Labor adjustment, productivity and output volatility: An evaluation of Japan's Employment Adjustment Subsidy

This paper provides a quantitative examination of the impact of Japan's Employment Adjustment Subsidy, a major employment insurance policy since 1975, on labor adjustment, productivity and output fluctuation in the iron and steel sector. A partial equilibrium industry model with heterogeneous establishments and aggregate uncertainty shows that the EAS reduces steady-state labor productivity by encouraging labor hoarding, and in some cases, preventing the exit of least efficient establishments. The EAS also reduces job flows and increases average establishment-level employment. Although the impact on productivity is roughly proportional to the size of subsidized workers in most cases, the effects of the subsidy on output and employment volatility are more than proportional. First, the subsidy can lead to a sizable increase in output fluctuations over business cycles by symmetrically increasing the output response to shocks. This result is achieved through lower output via a subsidy during unfavorable times and higher output via less time and money spent on hiring during favorable times. Second, the subsidy meets its primary objective of reduced employment volatility. The reduction can be considerable when firing costs are high.