Japan Should Introduce a Severance Payment Scheme for Settlement of Dismissal Disputes

TSURU Kotaro
Program Director and Faculty Fellow, RIETI

Against the backdrop of the deepening European crisis, momentum to reform the labor market is being built particularly in Southern European countries. One prominent example is the labor market reform law (see the Keywords section) enacted in June in Italy. Acknowledging that reviewing rigid restrictions on employment termination is crucial to achieving sweeping rationalization of industries and businesses, thereby putting the economy on a growth path, Italy paved the way for company-initiated employment terminations by means of monetary compensation.

Among the member economies of the Organisation for Economic Co-operation and Development (OECD), Italy and other Southern European countries had been relatively restrictive in the regulations on the dismissal of permanent employees with little room left for making any changes to the employment protection legislation (EPL) applicable to them. As such, the governments of those countries had typically pursued a two-tier approach in reforming their labor markets, namely, easing the EPL for temporary workers while keeping that for permanent employees unchanged. This caused a rise in the turnover rate for temporary workers, a decrease in job-training opportunities, and a decline in productivity, collectively bringing a significant negative impact particularly on the youth, women, immigrants, and unskilled workers.

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These problems developed into a serious issue between 2008 and 2010 as temporary workers were the first and hardest hit by the world recession. In his presentation in 2011, Professor Tito Boeri of Bocconi University showed that in Spain, temporary workers—who represented 29.5% of all workers at the time of the collapse of Lehman Brothers in 2008—accounted for 76.9% of jobs lost during this period. This is in striking contrast with France, where temporary workers, representing 14.3% of all workers prior to the crisis, accounted for 12.8% of jobs lost during the subsequent recession. The unemployment rate peaked at around 10% in France but surged to 25.1% as of July 2010 in Spain.

A 2012 paper coauthored by Professor Samuel Bentolila of the Center for Monetary and Financial Studies (CEMFI) in Madrid, Professor Pierre Cahuc of École Polytechnique, Professor Juan J. Dolado of Universidad Carlos III de Madrid (UC3M), et al. argues that such stark differences between the two countries in the magnitude of loss of temporary jobs are attributable to the fact that the EPL gap between permanent workers and their temporary counterparts—i.e., strong protection for the former and weak protection for the latter—is much larger in Spain than in France. It notes that the number of jobs lost in Spain due to the post-Lehman recession would have been 45% less had it adopted the French EPL.

Another 2012 paper written by Bentolila, Dolado, and Juan Jimeno of the Bank of Spain provides an analysis of the Spanish labor market. In 1997, the country introduced a new type of contract called the "permanent employment promotion contract" (PEPC) applicable to those with low employment opportunities, i.e., unemployed people below the age of 30 or above the age of 44. Employees hired under such contracts would receive a reduced amount of dismissal compensation as compared to what they would have been entitled to under regular permanent contracts, whereas employers' social security contributions for them were cut by 40% to 60% for the first two years of employment. However, Bentolila, Dolado, and Jimeno conclude that the impact of this reform has been very limited as many of those hired under PEPCs were dismissed with the expiration of the applicable period of reduced rates of social security contributions.

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Thus, in the face of the deepening economic crisis, a group of 100 economists in Spain and some other countries put forward a Proposal to Restart the Spanish Labor Market in 2009, calling for introducing a single permanent labor contract in order to put an end to the duality of the labor market. The single permanent labor contract is intended to address the current situation where severance payments (see the Keywords section) for temporary workers are significantly lower than those for their permanent counterparts. It is also meant to be a mechanism that applies the same severance payment program to all new hires with the amount of severance pay increasing with the number of years of service.

Similar single contract proposals, though differing in their mechanisms, have been filed with the government of France by Professor Olivier Blanchard of the Massachusetts Institute of Technology (MIT), Professor Jean Tirole of the Industrial Economics Institute, University Toulouse I, Professor Cahuc, and Professor Francis Kramarz of the Center for Research in Economics and Statistics (CREST), as with that of Italy by Professor Boeri and Professor Pietro Garibaldi of the University of Torino. Indeed, single contract schemes were one of the hot topics taken up in a series of seminars organized by the OECD and the European Commission in 2011 and 2012.

To date, no country has actually introduced a single contract scheme. However, Spain is planning to reduce severance payments for unfair dismissal of permanent workers as part of a labor market reform incorporating the idea of single contracts. In their 2012 paper, Professor Ignacio García Pérez of the Universidad Pablo de Olavide and his fellow researcher analyzed the effects of introducing identical severance payments for both permanent and temporary workers in Spain, whereby 12 to 36 days of wages per year of service (capped at 24 months of wages) would be given for all unfair dismissals, for instance, instead of 45 days of wages per year of service (capped at 42 months of wages) as currently applicable in the case of unfair dismissal of permanent workers. According to their estimates, the unemployment rate would be reduced from the current 14.5% to 11.4%.

