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.
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.
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.
Policy reforms should be aimed to use severance payments and reduce the ring cost component of lay-off costs.
Increasing welfare and a more stable business cycle could be supported by using severance payments instead of firing costs.
JEL Classifications — D61, E24, E32
I wish to thank Steffen Ahrens, Christian Merkl, and Céline Poilly for highly valuable comments. In addition, I thank participants at the IAB/LASER Workshop “Increasing Labor Market Flexibility – Boon or Bane?”
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