Quantitative effects of temporary employment contracts in Spain

In many countries, employers are forced to make large severance payments to workers when their employment is terminated for reasons other than worker misconduct.1 Actually, it is not uncommon for severance payments to exceed 20 days of pay per year worked, with a cap of one year of wages (for example, in Argentina, Italy, and Spain). In addition, employers often face substantial legal costs when they terminate their workers. Economic theory indicates that these firing costs have large effects on the hiring and firing decisions of firms. Not surprisingly, in an effort to economize their immediate costs, firms respond to the firing costs by reducing their firing rates. However, because they are afraid of the costs that they will have to face in the future, firms also respond by reducing their hiring rates. The net effects on their employment levels depend on whether the decrease in firing rates exceeds the decrease in hiring rates. While their effects on average employment are ambiguous, firing costs generate a clear misallocation of labor across firms. The reason is that firms that receive positive shocks do not expand as much as they should and firms that receive negative shocks do not contract as much as they should. Perhaps because of this misallocation of resources across firms, governments have introduced legislation attempting to improve the efficiency of their countries’ labor markets. One common way that governments have done this is through the introduction of temporary employment contracts of fixed lengths. These temporary contracts effectively provide a period of time during which workers can be fired at no costs. If a temporary worker is retained after their temporary contract ends, they become a permanent worker subject to regular firing costs. The purpose of this article is to provide a quantitative assessment of temporary contracts. In particular, we are interested in determining how effectively temporary contracts of observed length bring the economy close to laissez-faire outcomes (that is, to the economic outcomes that would be obtained under zero firing costs to firms).