent contracts (OECD, 2002).
The Spanish case offers a paradigmatic example since it is the European country with the highest rate of temporary contracts. Moreover, in order to reduce the presence of temporary contracts different levels of the Spanish administration have implemented both kinds of policies since the mid-1990s. In this paper, we aim at evaluating the effectiveness of regional wage subsidies those designed as a tool to fostering permanent employment by estimating their incidence over the exit rate from unemployment and from a temporary contract into a permanent one.
Although economists have long advocated employment subsidies, only a few theoretical models yield analytical results that can help to clarify the effect of employment subsidies on labour market flows. Katz (1986) provides a partial equilibrium dynamic analysis of wage subsidies for low wage workers. He points out that, in a situation of structural unemployment in which the effective labour supply is completely elastic, a proportional wage subsidy will not affect the worker’s wage, but rather will increase employment in proportion to the elasticity of labour demand for benefited workers. Yet as Calmfors (1994) has noted, the indirect effects of wage subsidies might weaken this result, at least in the short run. He studied three indirect effects (deadweight loss, substitution effect and displacement effect) of wage subsidies. More recent theoretical work on the way subsidies affect job creation offers some interesting new insights. Mortensen and Pissarides (2001) integrate wage subsidies in a search and matching equilibrium framework with endogenous job destruction. For economies with strong unemployment compensation packages and stringent employment protection laws, they conclude that hiring subsidies can actually decrease permanent employment by inducing a disproportionate number of firms to replace old jobs with new ones, thereby leading to a higher labour market turnover. Their main argument is that, while hiring subsidies do indeed stimulate job creation, once a job has been created, the opportunity cost of the match rises, since a firm needs only create a new position in order to receive the same subsidy again.
In Spain, the number of employees holding temporary contracts rose from 18% in 1987 to 33% in 1994 as a consequence of government enacted flexibility measures, such as the well-known 1984 labour market reform. This rise induced the government to pass different laws in 1997 and 2001 designed to reduce the number of fixed-term contracts by lowering the firing costs of new permanent hires. Since 1997, the Spanish government has also subsidized the creation of new permanent contracts by applying what often amounts to a substantial discount in firm payroll taxes for new permanent hires; and this, in turn, has encouraged some regional governments to establish their own wage subsidy programs.
These regional programs consist of two types of subsidies, paid to the firm only at the time of hiring: one for new permanent contracts signed for fixed-term employees at the same firm and other for unemployed workers. Thus, the promotion of permanent contracts has become an important labour market strategy in Spain. In fact, between 1999 and 2002, Spain devoted 0.28% of its GDP more than any other OECD country to subsidizing permanent employment. While a rigorous evaluation of the Spanish government’s active labour market policies would help to clarify the possible benefits brought on by these efforts, we have only been able to locate two studies on the subject though none of them are devoted to the study of the regional wage subsidies mentioned above.
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