Do firms obey the law when they fire workers? – Social

Do firms obey the law when they fire workers? – Social

Do firms obey the law when they fire workers? – Social criteria and
severance payments in Germany –
Elke J. Jahn
Aarhus School of Business, University of Aarhus, IAB and IZA
(October 2008)
LASER Discussion Papers - Paper No. 22
(edited by A. Abele-Brehm, R.T. Riphahn, K. Moser and C. Schnabel)
Correspondence to:
Elke J. Jahn, Hermodsvej 22, 8230 Åbyhøj, Denmark, Email: [email protected].
Abstract
Employment protection legislation defines social criteria according to which firms can dismiss
workers. If firms evade the law, then negotiation about compensations begins. To reduce legal and
financial uncertainty often associated with ex-post bargaining, the German government stipulated
severance payments in the case of mutual agreements into the law in 2004. The paper shows that
workers protected by law have the lowest probability of being dismissed. The expected severance
payment and firm size increase the probability of receiving compensation while the amount of
severance payment depends significantly on the way the employment relationship is dissolved.
Contrary to the intention of the legislator, the reform increased the level of compensation.
Do firms obey the law when they fire workers?
– Social criteria and severance payments in Germany –
Elke J. Jahn*
(October 2008)
Employment protection legislation defines social criteria according to which firms can dismiss
workers. If firms evade the law, then negotiation about compensations begins. To reduce
legal and financial uncertainty often associated with ex-post bargaining, the German government stipulated severance payments in the case of mutual agreements into the law in
2004. The paper shows that workers protected by law have the lowest probability of being
dismissed. The expected severance payment and firm size increase the probability of receiving compensation while the amount of severance payment depends significantly on the way
the employment relationship is dissolved. Contrary to the intention of the legislator, the
reform increased the level of compensation.
Keywords:
employment protection legislation, severance payment, bargaining, reform
JEL-classification:
*
J63, J65
1
Aarhus School of Business, University of Aarhus, IAB and IZA, Hermodsvej 22, DK-8230
Åbyhøj, Denmark, E-mail: [email protected]
1
Introduction
Employment protection legislation restricts the ability of the employer to utilize labor. These
restrictions are typically legislated but may also be set by collective agreements or by the
decisions of the judiciary through evolving case law. Employment protection rules impose
firing costs to the firm and have a tax and a transfer dimension. Firing taxes emerge as a
consequence of administrative restrictions under which a dismissal is justified and from procedural inconveniences that the firm has to obey if it wants to lay off. The tax includes red
tape costs and legal expenses in case of a trial and is paid outside the firm worker-pair. The
second component is a transfer from the firm to the worker to be laid off. The transfer dimension involves severance payments usually paid in case of unfair dismissals and may be set
by legal rules, be a result of individual and collective agreements or of ex-post negotiations
between the worker and the firm.
A vast literature has studied the quantitative effects of different degrees of firing taxes and
severance payments on macroeconomic labor market outcomes such as (un-)employment
and labor turnover.1 Up to today, little emphasis has been given to the interplay between the
statutory employment protection defined by law and the transfer component. One reason
may be that ex-post bargaining about severance payments is often implicit and not easily
observable by third parties if the firm has to lay off.
Which workers will be laid off if a firm needs to reduce its workforce for economic reasons? According to economic theory, workers with the lowest productivity will be fired first.
However, in Germany, as in many European countries, employment protection legislation
specifies social criteria determining the order in which workers are to be dismissed. But
meeting social criteria is complicated and often it does not serve the interests of the firm.
Germany is an especially interesting case to analyze because the law and its entangled
jurisdiction create a remarkable legal and financial uncertainty, the dismissal procedure is
complicated and time-consuming, and after an unfair dismissal lawsuit it is often impossible
to continue the employment relationship. As a consequence, it has become common to negotiate ex-post over severance payments instead of relying on the legal system if the firm
has to lay off.
In order to increase labor market flexibility, in 2004 the German government simplified the
dismissal procedure and specified the amount of severance payments if the firm dismisses
the worker for economic reasons. The aim of the legislator was to reduce the incentive of the
dismissed workers to file a lawsuit. Consequently, the legal uncertainty should have decreased. In addition, it was the aim to reduce financial insecurity by specifying the amount of
severance payments by law.
1
See Jahn (2005) and OECD (2004) for a comprehensive overview.
2
Recently, research concentrating on decisions of labor courts and the level of compensation has received increasing attention but is still in its infancy, see Section 2. Contrary to previous research, this paper investigates whether firms indeed obey the law and meet social
criteria if they have to lay off workers. Furthermore, a stepwise estimation strategy is developed to account for sample selection bias when examining which workers receive severance
payments and the determinants of severance pay variation. In addition, the dataset used
allows to distinguish between three forms of displacement: individual dismissals, collective
dismissals, and mutual agreements. Finally, the paper investigates whether the reform in
2004 indeed reduced financial uncertainty for the firms by decreasing severance payments.
The paper is organized as follows. Section 2 briefly summarizes the related literature. In
Section 3, the legal framework in Germany and the main hypotheses are outlined. Section 4
introduces the dataset and is devoted to the estimation strategy which combines two Heckman selection models in order to take sample selection issues into account. Section 5
presents the results and Section 6 concludes.
