How do employment contract reforms affect welfare? Theory and evidence

Short-term employment contracts have been deployed rapidly across the European Union (EU) in the past two decades. Characterized by a high degree of flexibility, they were thought to be the solution to persistent labor market rigidities and high unemployment rates. The objective of this paper is to investigate both theoretically and empirically the effects of introducing short-term employment contracts to the labor market, and to draw conclusions regarding the change in welfare for different categories of people. Data from the Italian labor market show that workers hired on a short-term basis are mostly young, female, inexperienced, less educated, and poorly qualified. Short-term contracts, which are associated with lower wages, often come in sequences. Labor force participation has increased in particular among older workers. Such changes in labor force composition and transition patterns can be explained by a search model with workers heterogeneity and differentiated contracts. In steady state, a pooling equilibrium of less and more productive workers exists, when only permanent contracts are available. In the presence of short-term contracts, a separating equilibrium allocates less and more productive workers towards different career paths. Through model calibration it is possible to quantify the change in welfare for different categories of workers. Moreover, within a multi-state duration framework, the model is estimated with the Heckman and Singer non-parametric maximum likelihood (NPMLE) estimation procedure. One of the major findings is that inexperienced workers are worse off after the reforms. However, after the accumulation of some work experience, they have the opportunity to compensate for their losses, if they are more productive. Less productive workers, even though provided with higher chances to work, are the ones paying the cost of higher turnover and lower wages.