Abstract

Can restricting firms' layoff choices improve welfare? We study this question in the German labor market, where we document substantial heterogeneity in layoff rules, ranging from productivity-based schemes to tenure-based cutoffs. On one hand, firms may not internalize heterogeneous displacement costs of workers, and policies that align layoff choices with costs faced by workers might therefore improve social efficiency. On the other hand, layoff rules that force firms only to let go of low-displacement-cost workers could undermine productive reallocation: firms may be unable to shed less efficient matches and become less likely to hire workers who are more difficult to fire. Our analysis proceeds in three main parts. First, we estimate the effects of more restrictive layoff rules on a firm's profits, productivity, and survival. To that end, we compare the evolution of outcomes in firms with flexible vs. restrictive layoff rules around a layoff event, and instrument for layoff rules with measures of works council strength (because, when mass layoffs occur in German firms with works councils, works councils negotiate a selection plan based on criteria such as age, dependents, or tenure, pushing firms towards a layoff rule that accounts for displacement costs). Second, drawing on the same identification strategies, we estimate the effects of more restrictive layoff rules on the future wages and unemployment duration of displaced workers. Lastly, we combine these estimates to compute the welfare effects of widely used layoff rules.