2
Literature
Since the pioneering study of Lazear (1990), which shows that without market imperfections
a compulsory severance payment can be neutralized by an appropriately designed wage
contract, the theoretical and empirical investigation of the labor market consequences of employment protection has exploded. The bulk of the literature analyzes the macroeconomic
effects of statutory employment protection, especially of firing taxes, compulsory severance
payments and notice periods. Firing taxes reduce the quasi-rent of a match while severance
payments prima facie redistribute the rent in favor of the worker (Jahn 2002). Especially the
effect of compulsory severance payments in imperfect markets has recently received attention.
Stähler (2006), Galdón-Sánchez and Güell (2003), Goerke (2002) and Fella (2000) integrate compulsory severance payments into the shirking model of Shapiro and Stiglitz (1984).
Fella (2000) shows that the unemployment rate decreases and worker welfare increases if
the severance payment goes to the dismissed worker. In contrast to these findings, Galdón Sánchez and Güell (2003) argue that a compulsory settlement increases the unemployment
rate, if third parties, such as a court in the case of a claim for wrongful dismissal, cannot easily distinguish between a dismissal for economic reasons and a dismissal due to misbehavior.
Goerke (2002) compares compulsory settlements for individual and collective dismissals. In
particular, settlements payable for collective dismissals may increase aggregate employment. Stähler (2006) allows for judicial mistakes when the court decides over severance
payments. Increasing the level of severance payments may increase employment for small
3
judicial mistakes and may dominate the effect of firing taxes which leave ambiguous effects
on employment.
Garibaldi and Violante (2005) argue theoretically and empirically that the transfer component of firing costs has a larger impact than the tax component if wage rigidity is endogenous. With a panel dataset of OECD countries they show that the transfer component of employment protection legislation may be considerably larger than the tax component. Thus
from a quantitative standpoint, the transfer component cannot be ignored.
Why do parties involved in a dismissal not always settle, avoiding the wasteful judicial
costs of going to court? Galdón-Sánchez and Güell (2000), Ichino et al. (2003) and Goerke
and Pannenberg (2005) explicitly model the litigation process under the presumption that the
rules of the law are very general, leaving room for a wide range of possible interpretations by
the parties and the judge. Galdón-Sánchez and Güell (2000) investigate two types of dismissals; dismissals for misconduct and for economic reasons and two reasons for conflicts,
namely disagreement between the agents or strategic behavior of the agents. They analyze
under which conditions cases are bilaterally settled or taken to court. It seems that the gap
between severance payments for fair and unfair dismissals is the key factor determining
court outcomes. Ichino et al. (2003) concentrate on dismissals for misconduct. Using data
from a large Italian bank, they find some evidence that jurisprudence may be affected by the
underlying labor market conditions and may tend to be particularly unfavorable to employers
when unemployment is high.
Bertola et al. (1999) also provide some evidence that the size of severance payments is
not independent from labor market conditions in some European countries. Berger and Neugart (2006) confirm that judges have ample room for discretionary decisions when it comes
to a lawsuit in Germany. They prove that court activity varies systematically with the ideological leaning of the government nominating the judge. Therefore, the outcome of a lawsuit may
also depend on the region in which the case is taken to court. As a consequence, labor court
activity and unemployment are significantly positivly correlated.
The impact of uncertain court rulings on privately negotiated severance payments has
been taken theoretically into account by Goerke and Pannenberg (2005). They show that the
outcomes of bargaining in dismissal conflicts depend on workers and firm characteristics and
the taxation of severance payments.
The studies of Grund (2004, 2006) and Goerke and Pannenberg (2005) are more in line
with the present study. They use data from the German Socio-Economic Panel (GSOEP) to
estimate the probability of receiving compensation and the incidence of severance payments
for the period 1991-2002 and 1991-2003, respectively. Both studies show that the probability
of receiving compensation increases with tenure, family responsibilities and firm size. The
results of the incidence of severance payments are less clear cut. Merely tenure and the
4
wage at the last job have a significant effect on the amount of severance payment. In addition, Goerke and Pannenberg (2005) estimate the effect of an increase in taxation of the severance payment. They show that the change had not only a negative effect on the probability of receiving severance payments but also on the amount of severance payment.
Both studies have one shortcoming in common. They do not control for potential selectivity bias. If the firms obey the law, they will first of all dismiss workers which are less protected
by the regulation. Therefore to estimate the determinants of the level of severance payments,
it has not only taken the probability of receiving severance payments into account but also
the probability of being dismissed.
In addition, this paper tries to shed light on two further questions: First, until 2000 the
questionnaires of the GSOEP regarding the reasons for termination of the last job have
changed several times. The questionnaires in 1999 and 2000 do not allow to distinguish between individual dismissals (lay offs) and collective dismissals (plant closing). Before 1999
the questionnaires did not clearly ask whether the employment contract was dissolved as a
consequence of a mutual agreement. Therefore, whether the way to dissolve an employment
contract has an effect on the probability of receiving severance payments and the amount of
severance payment could not be answered in previous studies.
Second, from the political point of view it is interesting to investigate whether the reform in
2004 indeed had an effect on the probability of receiving compensation and the incidence of
severance payments. The study addresses this question as well.
3
Legal Framework and Hypotheses
Employment protection legislation applies to workers employed in firms with more than five
and since 2004 more than ten workers and with a tenure of more than six months.2
A lay off is only justified if the firm can state a suitable reason for termination. According to
law a dismissal is considered to be fair in cases of personal misconduct, e.g. thievery, lack of
personal capabilities, mostly long-lasting sickness, or for economic reasons. To justify dismissals for misconduct or lack of personal capabilities, jurisdiction and case law set high
standards and therefore they are rarely considered to be fair by the court. As a consequence,
most firms dismiss workers for economic reasons or offer severance payments to dissolve an
employment relationship even though the true reason lies in the behavior or the capability of
the worker (Rüthers 2002, Thau 1999, Bauer 2002).
