Inside Severance Pay

All OECD countries have either legally mandated severance pay or compensations imposed by industry-level bargaining in case of employer initiated job separations. In the literature such transfers are either ineffective or less efficient than unemployment benefits in providing insurance against labor market risk. The paper shows that mandatory severance is optimal in presence of wage deferrals induced by workers' moral hazard. We also establish a link between optimal severance and efficiency of the legal system and characterize the effects of shifting the burden of proof from the employer to the worker. Quantitatively, the welfare effects of suboptimal severance payments vary in general equilibrium between 1 and 3 percent. The model accounts also for two neglected features of the legislation. The first is the discretion of judges in declaring the nature, economic vs. disciplinary, of the layoff. The second feature is that compensation for dismissal is generally increasing with tenure