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What implications should we draw from those developments in the Southern European countries? In Japan, employers are, in principle, free to dismiss employees under the Civil Code. However, the doctrine of abuse of the right of dismissal defines unfair dismissals as a form of such abuse, effectively negating dismissals per se. In other words, employers are obliged to reinstate dismissed workers to their original positions (and pay them unpaid wages). In contrast, in Europe, employers usually terminate employment contracts by paying a certain amount of money to dismissed workers even when the dismissals have been ruled as unfair by the court. This kind of monetary settlement or settlement by means of severance payments is not allowed in Japan.

Of course, monetary compensations are sought and awarded in court-mediated settlement, by employment tribunals, or through the mediation of the competent local labor department. However, survey findings by the Japan Institute for Labour Policy and Training (JILPT) and the University of Tokyo's Institute of Social Science show that the amount of money awarded differs significantly depending on the type of settlement and is, in many cases, very small. Meanwhile, even in cases where dismissals are negated by court judgments and dismissed employees are reinstated to their original positions, it is becoming increasingly difficult for them to rebuild their trust with other employees at their workplaces as the environments both within and outside their companies are changing rapidly. Among the OECD member economies, Japan—where monetary settlement is not permitted, leaving reinstatement as the only possible option—is classified among the most restrictive countries along with South Korea and Austria in regulations governing options for employers and employees in the case of unfair dismissals (see Figure).

Figure: Level of severance payments for unfair dismissal and the obligation and frequency of reinstatementFigure: Level of severance payments for unfair dismissal and the obligation and frequency of reinstatement
Source: OECD
Note: In Japan, employers are required to pay unpaid wages retrospectively from the time of commencement of court proceedings in the case of reinstatement. Therefore, the level of severance payments in Japan is set at six months of wages, assuming that court proceedings take an average of six months. In the United States and Canada, the amount of severance payments are subject to damage suits, and there are no prefixed amounts.

The comparison also shows that, as a general rule, the lower the frequency at which employers are required to reinstate dismissed employees, the more prevalent is the use of severance payments and the higher are their amounts. However, in Anglo-Saxon countries and the Netherlands, employers are rarely obliged to reinstate their dismissed workers and yet the amounts of severance payments are relatively small. Meanwhile, in Japan, changing jobs in mid-career is no longer a rarity. Thus, Japan should seek to introduce a severance system that allows employees to opt for monetary settlement, as is the case in Italy, while at the same time paying due consideration to the amount of severance payments.

The growing gap between permanent and temporary workers poses a serious problem in Japan. The latest amendments to the Labor Contract Act, enacted in the just-ended Diet session, will require, inter alia, that employers allow temporary workers to convert to permanent status after five years in service. This, however, will not have any tangible impact. Although European countries also have set the maximum allowable duration of successive fixed-term contracts, the average duration of such contracts is significantly shorter than the legal limit in most countries. In addressing the problem of sudden refusal to renew fixed-term contracts after successive renewals, Japan should seek to introduce a severance payment system for temporary workers with an eye on the eventual integration with that for permanent workers, rather than having the "doctrine of non-renewal of employment contracts"—which would effectively negate unfair refusal to renew fixed-term contracts—legislated into law.

Japan's existing restrictions on dismissal are a set of judicial precedents accumulated over the years and therefore cannot be eased simply by rewriting the text of statutory law. Indeed, recent rulings in cases on dismissal due to reorganization focused on the procedural aspect of such dismissal, indicating that a degree of flexibility has been exercised in a way to respond to the changing needs of time. Yet, it is crucially important to reexamine dismissal regulations, in particular, given the deepening of the problem of temporary workers over the past 20 years. The level of severance payments should be explicitly defined by law. Only then will it become possible to ease restrictions on dismissal effectively and explicitly by changing the level of such payments. This would constitute the first step toward the ultimate solution to the two-tier labor market, for instance, by facilitating the introduction of a single contract scheme. In the long run, this would lead to improvement in productivity through enhanced mobility of human resources.

>> Original text in Japanese

* Translated by RIETI.


[Labor market reform law in Italy]

Previously, in the case of unfair dismissal by companies with more than 15 employees, the court ordered reinstatement and compensation for unpaid wages for the period of court proceedings while dismissed employees had the right to refuse the court order and instead receive compensation payments equivalent to 15 months of wages. In reality, however, dismissing employees was not a viable option for major companies in Italy, a country where court proceedings usually require an extended period of time, because the amount of compensation payments in the case of reinstatement would have been unacceptably large. The labor market reform law defines a severance payment scheme as the primary way of settlement, calling for compensation payments of a maximum of 24 months of wages.

[Severance payment]

There are three types of dismissal, namely, that for economic reasons (equivalent to "dismissal due to reorganization" in Japan), that for disciplinary reasons ("punitive dismissal"), and that for personal reasons ("ordinary dismissal"). Courts are the final arbiters of disputes over dismissal irrespective of its kind. In the event of unfair dismissal, a practice observed in a significantly large number of countries is that companies are allowed to terminate employment by making severance payments in an amount designated by law. In many countries, companies are required to offer severance payments, though in a small amount, even in the case of fair dismissal.

September 18, 2012 Nihon Keizai Shimbun

October 15, 2012