Firms displacing workers for economic reasons cannot simply adjust their workforce according to the volatility of the business cycle. Instead they have to prove a long-lasting severe decline of orders which will persist in the future and that lay offs cannot otherwise be
2
A comprehensive description of the German employment protection legislation can be found in
Jahn (2002, 2005).
5
avoided. In addition, the judge has to weight the interest of the worker to keep his job against
the interest of the employer to dissolve the employment relationship. But even if the firm can
justify the lay off with business needs, it cannot dismiss the worker whose job became redundant.
In a second step the firm has to compare workers with similar skills and rank them according to social criteria. The worker with the lowest rank must be dismissed first. Jurisdiction and
since 2004 the law specify as social criteria age, tenure within the firm, family responsibilities,
and disability (see Table 1). However, the law does not weight these criteria, and many exceptions exist. In addition, judges enjoy a high degree of independence in interpreting legal
rules (Berger and Neugart 2006). Ranking workers is therefore a complex task, especially for
larger firms because so many workers must be compared. As a consequence, even trained
and experienced labor law experts are not able to predict with certainty whether a dismissal
may be justified, even though the firm successfully proves that the redundancy made can be
justified by economic reasons (Willemsen 2000).
As a consequence of this legal uncertainty, firms are tempted to evade a judicial settlement when making a dismissal decision as the following figures prove: In 2003, 65 percent of
all lawsuits ended with an amicable settlement, 24 percent with an out-of-court agreement
and only 11 percent finally were decided by the judge (Höland et al. 2005). Obviously, bargaining after a dismissal is important when making a firing decision.
The law does not unambiguously set the level of compensation and mandatory severance
payments do not exist. Instead, severance payments are the result of ex-post bargaining if a
lay off may be considered to be unfair. Severance payments can be the outcome of three
types of dismissals:
Unfair lay offs: Workers who believe they have been unfairly dismissed can file a lawsuit
and claim to be re-instated again. After a compulsory conciliation procedure the trial begins.
Court decisions can take time; in 2006 14 percent of all 231,588 settled lawsuits lasted longer than 6 months. If the firm loses the lawsuit, it has to continue wage payments from the day
of termination notice through to the date when the lawsuit is settled which is considered as
one source of the tremendous financial uncertainty. However, after adjudication it is often
impossible to continue a cooperative employment relationship. As a consequence, reinstatement to the previous job can only rarely be observed (Höland et al. 2005, Pfarr et al.
2005). Provided both parties agree, the judge can dissolve the employment contract if the
firm pays a compensation set by the judge. As an orientation, courts use a severance pay
factor of 0.5, which means one half of a monthly gross wage for each year the worker was
employed by the firm. Given the discretionary power that judges enjoy in the German labor
court system, they may chose to set the compensation above or below this rule of thumb,
6
depending on their political preferences, the likely consequences for the worker or the regional unemployment rate.
Collective dismissals: In the case of collective dismissals or plant closings, works councils
bargain a social plan for all redundant workers. Works council presence tends to increase
sharply with establishment size, from about 9 percent in firms with 5 to 20 employees to
about 90 percent in large firms with more than 500 employees (Addison et al. 2003). The
bottom line for the negotiations is the severance pay factor of 0.5, but compensations are
usually higher since the bargaining power of works councils exceeds that of an individual
worker (Jahn and Schnabel 2003).
Mutual agreements: Firms increasingly offer redundancy pays and release workers from
work in exchange for a mutual agreement dissolving the employment contract. The rationale
for the firm is to reduce legal and financial uncertainty, to prevent an unfair dismissal claim,
and to avoid wage payments until the case is settled by the court. However, to offer a mutual
agreement may signal that firms anticipate they will lose the lawsuit. In this case, the fallback
position of the worker is the amount of severance payment that the judge is likely to recommend. Therefore the offer should usually be higher than the severance pay factor of 0.5.
Up to 2003 the legislator has judged bargaining about severance payments and mutual
agreements as a means to circumvent employment protection legislation. Therefore workers
accepting a mutual agreement were not eligible for unemployment benefits for the first 12
weeks in case of a subsequent period of unemployment. Hence, the severance payment also
has to cover unemployment benefits if the parties have to assume that the worker will become unemployed after being displaced.
In light of the increasing critique of the employment protection legislation, the growing
number of cases brought to court, and an increasing trend to negotiate over severance payments the government decided to integrate mutual agreements into the law from January
2004 on (see Table 1). Since then a firm can offer ex-post severance payments if it dismisses the worker for economic reasons. In this case, the minimum compensation amounts
to one half of a monthly gross wage for each year the worker has been employed by the firm;
the severance pay factor of 0.5 previously used as a rule of thumb by the courts. After receiving the termination notice which must explicitly refer to the new legislation, the worker can
decide whether he wants to file a lawsuit or accept the offer. If the worker signs the mutual
agreement, he loses the right to claim but remains eligible for unemployment benefits from
the first day of unemployment on. The idea of the legislator was not only to decrease the
number of lawsuit but also to lower the financial and legal uncertainty for both parties.3
3
In 1965, British policymakers passed the Redundancy Payments Act mandating lump sum payments to workers who are to be laid off. As in Germany, the Act was an effort to reduce uncertainty
due to time-consuming judiciary processes to spur labor market flexibility. As a consequence of the
new Act, the number of lay offs increased significantly in the UK. The considerable boost in redun-
7
Against this expectation Jahn and Walwei (2005) and Jahn (2005) have objected that the
reform may have increased the bargaining power of the worker. The reason is that the law
now sets a minimum standard for the amount of severance payment which was previously
subject to ex-post bargaining. After receiving the termination notice, the worker still can decide to take the case to court. Because the firm already offered the compulsory severance
payment, it is likely that the judge will at least recommend the severance pay factor of 0.5. In
contrast to the legal situation before 2004, the judge will be more hesitant to undercut the
severance pay factor of 0.5 because it is now stipulated by law as a bottom line. To ensure
that the redundant worker trades his right to sue against a severance payment, the worker is
likely to receive after a lawsuit in any case; firms have to offer higher compensations. As a
consequence, the amount of severance payment should have increased after the reform.
