Temporary Contracts, Incentives and Unemployment

Firing-cost-free temporary contracts were introduced in many European countries during the eigthies in order to fight high unemployment rates. Their rationale was to increase job creation in a context of high firing costs that were politically hard to decrease. Temporary contracts have become a prevalent labor market institution in many countries, and with hindsight it seems uncontroversial that they have failed at decreasing unemployment. Evidence indicates that temporary contracts not only increases unemployment fluctuations, but also unemployment levels. In this paper we argue that the rationale for the introduction of temporary contracts is flawed at its root. We provide a novel explanation of why temporary contracts can increase unemployment even in a context where a reduction of firing costs would actually reduce unemployment. We argue that, if minimum wages are kept at high levels, temporary contracts have an effect not unlike the increase of unemployment benefits. By increasing the flows in and out of unemployment into relatively highly paid temporary jobs (minimum wage), they increase the value of being unemployed. This has a negative effect on incentives, increases wages and reduces the willingness of firms to create employment. We present empirical evidence supportive of some of the implications of the model.