Determining the "Appropriate Level" of Severance Payments

TSURU Kotaro
Faculty Fellow, RIETI

The 2015 employment system reforms under the Shinzo Abe administration are likely to focus on the issue of employment termination (dismissal). Disputes arising from dismissal should be dealt with as the combination of (1) prevention, (2) swift and efficient resolution even if prevention fails, and (3) diversification of resolution approaches.

Article 16 of the Labor Contract Law stipulates that a dismissal shall, if it lacks objectively reasonable grounds and is not considered to be appropriate in general societal terms, be treated as an abuse of rights and invalidated. Under the current system, a court ruling invalidating a dismissal confirms the continuation of a labor contract.

However, in reality, few cases result in reinstatement to the original position. In the end, a dispute of this nature is typically settled with monetary compensation. Resolution with monetary compensation is also seen in many settlements through arbitration by a prefectural labor bureau or labor tribunal, but significant variations in the level of compensation have been pointed out.

In view of this situation, from the aforementioned perspective (3), it is necessary to develop a mechanism of dispute resolution, other than the continuation of a labor contract, which benefits both employers and employees. More specifically, a system of severance payments (or monetary resolution) should be introduced.

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The severance payment system is a mechanism in which, when an unfair dismissal occurs, the employer pays a set amount of severance payments, defined by laws, to the employee to terminate the contractual relationship. Such a system is widely adopted in Europe. Laws and other regulations set out guideline figures for compensation of unfair dismissal, according to the number of years of service. Once the system is introduced, the predictability of the amount of compensation is expected to increase.

The growth strategy compiled by the government last year (revised version of the Japan Revitalization Strategy) pledges to conduct a far-reaching study in 2015 for developing a transparent and objective labor dispute resolution system in light of the fact that major industrialized nations have mechanisms for pecuniary remedies provided to workers through court decisions. The reforms in this area are urgently necessary.

The major contentious issue is the approach for determining the level of severance payments. In continental Europe, employers pay the amount equivalent to one to two years' wages to an employee who has served for 20 years. In the Netherlands and English-speaking countries, which have weaker labor protection, the amount paid is equivalent to six months' wages, creating large variations (See the table below.)

Table: Severance Payments for Unfair Dismissal Varies among Countries
(Severance payments are calculated as the number of months of wages)
(Unit: months)
United Kingdom5.5
New Zealand6.0
Note: 20 years of services for most countries. 10 years of services for Sweden. Wages equivalent to 6.2 weeks are added for New Zealand. Retirement payment is deducted in Germany and Spain. In the United States, there are no prefixed amounts.

In order to determine the average compensatory level, the survey conducted by the World Bank in 2012 calculated the different figures based on the length of service and figured out the level of severance payments per year of service. Workers in 48 high income countries received an amount equivalent to 1.8 weeks' wages (on average), whereas those in 35 Organisation for Economic Co-operation and Development (OECD) nations received an amount equivalent to 2.1 weeks' wages (on average).

Even where governments determine the level of severance payments with laws and regulations, it is assumed that the characteristics of each country's labor market are reflected. To examine the desirable level of compensation, it is first necessary to consider what is the optimum compensation level achieved through negotiations between companies and workers.

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What must be noted is the "neutrality" of severance payments, which Stanford University Professor Edward P. Lazear presented theoretically in his 1990 paper. More specifically, his results show that if some conditions are met--such as workers are risk-neutral and wages are completely flexible--then compensation would not affect employment, workers' welfare, or companies' profits.

This is because the introduction of compensation would be offset by the change of temporal wage profile (wage structure according to the number of years in service), which reduces the amount of wages during the term of employment. Thus, such introduction will not have any impact on the future net income of workers and companies (aggregate sum, based on the discounted present value), as risk-neutral workers are only interested in the future net income and indifferent to the wage profile.

However, workers are usually risk-averse and wages are not completely flexible. Wages would not necessarily decrease to accommodate compensation, and the change of the wage profile would affect employee welfare. For this reason, workers would not normally take the position of risk neutrality. There are many studies analyzing the impact of employment protection on the labor market, but the number of studies on determining the optimum level of compensation is very limited.

The 2014 paper by the National School for Statistics and Information Analysis (ENSAI) Professor Stephane Auray et al. analyzed labor-management negotiations on wages and severance payments using a standard matching model with risk-averse workers. According to this model, the optimum level of severance payments (over wage) is expressed as: (1 - Unemployment insurance replacement rate) / (Discount rate + Unemployed persons' job finding rate). In other words, the higher that the unemployment insurance replacement rate, unemployed persons' job finding rate, or discount rate is (interest rate), the lower is the level of severance payments.

From the perspective of compensating for the future net income that a worker would have earned if the worker had maintained employment, the availability of generous unemployment benefit would reduce the level of severance payments. Similarly, the level of severance payments would not have to be high if it were easy to find the next job, which would provide wages.

Professor Auray et al. compared the level of severance payments theoretically predicted against the level of severance payments mandated by laws and regulations in reality, and concluded that countries such as Norway, France, and Germany provide compensation close to the predicted value. In comparison, countries such as Italy and Spain offer compensation significantly greater than the predicted value. It was consistent with the level obtained from a model that explicitly incorporates the impact of labor unions, thereby indicating a strong union influence in these countries.

Meanwhile, Bocconi University Professor Tito Boeri et al. in their 2014 paper stressed the significance of severance payments under the seniority-based system in the presence of wage deferral, even when workers take the stance of risk neutrality.

When there is a seniority mechanism of making up for low wages in the earlier years later on in life, middle- and senior-aged workers earn wages that exceed their productivity level. This gap creates an inducing factor for dismissal. In this case, inefficient dismissal could be deterred by setting the level of compensation greater than this gap.

Considering that the wage level greater than productivity is a reflection of the workers' contribution to the employer in their earlier years (e.g., acquiring specific skills only useful at the company = corporate-specific investment), it is clear that the optimum level of compensation relies on the cost of such investment. This model makes it easy to understand that the level of compensation depends on the number of years in service.

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A good point of reference when considering the introduction of severance payments system to Japan is a RIETI survey concerning monetary resolution on over 2,000 full-time workers. The median value of compensation that the samples wanted to receive in case of an unfair dismissal was the sum equivalent to 16 months' wages. The samples who have worked longer gave higher figures, ranging between 10 to 17 months' wages. The results were close to the aforementioned figures for continental Europe.

However, the number of years in service is strongly reflected in the compensation level in Europe because of the enforcement of the "seniority rule," in which the priority of dismissal is given to those who have served for a shorter period of time. In comparison, compared to other countries, middle- and senior-aged workers in Japan who have served longer already benefit strongly from it in the form of higher wages. For this reason, in view of the burden on the part of employers, the number of years in service should not have as much influence on compensation as they do in European countries.

These factors unique to Japan must be considered in taking a flexible, unbiased approach in drawing up the rules of severance payments that satisfy both employers and employees.

>> Original text in Japanese

* Translated by RIETI.

January 19, 2015 Nihon Keizai Shimbun

March 24, 2014

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