With respect to the probability of being dismissed, the probability of receiving severance
payments and the incidence of severance payment the following hypotheses can be summarized:
1. If firms indeed obey the law and social criteria affect the dismissal decision of the employer, then older workers, employees with longer job tenure, handicapped persons and
persons with family responsibilities should have a lower dismissal probability. The dismissal probability should be higher in firms below the threshold at which employment protection legislation applies; it should decrease with increasing firm size because works
councils are more likely present in larger firms who usually rule in favor of the worker. Finally, larger firms may more often be able to offer redundant workers a job in another division.
2. Social criteria should influence the probability of receiving compensation for two reasons:
First, it is more likely that the worker receives a voluntary severance pay offer if the firm
anticipates that it will lose the trial in case the worker goes to court. This will be more likely if the dismissal decision does not meet the social criteria defined by law. Second,
whether a worker receives compensation may also depend on his decision to claim which
is a prerequisite to receive compensation if the worker does not receive a voluntary offer
by the firm. This may depend on the credibility of the reason stated in the termination notice, on whether the workers believe that social criteria are met and finally on whether the
local judge, who has some discretionary power, is known to decide more in favor of or
against workers’ interests.
Firm size should have a positive effect on the probability of receiving severance payments as well. It is more likely that a works council is present and bigger firms can more
easily bear the financial burden. Moreover, in bigger firms the personal relationship bedancies in Britain during the 1970s may be an indication that firms are indeed prepared to bear
higher firing costs as long as they are able to calculate ex-ante the costs of a displacement (Booth
and McCulloch 1999, Oswald and Turnbull 1985).
8
tween the employer and the dismissed worker is weaker. Therefore redundant workers
may be more prone to bring the case to court or claim severance payments. Filing a lawsuit is time-consuming and may be associated with emotional stress. Hence, it is likely
that the expected severance payment, calculated on the basis of the severance pay factor, may have a positive impact on the probability to suing the employer and therefore receive compensation.
3. Severance payments are to be seen as having an insurance function if the unemployment risk is not full insurable (Alvarez and Veracierto 2001). Judges may account the unemployment risk of the worker in their decisions for damages corresponding to past and
expected future financial losses. Having found a new job at the end of the notice period
therefore weakens the workers’ bargaining position and judges are often more benign
and may decide in favor of the firm. Therefore, it is likely that the probability of receiving a
severance payment and its incidence should be lower for workers who already have
found a new job at the end of the notice period.
4. Firm size is likely to increase the amount of severance payment. For larger firms it is
nearly impossible to meet social criteria. Therefore, compared to smaller firms, the likelihood to lose a lawsuit is higher. As a consequence, it can be expected that larger firms
will be more prone to offer at least a severance payment in the range of the severance
pay factor or even higher. Moreover, because of the strategic position of the workers, it
can be expected that the highest severance payments will result from mutual agreements, followed by collective dismissals and traditional lay offs.
5. Finally, as already argued above, the reform should have increased the amount of severance payments because it strengthened the workers’ bargaining position.
4
Data and Empirical Approach
The paper uses data from the GSOEP, a longitudinal representative household survey of
people living in Germany. Whether a dismissal in the previous year is followed by a mutual
agreement is reported from 2000 on, see Section 2. The sample therefore covers the period
2000-2006, information on employment characteristics are added from 1998 on. Workers
between 18 and 65 years of age who lost their jobs as a consequence of lay offs, plant closings or who signed a mutual agreement are included. Workers with tenure of less than six
months, apprentices, self-employed and civil servants are excluded because different dismissal rules apply to these groups. The variables used in the analysis and selected summary
statistics are described in Table 2.
To explain the determinants of receiving redundancy pays and the incidence of a severance payment, a stepwise estimation strategy is applied. First, the probability of being dismissed is estimated. For the redundant workers, it is determined whether they receive a se9
verance pay. If the second hurdle – receiving compensation – is cleared, the determinants of
the level of severance payments are estimated. Theses hurdles are stepwise interdependent
and we have to control for potential selection bias.
Workers receiving severance payments are not a random selection of all dismissed employees. It is plausible that firms first dismiss those workers who are not protected by law and
therefore have a low probability of receiving any redundancy pay at all. A second selectivity
problem is at hand with respect to the amount of severance payments observed only for
workers who received compensation. Once the bargaining has started, the amount of severance payment depends on how displacement occurs (lay offs, plant closings, mutual agreement), the probability of receiving compensation and, indirectly, of being dismissed.
