New studies examine effects of dismissal protection

In October 2004, the Institute for Employment Research (IAB) published a study investigating the impact of Germany's dismissal protection legislation on employment in small establishments. It finds that the stringency of this legislation has no significant effect on labour turnover in such establishments. Nonetheless, the authors conclude that the results are insufficient to claim that constraints on dismissal do not matter at all. This point is underlined by two other recent studies: one finds that strict dismissal protection can have a negative impact on firms’ hiring decisions; and the other concludes that such protection can increase the rate of economic growth that must be reached for employment to rise.

On 18 October 2004, the Institute for Employment Research (Institut für Arbeitsmarkt- und Berufsforschung, IAB) presented the findings of a study on the effects of dismissal protection regulations. The study finds no significant relationship between the stringency of dismissal protection legislation and employee turnover levels. These empirical results are seen as being inconsistent with the economic theory that predicts a detrimental effect of dismissal protection legislation, which raises the level of adjustment costs to firms, on hiring and 'separation' rates.

Specifically, the study analyses one element of a set of recent reforms aimed at reducing Germany’s persistently high unemployment. This is a change in the coverage of small establishments by the Dismissal Protection Act (Kündigungsschutzgesetz, KSchG). With effect from 1 January 2004 (DE0401205F), the statutory provisions on protection against dismissal- a system of restrictions on the lawfulness of termination of employment by the employer, laying down for example the valid grounds for dismissal (DE0304204F and DE0306108F) - has applied only to employees employed in enterprises with more than 10 employees (apprentices are not counted in calculating workforce size and part-time employees are counted only proportionally), rather than five as before. This recent amendment followed two previous changes within a decade. In 1996, the governing coalition of the Christian Democrats (Christlich Demokratische Union, CDU/Christlich Soziale Union, CSU) and Free Democrats (Freiheitlich Demokratische Partei, FDP) had raised the company-size threshold for application of the rules from five to 10 employees, but the coalition of the Social Democratic Party (Sozialdemokratische Partei Deutschlands, SPD) and Alliance 90/The Greens (Bündnis 90/Die Grünen) rescinded this change in January 1999 (DE9901291N).

The IAB study assesses the reactions of small enterprises to: first, the lower level of dismissal protection legislation that came into force in 1996 (as a result of the workforce-size threshold being raised); and, second, the repeal of this reform in 1999. The study is based on a representative sample of around 50,000 establishments, each of which had fewer than 30 employees. The IAB analysis concludes that: 'The change in the threshold level for employment protection legislation in Germany did not change either the number of recruits or the number of dismissals in a measurable way. Therefore, a significant influence of employment protection legislation on either employment levels or unemployment cannot be shown.'

In terms of policy, the IAB study contributes to a public debate over whether demands for further deregulation of the dismissal protection rules - which the Organisation for Economic Cooperation and Development (OECD) has assessed as rather rigid - should be dropped. Critics of the study maintained that such a conclusion would be premature, as other studies have found unwanted effects of dismissal protection.

Other recent studies

At the end of May 2004, the Cologne Institute for Business Research (Institut der deutschen Wirtschaft Köln, IW) published the findings of a representative survey that found a strong link between labour law and employment levels. According to the survey of 859 companies with at least one employee, a reduction of current barriers to hiring would improve the overall employment situation. Around four out of five companies were convinced that the Dismissal Protection Act hampers job creation. More than half said that they had put off new hiring at least once because of the restrictions on, and cost of, dismissals. Some 70% of companies said that they would take on new workers if the law on dismissals were relaxed, and considered the inflexibility of the law as well as the risk of protracted labour court proceedings as being responsible for a shortage of jobs. According to the IW study, a lower level of dismissal protection and more room for fixed-term contracts would thus increase companies’ willingness to create more jobs in Germany.

Similarly, in September 2004 the Ifo Institute (Institut für Wirtschaftsforschung an der Universität München, ifo) published a study that found unwanted effects of strong dismissal protection. The study examines the effect of dismissal protection laws on the 'employment threshold'- that is, the rate of output growth that must be reached for employment to rise. According to ifo, a comparison of 17 OECD countries shows that stricter dismissal protection legislation increases the employment threshold significantly. In the 1990s, the employment threshold in Germany was 2.4% but the study finds that, if, for example, UK dismissal protection laws had been in place in Germany, an economic growth rate of 1.2% would have sufficed to increase employment.

The authors of the IAB study concluded in the technical version of their paper that their findings are not sufficient to claim that constraints on dismissal do not matter at all: 'On the one hand, we do not know how inflexibility with regard to firings affects small establishments that go out of business, or, more fundamentally, are not established because of expected firings costs. On the other hand, we do not know how larger establishments behaved in the presence of less stringent dismissal protection legislation.' Furthermore, the authors suggest that, for example, changes in dismissal protection can change the quality of recruitments and 'separations' in a way that cannot be detected by their analysis: 'Firms might reduce the expected value of dismissal tax payment by establishing better job matches. If this is the case, the amount of hiring, for example, might not change, whereas the composition shifts towards more productive employees earning higher wages.'

Commentary

Even if merely weakening dismissal protection rules will not lead directly to job creation in the short term, dismissal protection may well be a barrier to employment instead of encouraging it in the medium to long term. Moreover, further deregulation of dismissal protection is likely to enhance the effects of the general overhaul of labour market regulation and the welfare state started by recent reforms (DE0409103N). Further deregulation of dismissal protection should be part of such reforms in order to foster economic growth and employment. (Lothar Funk, Cologne Institute for Business Research)