Labour Law Should Aim to be neither Flexible nor Rigid, but to Correct Market Failures

Ukraine has been waiting for its Labour Code since independence. It is no wonder that the draft of the new Labour Code attracts wide attention.

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Should it be liberal and flexible? Or should it be protective? Who should it protect – workers or businesses? And at which expense? I argue that, for it to be effective, its role should actually not be in fitting a political course of flexibilization or protectionism, but in correcting market failures.

Why do we need any law, and labour law in particular? After all, economists who believe in Adam Smith’s invisible hand would argue that, if left free, markets would automatically self-channel towards a socially desirable optimum, without any laws. So would argue the neoclassical economists. 

Yet, the economic theoretical thinking, starting from the pioneering works of Nobel-prize winners Coase (works of 1937 and 1960) and Akerlof (works of 1970), is highly sceptical of this laissez-faire approach. It widely recognizes that most real-life markets are not perfectly competitive. Labour markets in particular are prone to information asymmetries, negative externalities, transaction costs and incomplete contracts that do not ensure workers and employers fully against income losses. All of these aspects lead to market failures. It is precisely to remedy them that we need labour market regulations (Kaufman, 2007; Boeri and van Ours, 2008). 

Take as an example dismissals at the initiative of the employer: 

Information asymmetries stem from the fact that, compared to a worker, an employer usually has more and better information on the economic situation of a firm. An employer knows better whether a dismissal is truly inevitable. As a result, there is a de facto asymmetry of contractual rights. In this situation of unequal balance of powers, if workers can be dismissed very easily and do not have any protection, implications for the whole duration of an employment relationship can be severe. Workers would simply fear to exercise any other right at work, including what is considered as fundamental rights: a right for a maternity leave, a right to join a trade union, let alone a right to ask for a training or for a salary increase. Thus, one of the key objectives of labour regulations throughout the world is to redress the bargaining power between workers and employers (Buechtemann, 1992; Deakin, 2014), in order to guarantee all other rights at the workplace (De Stefano, 2014). This objective is often achieved by stating in the labour law that no dismissal can take place without a valid reason. This principle is also at the heart of one of the international labour norms in this field, the ILO Employment Termination Convention, 1982 (No. 158), Article 4.

In their turn, negative externalities stem from the fact that the social value of even one individual’s job can go beyond its private value (Cahuc and Zylberberg, 2006). A mere inconvenience for an employer, a dismissal can put a worker at risk of poverty and social exclusion, which would affect also her family. The worker may also experience stress over job loss, sleep deprivation, depression, which can result in severe consequences for health (for a review, see Countouris et al., 2016). In addition, the value of worker’s human capital can be greater for a society than for an individual firm (Booth and Zoega, 2003). Thus, when effectuating a dismissal, firms may over-dispose of workers and their human capital as compared to a socially desirable optimum. In an economic downturn, if dismissals are easy, many workers entering suddenly into unemployment will also interact in their job search activities. This can create congestion, with negative effects on search efforts of new unemployed workers, decreasing their likelihood of finding a suitable job at a local level. This is why, another objective of labour laws and practices in many countries throughout the world is to avoid systemic disruption of the labour market, as well as of the aggregate consumption, by playing a role of an automatic stabilizer and discouraging avoidable dismissals.

The social costs of a dismissal may include, but not limited to, providing the economic support to the unemployed; expenses linked to retraining workers and helping them in finding employment; expenses linked to relocations of workers and their families. In case of collective dismissals, the social costs can include economic desertification of an area and negative consequences for other enterprises and sectors, including education and medical sectors, among others (Collins et al., 2012). 

Thus, as a third objective, in many jurisdictions, national laws and practices on dismissals explicitly aim at internalizing these costs: they involve employers in sharing the burden of dismissal costs with the society, with public authorities and public budgets. But because bearing all of the social costs by one firm may be neither possible nor desirable, yet another objective of the legal regulations is to redistribute the losses and share them equitably – not only between workers and societies, but also between employers and societies. To recognize this, one of the international labour norms in this field, the ILO Employment Termination Recommendation, 1982 (No. 166) states that the spirit of the dismissal regulations should be “without prejudice to the efficient operation of the undertaking, establishment or service” (Para. 19).

