Firing tax vs severance payments – an unequal comparison

Abstract

Purpose – The purpose of this paper is to compare two elements of lay-off costs in a dynamic model of the labor market and analyze the differences for business cycle dynamics and welfare. Design/methodology/approach – The paper builds a general equilibrium Real Business Cycle model and introduces firing costs and severance payments. Labor market frictions are assumed to follow the famous search and matching approach. Findings – The paper finds that firing costs imply a higher volatility over the cycle and have stronger negative welfare effects. Severance payments have a lower volatility, reduce unemployment, and reduce welfare by a smaller amount. Practical implications – Policy reforms should be aimed to use severance payments and reduce the ring cost component of lay-off costs. Originality/value – Increasing welfare and a more stable business cycle could be supported by using severance payments instead of firing costs.