Policies intended to reduce unemployment and promote job stability come at a substantial cost in terms of the pay of newly hired employees, particularly those working in low-paid jobs and low-employment regions. That is the central conclusion of new research by Professors Marco Leonardi and Giovanni Pica, published in the December 2013 issue of the Economic Journal.


Their analysis of the Italian government''s introduction of mandated severance payments of between two and a half and six months pay finds that the policy reduces workers'' wages by about 1.1 percentage points. The effect is meaningful: cumulated over time, it implies that workers pay more than two thirds of the expected lay-off cost.


But not all workers are equally affected. Incumbent workers are left untouched: the introduction of severance payments does not affect compensations packages within existing employment relationships. Rather, it is newly hired workers who suffer a drop in the entry wage of up to 6%. The negative effect of the reform is stronger for young blue-collar workers, low-wage workers and workers in low-employment regions where there are few ''outside options'' of alternative work.


This pattern suggests that the ability of employers to shift rising costs onto wages crucially depends on workers'' relative bargaining power. While incumbent workers, who have high bargaining power vis à vis the firm, are able to oppose wage cuts, outsiders, who have no bargaining power, have to accept the cuts in exchange for higher employment protection.


The new study complements previous empirical research showing that employment protection legislation reduces labour market flows and increases both job tenure and unemployment duration. The legislation has no detectable impact on rates of employment or unemployment.


The authors comment:


''Our research highlights a previously overlooked effect of government-mandated job protection on workers'' welfare that goes through lower wage rates.


''Policy-makers should take account of this effect when evaluating the potential costs and benefits of employment protection legislation.''


''Who Pays for It? The Heterogeneous Wage Effects of Employment Protection Legislation'' by Marco Leonardi and Giovanni Pica is published in the December 2013 issue of the Economic Journal. Marco Leonardi is at the University of Milan. Giovanni Pica is at the University of Salerno.