So what kind of labour regulations can remedy market failures? In fact, there is no one recipe, and many countries have regulations that reflect their history, democratic tradition, legal systems, and social models. There is a general agreement that workers should not be left unprotected. Yet, there is much less agreement about who should pay for this protection, and how to make sure that the regulations are well respected and do not stay on paper.

The most successful labour market regulations usually do not operate in isolation, but as a system. Such systems are rarely over-flexible or over-protective. Rather, in such systems, there is always a counter-balancing, compensating regulation: if more freedom is given to employers in one domain, usually this is compensated by more protections to workers in another domain. 

Take the USA. It is often cited as an example of perfect flexibility, a country with “employment at will”, where a worker can be dismissed at any moment, without a particular reason, without prior notification, and without paying a severance pay. However, unlike what is often believed, “employment at will” does not result in a total freedom to dismiss: it must be understood in light of the existing prohibited grounds for dismissal. 

In fact, the US laws contain a very long and detailed list of the grounds, on the basis of which dismissals are unlawful. They include pregnancy; maternity leave; filing a complaint against the employer; discrimination based on race, sex, sexual orientation, religion, age, trade union membership and activities, or genetic information; disabilities; taking a lawful parental leave; whistle blowing; gender identity; taking an adoption leave; raising occupational health and security concerns; performing jury service. Each of these grounds is backed by a clear law and practice of determining this situation (for the exact law references, see the USA profile in the ILO EPLex database). 

What’s more, the protection against arbitrary dismissals is granted by strong and efficient court system: any worker can file a complaint, and in case of winning it, not only he or she may be reinstated in the previous job, but receive a very sizeable compensation. This possibility acts as a very strong deterrent for an employer to practice unlawful dismissals. In other words, the flexibility given to the employers by the “employment at will” legal rule is counterbalanced by the efficient judiciary system. Can this be said of Ukraine?

Another example is Nordic countries, such as Denmark. Here too, the laws do not specify any reasons to dismiss a worker, and prescribe severance pay only to workers with over 10 years of tenure. Dismissal procedures are seen as flexible and easy. But workers feel protected thanks to a generous social net. They can receive unemployment benefits up to 90% of their previous wage, for 4 years. Workers are eligible to receive it by working only 6 months within the last 36 months. After the unemployment insurance period, workers can further apply for social assistance. In addition to this, the state provides a very effective system of activation policies, helping workers to retrain and to quickly find employment. The Danish example is in fact a classical example of “flexicurity”: giving the flexibility to employers, but protecting workers through the two-pillar social net (Boeri et al., 2012).

But the vast majority of countries provide employment protection to workers primarily by means of labour laws. This is done either instead of other types of protections, or in addition to them. When employment protection laws exist in addition to other labour market regulations and institutions (such as unemployment benefits), the legislators, again, usually balance between protection by law and protection by other labour regulations and institutions. 

Employment protection by law is in itself a complex area of labour law, as several aspects of dismissals can be regulated, starting from valid grounds for dismissals, to notice periods, to severance pay, to establishing rules for compensations and reinstatement in case of unlawful or unjustified dismissals. Many commentators note that such legal rules have a strong potential to improve the efficiency of the labour markets, provide more equitable outcomes, and serve as an effective alternative to redistribution systems (Nickell and Layard, 1999; Boeri and van Ours, 2008). Thus, many countries adopt such dismissal rules as part of their development, recognizing that a balanced employment protection law is compatible with longer-term development goals (Deakin et al., 2014). 

Figure 1. Distribution of the de jure level of employment protection, achieved by labour laws. Ninety-five countries, 2010 – 2015.

Source: ILO, 2015

Note: EPLex indicator is a synthetic indicator of the level of employment protection granted by the labour laws. It is computed by taking into account 9 aspects of employment protection: valid grounds for dismissal, prohibited grounds for dismissal, regulation of the trial period, procedural requirements for dismissals, length of notice periods, amount of severance pay, amount of redundancy pay, possibility of redress. The values of the indicator situate on the 0-1 scale, with 1 showing the highest protection. The vertical axes shows the number of countries that adopted the level of protection, shown on the horizontal axes. 

