All OECD countries have either legally mandated severance pay or compensations imposed by industry-level bargaining in case of employer initiated job separations. According to the extensive liter- ature on Employment Protection Legislation (EPL), such transfers are either ineffective or less efficient than unemployment benefits in providing insurance against labor market risk. In this paper we show that mandatory severance is optimal in presence of wage deferrals when there is moral hazard of workers, shirkers can get away with it and adverse selection prevents employers to commit not to fire a non-shirker. Our model also accounts for two neglected features of EPL. The first is the discretion of judges in inter- preting the law, which relates not only to the decision as to whether the dismissal is deemed fair or unfair, but also to the nature, economic vs. disciplinary, of the layoff. The second feature is that compensation for dismissal is generally increasing with tenure. We provide new cross-country comparable measures of these two features of EPL. The model also explains why severance is generally higher in countries with less efficient judicial systems and why small firms are typically exempted from the strictest EPL provisions.
