Working Paper, School of Economics and Finance, Queen Mary, University of London 698
This paper studies the effect of mandated severance pay in a matching model featuring wage rigidity for ongoing, but not new, matches. Mandated severance pay matters only if binding real wage rigidities imply inefficient separation under employment at will. In such a case, large enough severance payments reduce job destruction, and increase job creation and social efficiency, under very mild conditions. Furthermore, mandated severance pay never results in inefficient labor hoarding. Whenever separation is jointly optimal, the parties agree to end the match with a spot severance payment below the statutory one. The marginal effect of mandated severance pay is zero when its size exceeds that which induces the same allocation that would prevail in the absence of wage rigidity. The results hold under alternative micro-foundations for wage rigidity.