 

Interestingly, because employment protection features many aspects, rarely do countries choose to have “strict” regulation on every single aspect. Yet again, they rather balance between stricter rules on some aspects, and lighter rules on others. As a result, globally, the total level of employment protection provided by the law is somewhere in the mid-range of possible protections, neither too high, nor too low (Figure 1). Actually, there is a relative agreement both in academia and among international institutions, such as the ILO and the World Bank, that both overly protective and inadequate labour law regulations (set too low) are harmful for employment or productivity at the macro level (Cazes et al., 2012; World Bank, 2013). 

Of course, the key condition for the efficacy of such laws is their enforcement. Countries that provide worker protection through labour laws need to ensure that the labour inspectorate is not corrupt, has enough financial means to effectuate controls, and has sufficient legal mandate to prevent abuses. But the very best protection comes from the fact that both workers and employers have interest in respecting the law. And the best way to achieve this is to make sure that workers and employers (or their representatives) are effective authors of such laws; that they agree on its logic and see benefits from complying with it. 

As of today, Ukraine can choose to have any type of labor law. But in light of the above, it is to be remembered that one labour law alone cannot be a miracle solution to labour market imperfections. It has to be part of a self-enforcing system of legal checks and balances. If the labour law is to be “flexible”, it has to be complemented immediately by other reforms, such as the reforms of the judiciary system and of unemployment benefits. Ideally, reforms of unemployment benefits should take place before, or at least at the same time as the reforms of dismissal rules; the details of both should be part of the joint negotiation package. If the new labour law has to be “strict”, it has to be complemented by a reform of the labour inspectorate. It may also find its balance between “flexible” and “strict” by providing articles that can be appealing to both workers and employers. The best of such balances is usually the result of a social dialogue.

Notes

World Bank. 2013. The World Development Paper 2013: Jobs, Washington, DC.

Boeri, T., Conde-Ruiz, I., and Galasso, V. 2012. “The Political Economy Of Flexicurity,” Journal of the European Economic Association, European Economic Association, Vol. 10(4), pp. 684-715.

Boeri, T., van Ours, J., 2008. The Economics of Imperfect Labor Markets. Princeton, NJ: Princeton University Press. 

Booth., A. L., and G. Zoega, 2003. On the Welfare Imlpications of Firing Costs. European Journal of Political Economy, 19, pp. 759-75.

Buechtemann C.F. (1992), “Employment Security & Labour Markets: Assumptions, International Evidence and Theoretical Implications,” in C.F. Buechtemann (ed.) Employment Security and Labor Market Behavior: Interdisciplinary Approaches and International Evidence, Ithaca, NY: ILR Press, Cornell.

Cahuc, P., Zylberberg, A., 2006. The Natural Survival of Work: Job Creation and Job Destruction in a Growing Economy. Cambridge, MA: MIT Press.

Cazes, S.; Khatiwada, S.; Malo, M. 2012. Employment Protection and Collective Bargaining: Beyond the Deregulation Agenda, ILO Employment Working Paper No. 133.

Collins, H., Ewing, K., McColgan, A., 2012. Labour Law. Cambridge University Press: Cambridge.

Countouris, N., Deakin, S., Freedland, M., Koukiadaki, A., Prassl, J. 2016. Collective dismissals: A comparative and contextual analysis of the law on collective redundancies in 13 European countries. ILO: Geneva.

Deakin, S., Fenwick, C. and Sarkar, P., 2014. Labour Law and Inclusive Development: The Economic Effects of Industrial Relations Laws in Middle-Income Countries. In: Schiegelow, M. and Schmiegelow, H. (Eds). Institutional Competition between Common Law and Civil Law, pp 185-209.

De Stefano, V. 2014. “A Tale of Oversimplification and Deregulation: The Mainstream Approach to Labour Market Segmentation and the Recent Responses to the Crisis in European Countries”, Industrial Law Journal, Vol. 43. doi:10.1093/indlaw/dwu014.

ILO, 2015. Employment protection legislation: summary indicators in the area of terminating regular contracts (individual dismissals). ILO: Geneva. 

Kaufman, B., 2007. The impossibility of a perfectly competitive labour market. Cambridge Journal of Economics. Vol. 31, pp. 775-87.

Nickell, S. and Layard, R., 1999. “Labor Market Institutions and Economic Performance”, in O. Ashenfelter and D. Card (eds), Handbook of Labor Economics, Vol. 3, Amsterdam, Netherlands , pp. 3029–3084.

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