More stringent employment protection legislation (EPL) tends to redistribute job opportunities from unemployed workers to employed workers. That is the central conclusion of research by Professor Fabien Postel-Vinay and Dr Hélène Turon, published in the March 2014 issue of the Economic Journal.


Much labour reallocation in the economy happens with workers moving from one job to another – and with stricter EPL, incentives become increasingly strong for job-to-job turnover rather than recruitment of the currently unemployed.


At the same time, while high ''firing costs'' – mandated severance pay, firing taxes, judicial and procedural costs, etc. – discourage firms from hiring, they also keep them from firing workers. The study finds that the combined impact of reduced hiring and firing is that unemployment is lower than was previously thought.


One of the most robust lessons of economic theory about the impact of EPL on the labour market is that layoff costs discourage both firing and hiring, thereby substantially reducing both unemployment outflows and inflows. Those opposite effects combine into an ambiguously signed and quantitatively negligible impact of EPL on unemployment.


A further conclusion of the theory is that the predicted dampening effect of EPL on hiring and firing has obvious consequences for the distribution of lifetime earnings among workers in different situations in the labour market. A lower risk of job loss benefits the employed; and lower rates of hiring hurt the unemployed.


While the available evidence largely bears out the conclusion that EPL reduces the flows between non-employment and (permanent) employment, it is somewhat inconclusive about the overall impact of EPL on unemployment. The estimated impact of firing costs on unemployment is very sensitive to the data and specification used.


But a noticeable shortcoming of theoretical research on EPL is that it focuses on transitions between employment and unemployment (or non-employment), ignoring direct job-to-job reallocations. The general argument is that worker reallocations not involving a spell of unemployment are of second-order importance in the determination of the unemployment rate. The new study argues that this may not be the case.


Direct job-to-job flows are quantitatively substantial, amounting to between a third and a half of total labour reallocation. They are also relevant to the issue of EPL as workers who quit their job spontaneously are usually not entitled to any redundancy payment and do not make their employers liable for a firing tax.


Conversely, by affecting firms'' incentives to hire and fire, EPL is likely to affect the intensity of job-to-job reallocation. Indeed, there is ample evidence (in 1999 research by Tito Boeri) that the share of job-to-job reallocation within total labour reallocation is positively correlated across dates and (European) countries with measures of the strictness of EPL.


In theory, job-to-job turnover provides a way for employers to escape firing costs. While firing costs induce firms to keep employees in unprofitable matches, such unprofitable employees may willingly quit their job on receiving an outside offer, thus sparing their initial employer the firing costs.


What''s more, employers can induce their unprofitable workers to accept outside job offers that they would otherwise reject by offering voluntary severance packages, which are generally less costly than the full statutory dismissal cost.


The new study extends the standard theory of the labour market to allow for direct job-to-job turnover and formally investigates the intuition about its impact. The researchers show that allowing for on-the-job search in this way strongly affects the standard predictions about the impact of EPL on employment stocks and flows.


Specifically, they find that higher firing costs discourage job destruction to a much larger extent than predicted by the standard theory (which, again, rules out direct job-to-job transitions). Conversely, they find that direct job-to-job turnover largely cushions the adverse impact of firing costs on job creation.


As a result, the impact of firing costs on unemployment is not as damaging as was previously thought. Those differences in the economy''s behaviour brought about by on-the-job search are due to the fact that job-to-job turnover enables employers to avoid paying the statutory firing cost in some cases.


The research further shows that more stringent EPL, while reducing overall hiring, increases the share of job-to-job reallocation in total job accessions, a prediction consistent with the cross-country evidence. As such, EPL tends to redistribute employment opportunities from unemployed to employed workers.


''The Impact of Firing Restrictions on Labour Market Equilibrium in the Presence of On-the-job Search'' by Fabien Postel-Vinay and Hélène Turon is published in the March 2014 issue of the Economic Journal. Fabien Postel-Vinay is at University College London and the Institute for Fiscal Studies. Hélène Turon is at the University of Bristol.