Firing cost and firm size: a study of Sri Lanka's severance pay system

Sri Lanka's Termination of Employment of Workmen Act (TEWA) requires that firms with 15 or more employees justify layoffs and provide generous severance pay to displaced workers, with smaller firms being exempted. Although formally subject to TEWA, firms in Export Processing Zones (EPZs) may have been partially exempt from TEWA due to lax enforcement in that sector. A theoretical model shows that firms subject to TEWA will tend to mass at or below the threshold of 14 workers until they get an atypically large productivity shock that would propel them beyond the threshold. EPZ firms will be largely unaffected by the law. In addition, EPZ firms receive preferential tax treatment and exemptions from customs duty. Consequently, firms that anticipate rapid growth will have an incentive to locate in the EPZ sector. We test these predictions using 1995-2003 panel data on the universe of all private, formal sector firms in Sri Lanka. We find that at all sizes, EPZ firms are more likely to add employees than nonEPZ firms. Above the threshold, nonEPZ firms are more likely to shed workers while EPZ firms are more likely to add workers. Once passing the threshold, nonEPZ firms grow faster than nonEPZ firms below the threshold, consistent with a theoretical prediction that only atypically productive nonEPZ firms would cross the threshold. Finally, evidence is consistent with the hypothesis that TEWA restrictions retard the growth of nonEPZ firms below the threshold, but only some of the evidence passes tests of statistical significance. The combined impacts of retarded growth below the threshold, the need for a large productivity shock to cross the threshold, and slower employment growth above the threshold suggest that the TEWA failed to lower unemployment. Instead, it slowed employment growth of nonEPZ firms and induced other firms to seek the EPZ sector in order to evade the law.