Therefore, two Heckman sample selection models are combined with one selection equation for each of the models:4 First a bivariate probit selection model is applied to estimate the
compensation probability conditional on the probability of being dismissed. To receive consistent estimates for the parameters for the amount of severance pay, this estimation is used
to construct the inverse Mills ratios. These are included in the second Heckman selection
model estimated by maximum likelihood conditional on who receives compensation. This
procedure controls stepwise for being dismissed and receiving compensation.
The amount of severance payment of a worker i, si , is estimated as
(1)
si* = β x i + ε i if
where x i is a vector of controls and ε i an idiosyncratic error term.
However, the model needs to account for the probability of receiving compensation, c i* ,
and, indirectly, of being dismissed, d i* . The corresponding selection equations are given by
1, c = c *
if d i* > 0
i
i
di = 
0, c i is unobserved otherwise
and
1, s = s *
if c i* > 0
i
i
Ci = 
0, si is unobserved otherwise
These probabilities can be specified as latent variable models.
(2)
c i * = δzi + η i
(3)
d i * = γw i + υ i .
4
The basic assumptions of the Heckman model can be found in Wooldridge (2002).
10
w i and zi are vectors of controls, η i , and υ i are idiosyncratic error terms, respectively,
δ in equation (2) is estimated by a bivariate probit model with sample selection. To receive
consistent estimates of the parameters, this estimation is used to construct the inverse Mills
ratios, which are included in the second Heckman equation (1). This procedure corrects
stepwise for being dismissed and receiving compensation. 5
The appropriateness of this approach relies on the identifying ability of the exclusion variables. They need to identify the propensity of being dismissed and the propensity of receiving compensation. Identification in the former case is obtained by using job satisfaction.
Workers with lower job satisfaction prior to dismissal may have lower productivity. It can be
assumed that employers who have to choose between two otherwise identical workers would
try to get rid of a worker with lower job satisfaction. But job satisfaction may not influence the
probability of receiving compensation.
In the second case, the identification strategy relies on whether a worker had a dismissal
experience in the previous three years.6 After a dismissal experience, the worker may be
better informed about the respective litigation. This may result in strategic behavior to increase the compensation probability. As argued above, the probability of receiving compensation may decline, if the worker has already found a new job after the notice period has
ended. A widespread strategy to increase the compensation probability is for example to
reduce search efforts for a new job before the case is settled or to hide the fact that the
worker has already found a new job (Willemsen 2000). But this procedural knowledge may
not directly influence the amount of severance pay.
5
Results
The estimation includes 47,678 persons, whereas 2,198 were dismissed during the observation period, see Table 2. About half of the persons have been laid off, one out of four were
either dismissed as a consequence of plant closings or terminated their job by signing a mutual agreement. In total, 404 workers reported that they received compensation but only
about 90 percent revealed the amount of severance payments. On average, 18 percent of
5
6
If one assumes that the probability of being dismissed and the amount of compensation is not independent, a double hurdle model would be the adequate estimation strategy (Maddala 1983). But
firms are only able to roughly calculate one part of the expected costs of dismissing a worker,
namely the direct severance payment based on the severance payment factor. But the firm faces a
large uncertainty with respect to the costs arising due to continued wage payments until the case is
settled. The reason is that the firm hardly can predict whether the labor court will rule in favor of the
firm or the worker when making the separation decision. I am grateful to Jeffrey Smith, Katja Görlitz
and an anonymous referee for this helpful comment.
The threshold of three years is chosen because employment protection legislation was last
amended at the end of 1996. Procedural knowledge of workers being dismissed in 2000 was only
valuable if they had a dismissal experience after 1997 or in the past three years. In addition, in
Germany case law and jurisdiction is evolving fast. Therefore, it has to be assumed that procedural
knowledge underlies a high depreciation.
11
the workers being dismissed received severance payments, whereby this fraction is lower for
workers laid off (17 percent) compared to workers being dismissed as a consequence of
plant closings or who signed a mutual agreement (both around 20 percent).7 On average,
laid-off workers received a compensation of about 9,700 Euro. If the worker lost his job because of a plant closing, he received 16,800 Euro on average. Workers who signed a mutual
agreement realized 24,000 Euro. The severance pay factor amounts to 0.76 in case of mutual agreements, 0.69 in case of a plant closing and 0.53 if the worker is laid off. Moreover,
Table 2 documents that the variance of the severance pay factor received is highest for mutual agreements indicating that indeed financial insecurity is present. If we assume that severance payments paid for lay offs are more likely the outcome of a lawsuit while severance
payments bargained in mutual agreements are not, then the difference between the severance pay factors can be interpreted as a premium to avoid legal uncertainty.
For comparison, Table 3 displays the estimations using binary probit approaches to estimate the probability of being dismissed (Model 1) and the probability of receiving compensation (Model 2) as well as an OLS estimation to determine the amount of severance payments
(Model 3).
According to law and the first Hypothesis, the dismissal probability should be lower for
older workers, for workers with longer tenure, severe disabilities and family responsibilities;
the latter measured by the interaction term “married and child living in the household”. This is
confirmed by Model 1 in Table 3 estimating the dismissal probability. To measure the impact
of the firm size, we had to use the stated firm-size classes in the dataset. Therefore the
change of the threshold at which employment protection legislation is applied in 2004 could
not be taken into account.8 Again, we receive the expected pattern: the dismissal probability
decreases considerably with firm size. This is an indication that larger firms may be more
able to offer redundant workers another workplace as is also stipulated by law.
