The Value of Flexible Contracts : Evidence from an Italian Panel of Industrial Firms

Fixed-term contracts have been used in many European countries to reduce firms' firing costs. In this paper we evaluate the size of these costs by measuring firms' willingness to trade fixed-term for open-ended contracts in exchange for a cut in the labor cost of permanent jobs. Our results are based on a panel of Italian firms in the engineering sector exposed to an exogenous reduction in their labor cost induced by a tax credit granted to all firms hiring workers with open-ended rather than fixed-term contracts. We found that firms value the possibility of hiring one percent of new workers with a fixed-term contract as much as a 2.2 (and up to 2.6) percent cut in the labor cost of an open-ended worker. Results are not driven by spurious trends and are confirmed by a matching estimator base on p-score. In Italy, the share of fixed-term contracts among new hires grew from 34 to 42 percent between 1995 and 2003. Using our most conservative results, we evaluate that the labor cost reduction associated with this expansion amounted to about 17 percent. Given the elasticity of employment to wage, the inflow of flexibility in the Italian labor market can account for an employment growth of 5.3 percent, that is almost 2/3 of the overall expansion in the private sector