Children living in the household increase the dismissal probability. It is also worth noting
that workers who have been sick for more than 6 weeks in the previous year have a significantly higher dismissal probability. One possible interpretation might be that firms try to get
rid of workers who might receive the disability status soon. Alternatively, these can be seen
as dismissals due to lack of personal capabilities which is one of the reasons which may justify a dismissal. The significant coefficient of the expected severance payment, calculated
7
8
It is worth to mention that in the dataset about 7 percent of all retired workers received severance
payments. It is well known that firms dismiss older workers up to three years before they reach the
retirement age. During this period, the worker is usually eligible to receive unemployment benefits
but is not obliged to search for a new job. The difference between the amount of unemployment
benefits and the wage is then paid as a severance payment if the worker signed a mutual agreement.
Anyway, workers might not be exactly informed about the number of workers employed at their firm
at the time they lose their job.
12
using the severance pay factor, indicates that the dismissal decision is at least indirectly influenced by the expected dismissal costs and may justify the estimation approach.
Table 4 presents the results after applying the stepwise estimation approach described in
Section 3 and confirms that indeed sample selection is present.
Model 4 shows the results for the probability of receiving compensation and the corresponding marginal effects after taking into account the dismissal probability. The way of dissolving the employment contract has no influence on the compensation probability. Only the
variable age is significant. Contrary to the second Hypothesis, the remaining social criteria do
not influence the probability of receiving compensation. One possible reason could be that
the judge proves in a first step whether the reason stated in the termination notice for dismissing a worker is justified. For example, firms are often not able to convince the court that
the downturn of orders will persist in the future and that lay offs cannot be avoided otherwise.
If the firm is not able to convince the court, the judge will, irrespective on whether the firm
has met social criteria, decide in favor of the worker. Provided both parties agree, the judge
can dissolve the employment relationship if the firm compensates the worker. This result may
be seen an indication that the high legal insecurity following from the ambiguous definition of
the reasons for termination and, in a second step, of the social criteria creates an incentive to
file a lawsuit if there is any doubt.
Especially larger firms face greater difficulties in justifying lay offs and can more easily
carry the financial burden. Model 4 confirms that the probability of receiving compensation
indeed increases with the size of the firm.
An important factor determining the compensation probability is the expected severance
pay as presumed in Hypothesis 2 and not the tenure with the employer by itself. Filing a lawsuit, consulting a lawyer, or bargaining for a severance pay are often linked with high emotional stress, opportunity costs, and costs of becoming stigmatized for having sued a previous employer. In addition, re-instatements are rare. If the expected financial return is low,
workers may not be prepared to claim their due.9 Also lawyers will not be willing to accept a
case if the amount in dispute determining their remuneration is small.
That the compensation probability for workers who have already found a new job at the
end of the notice period is significantly lower is in line with Hypothesis 3. It seems that judges
indeed account in their decision the damage a dismissal will cause for the worker. There is
no indication that the probability of receiving compensation depends on the way the employment contract is dissolved. Finally, the insignificant coefficient of the reform dummy indicates
that the recent reform of the employment protection legislation had no effect on the compensation probability. Obviously, firms did not respond to the new regulation by offering more
often redundancy pays.
9
In Germany, legal costs of suing an employer are not likely to play an important role because they
are often covered by unions or by defense insurances.
13
Model 5, Table 4 presents the results for the incidence of severance payments after controlling for the dismissal and compensation probability. Model 5 confirms that the way of dissolving the employment contract affects the size of severance pay, which is highest if the
contract is dissolved by a mutual agreement, followed by collective dismissals and traditional
lay offs (see Hypothesis 4).
The expected severance payment is an important factor explaining the size of compensation as well as age and being married. Working previously in a large firm with more than 200
employees increases the compensation as well. But having found a new job has no influence
on the bargaining position of the worker; at least not on the size of the severance payment.
In addition, Model 5 proves that severance payments have increased considerably after
the reform in 2004. This result confirms our expectation that the reform strengthened the
bargaining power of the workers by setting a minimum standard for the amount of severance
payments. Interestingly enough, it seems that all workers benefitted from the recent reform.
The severance payments increased irrespective of the way the worker is dismissed, as the
insignificant interaction terms mutual*reform and plantcl*reform show.
6
Conclusions
It is often claimed that firms do not follow the rule of the law when reducing their workforce.
The paper contradicts this view showing that social criteria specified by law and jurisdiction
have an identifiable effect on the dismissal probability.
Nevertheless, if parties involved in a dismissal disagree, bargaining about severance
payments may be attractive to avoid costly and nerve-racking legal disputes. Workers’ return
from signing a mutual agreement may be higher than from filing a lawsuit in view of the fact
that the chances for re-instatement are low. Nevertheless, a dismissal leaves a scar and the
worker will never find out whether he was in the right. On the other hand, firms may gain financial security and avoid continuing wage payments from the day of termination notice
through to the date when the lawsuit is settled. But for this they have to pay a premium in the
form of higher compensations.
The recent reform had no effect on the compensation probability. The reason is that the
new legislation did not reduce their legal and financial uncertainty following a dismissal decision. On the contrary, after the reform the amount of severance pay the worker can realize
after a dismissal increased. The reason is that after receiving the termination notice the
worker can decide whether he accepts the offer or takes the case to court. Obviously, the
reform indeed increased the bargaining power of the worker.
The high variance of the severance pay factor and the fact that social criteria hardly influence the compensation probability and the incidence of severance payments is an indication
for the high legal and financial uncertainty. It can be doubted whether this bargaining process
14
is efficient. Hence, it in no surprise that not only politicians but increasingly also scholars advocate for mandatory severance payments which are not subject to ex-post bargaining.
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16
Table 1: Major changes of employment protection legislation in 2004
before Jan 2004
after Jan 2004
5 employees
10 employees
only by jurisdiction
tenure with the firm, age, alimony
duties and disability
Mutual agreement integrated into
the Protection against Dismissal
Act
No
yes
Eligibility for unemployment
benefits after accepting a mutual
agreement
after 12 weeks
From the first day of
unemployment on
Minimum standard for severance
payment if dismissal is considered to be unfair
no, only rule of thumb,
by jurisdiction
severance pay factor of 0.5
Threshold at which EPL applies
Social criteria
17
Table 2: Summary statistics and description of variables
Variable
Description
comp
compensation
diss
dismissed
lnsevp
log amount severance pay
sevp_lay
severance pay lay off (€)
sevp_pcl
severance pay plant closing (€)
sevp_mut
severance pay mutual agreement (€)
spfac_lay
severance pay factor lay off
spfac_pcl
severance pay factor plant closing
spfac_mut
severance pay factor mutual agreement
lay off
lay off (reference)
plantcl
plant closing
mutual
mutual agreement
male
gender (male)
age
age
marital
married
child
child in household
foreign
nationality (Non-german)
west
region (West
job tenure (years)
tenure
disable
disabled
sick
sick more than 6 weeks in previous year
part
part-time
blue
blue-collar worker
edu
years of education
firm1
firm size < 5
firm2
firm size 6 – 20
firm3
firm size 21 – 200 (reference)
firm4
firm size 201 – 2000
firm5
firm size > 2000
lnincome
log gross income (deflated by CPI)
exsp
expected severance payment
lnexsp
log expected severance payment
new job
new job at the end of the notice period
job satisfactionjob satisfaction (0 unsatified - 10 satisfied)
dissexp
previous dismissal experience
reform
reform
gdp
real gdp
nace1
agriculture (reference)
nace2
production sector
nace3
services sector
year00
2000 (reference)
year01
2001
year02
2002
year03
2003
year04
2004
year05
2005
year06
2006
Obs.
2,198
47,678
375
181
100
94
181
100
94
2,198
2,198
2,198
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
2,198
47,678
2,198
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
47,678
Mean Std. Dev.
0.18
0.39
0.05
0.21
1.25
8.87
9,685
12,304
16,849
25,476
38,318
23,558
0.53
0.59
0.69
0.65
0.77
0.76
0.50
0.52
0.25
0.43
0.24
0.42
0.50
0.54
42.02
10.07
0.47
0.67
0.40
0.49
0.29
0.09
0.77
0.42
10.90
9.25
0.06
0.24
0.05
0.22
0.42
0.22
0.36
0.48
12.21
2.53
0.08
0.27
0.13
0.34
0.32
0.47
0.25
0.43
0.42
0.23
7.54
0.71
14,182
17,890
8.79
1.42
0.44
0.25
7.03
1.94
0.24
0.42
0.41
0.49
1.10
1.08
0.01
0.11
0.49
0.38
0.61
0.49
0.10
0.31
0.16
0.37
0.16
0.37
0.16
0.37
0.16
0.37
0.13
0.34
0.12
0.32
Min
0
0
5.54
256
484
335
0.01
0.01
0.01
0
0
0
0
19
0
0
0
0
0.5
0
0
0
0
7
0
0
0
0
0
3.19
17
2.83
0
0
0
0
-0.2
0
0
0
0
0
0
0
0
0
0
Max
1
1
12.51
86,919
174,200
270,793
4.89
3.11
5.74
1
1
1
1
65
1
1
1
1
49.5
1
1
1
1
18
1
1
1
1
1
10.38
292,867
12.59
1
10
1
1
3.2
1
1
1
1
1
1
1
1
1
1
18
Table 3: Probability of being dismissed and of receiving compensation;
determinants of amount of severance pay
dependent variable
plantcl
Probability of being
dismissed
(1) Probit
dismissed
mutual
male
age
foreign
west
tenure
disabled
sick
marital
child
mar*child
part
blue
edu
firm size: < 5
firmsize: 6-20
firmsize: 201 – 2000
firmsize: > 2000
lnincome
lnexsp
new job
job satisfaction
reform
0.145***
(0.028)
-0.056***
(0.008)
-0.017
(0.040)
-0.124***
(0.026)
-0.043***
(0.009)
-0.136***
(0.047)
0.688***
(0.038)
-0.051
(0.033)
0.185***
(0.041)
-0.168***
(0.050)
-0.221***
(0.041)
-0.072**
(0.029)
-0.001
(0.006)
0.262***
(0.038)
0.169***
(0.031)
-0.170***
(0.032)
-0.239***
(0.035)
-0.088**
(0.041)
-0.081**
(0.033)
-0.090***
(0.005)
-0.967***
(0.069)
Probability of receiving
compensation
(2) Probit
compensation
-0.019
(0.105)
-0.175
(0.115)
-0.151*
(0.088)
0.062**
(0.025)
-0.122
(0.132)
0.113
(0.086)
-0.038
(0.031)
0.180
(0.144)
0.212**
(0.105)
0.081
(0.102)
0.081
(0.131)
-0.050
(0.162)
0.009
(0.120)
-0.215**
(0.093)
0.007
(0.017)
-0.843***
(0.152)
-0.395***
(0.100)
0.372***
(0.096)
0.187
(0.116)
-0.036
(0.149)
0.462***
(0.119)
-0.215**
(0.093)
Amount of
severance pay
(3) OLS
ln severance pay
0.190
(0.105)
0.417***
(0.135)
0.204
(0.124)
0.054
(0.037)
0.198
(0.189)
0.101
(0.107)
0.048
(0.041)
-0.175
(0.193)
0.151
(0.115)
0.320**
(0.132)
-0.050
(0.182)
-0.215
(0.218)
0.091
(0.157)
-0.238
(0.127)
0.038
(0.021)
-0.213
(0.371)
-0.018
(0.151)
0.293***
(0.110)
0.427***
(0.126)
0.364
(0.230)
0.466**
(0.181)
-0.104
(0.117)
-0.031
0.334
(0.267)
(0.213)
plantcl*reform
-0.242
0.167
(0.192)
(0.221)
mutual*reform
-0.116
-0.043
(0.200)
(0.243)
N
47678
2198
375
(Pseudo) - R2
0.133
0.207
0.630
*, **, *** indicate significance at the 0.05, 0.01 and 0.001 level. Standard errors are robust, weights are used, industry
dummies, year dummies, the real gdp growth rate, age square, tenure square and an overall constant are included.
19
Table 4: Estimation results
dep variable
plantcl
mutual
male
age
foreign
west
tenure
disabled
sick
marital
child
mar*child
part
blue
edu
firm size: < 5
firmsize: 6-20
firmsize: 201 - 2000
firmsize: > 2000
lnincome
lnexsp
new job
job satisfaction
mills ratio
Probability of receiving compensation
(4) Heckman bivariate probit
coeff.
marg. effects
sel. equation
compensation
dismissed
-0.017
-0.006
(0.097)
(0.037)
-0.142
-0.055
(0.108)
(0.043)
-0.189**
-0.072**
0.144***
(0.083)
(0.031)
(0.027)
0.071***
0.027***
-0.056***
(0.024)
(0.009)
(0.008)
-0.110
-0.042
-0.017
(0.124)
(0.049)
(0.039)
0.143*
0.055*
-0.124***
(0.081)
(0.031)
(0.025)
-0.020
-0.008
-0.043***
(0.029)
(0.011)
(0.008)
0.206
0.076
-0.136***
(0.134)
(0.049)
(0.045)
-0.064
-0.025
0.687***
(0.142)
(0.053)
(0.034)
0.092
0.035
-0.051
(0.095)
(0.037)
(0.032)
0.012
0.005
0.185***
(0.127)
(0.049)
(0.038)
0.014
0.005
-0.168***
(0.154)
(0.059)
(0.047)
0.090
0.034
-0.222***
(0.117)
(0.043)
(0.040)
-0.171*
-0.066*
-0.072***
(0.090)
(0.037)
(0.028)
0.006
0.002
-0.001
(0.016)
(0.006)
(0.006)
-0.860***
-0.332***
0.262***
(0.142)
(0.050)
(0.036)
-0.427***
-0.168***
0.169***
(0.094)
(0.038)
(0.030)
0.416***
0.153***
-0.170***
(0.090)
(0.036)
(0.031)
0.268**
0.100**
-0.239***
(0.110)
(0.039)
(0.034)
0.019
0.007
-0.088**
(0.140)
(0.053)
(0.038)
0.443***
0.170***
-0.081***
(0.111)
(0.048)
(0.031)
-0.189**
-0.072**
(0.088)
(0.036)
-0.090***
(0.005)
dissexp
reform
0.339
(0.279)
-0.220
(0.178)
-0.108
(0.184)
47,678
-9,403,167
0.128
(0.097)
-0.084
(0.069)
-0.042
(0.071)
-0.131***
(0.037)
Amount of severance pay
(5) Heckman ML
coeff.
sel. Equation
ln severance
compensation
0.297**
-0.060
(0.144)
(0.102)
0.479***
-0.248**
(0.176)
(0.115)
0.053
-0.179**
(0.164)
(0.088)
0.094*
0.062*
(0.053)
(0.025)
0.207
-0.061
(0.200)
(0.134)
0.185
0.093
(0.141)
(0.087)
0.058
-0.050
(0.047)
(0.031)
-0.035
0.244*
(0.208)
(0.146)
-0.119
0.223**
(0.137)
(0.103)
0.331**
0.112
(0.142)
(0.102)
-0.040
0.028
(0.205)
(0.133)
-0.183
0.001
(0.246)
(0.164)
0.125
-0.001
(0.187)
(0.119)
-0.319**
-0.182*
(0.161)
(0.094)
0.047*
0.005
(0.025)
(0.017)
-0.803
-0.814***
(0.726)
(0.156)
-0.339
-0.407***
(0.289)
(0.100)
0.486**
0.350***
(0.226)
(0.097)
0.543***
0.162
(0.186)
(0.118)
0.408
-0.088
(0.258)
(0.152)
0.674**
0.510***
(0.324)
(0.121)
-0.183
-0.198**
(0.169)
(0.093)
2.319***
(0.875)
0.084
(0.081)
0.017
(0.140)
-0.153
(0.187)
0.083
(0.200)
0.678**
(0.313)
plantcl*reform
-0.048
(0.259)
mutual*reform
-0.153
(0.272)
N
2,194
ll
-1,342,136
lambda
-1.014
rho
-0.411**
-0.886***
*, **, *** indicate significance at the 0.05, 0.01 and 0.001 level. Standard errors are robust, weights are used, industry
dummies, year dummies, the real gdp growth rate, age square, tenure square and an overall constant are included.
20