Do firms obey the law when they fire workers? – Social criteria andseverance payments in Germany –

Elke J. JahnAarhus School of Business, University of Aarhus, IAB and IZA

(October 2008)

LASER Discussion Papers - Paper No. 22

(edited by A. Abele-Brehm, R.T. Riphahn, K. Moser and C. Schnabel)

Correspondence to:

Elke J. Jahn, Hermodsvej 22, 8230 Åbyhøj, Denmark, Email: elja@asb.dk.

Abstract

Employment protection legislation defines social criteria according to which firms can dismissworkers. If firms evade the law, then negotiation about compensations begins. To reduce legal andfinancial uncertainty often associated with ex-post bargaining, the German government stipulatedseverance payments in the case of mutual agreements into the law in 2004. The paper shows thatworkers protected by law have the lowest probability of being dismissed. The expected severancepayment and firm size increase the probability of receiving compensation while the amount ofseverance payment depends significantly on the way the employment relationship is dissolved.Contrary to the intention of the legislator, the reform increased the level of compensation.

* Aarhus School of Business, University of Aarhus, IAB and IZA, Hermodsvej 22, DK-8230 Åbyhøj, Denmark, E-mail: elja@asb.dk

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Do firms obey the law when they fire workers?

– Social criteria and severance payments in Germany –

Elke J. Jahn*

(October 2008)

Employment protection legislation defines social criteria according to which firms can dismiss

workers. If firms evade the law, then negotiation about compensations begins. To reduce

legal and financial uncertainty often associated with ex-post bargaining, the German gov-

ernment stipulated severance payments in the case of mutual agreements into the law in

2004. The paper shows that workers protected by law have the lowest probability of being

dismissed. The expected severance payment and firm size increase the probability of receiv-

ing compensation while the amount of severance payment depends significantly on the way

the employment relationship is dissolved. Contrary to the intention of the legislator, the

reform increased the level of compensation.

Keywords: employment protection legislation, severance payment, bargaining, reform

JEL-classification: J63, J65

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1 Introduction

Employment protection legislation restricts the ability of the employer to utilize labor. These

restrictions are typically legislated but may also be set by collective agreements or by the

decisions of the judiciary through evolving case law. Employment protection rules impose

firing costs to the firm and have a tax and a transfer dimension. Firing taxes emerge as a

consequence of administrative restrictions under which a dismissal is justified and from pro-

cedural inconveniences that the firm has to obey if it wants to lay off. The tax includes red

tape costs and legal expenses in case of a trial and is paid outside the firm worker-pair. The

second component is a transfer from the firm to the worker to be laid off. The transfer dimen-

sion involves severance payments usually paid in case of unfair dismissals and may be set

by legal rules, be a result of individual and collective agreements or of ex-post negotiations

between the worker and the firm.

A vast literature has studied the quantitative effects of different degrees of firing taxes and

severance payments on macroeconomic labor market outcomes such as (un-)employment

and labor turnover.1 Up to today, little emphasis has been given to the interplay between the

statutory employment protection defined by law and the transfer component. One reason

may be that ex-post bargaining about severance payments is often implicit and not easily

observable by third parties if the firm has to lay off.

Which workers will be laid off if a firm needs to reduce its workforce for economic rea-

sons? According to economic theory, workers with the lowest productivity will be fired first.

However, in Germany, as in many European countries, employment protection legislation

specifies social criteria determining the order in which workers are to be dismissed. But

meeting social criteria is complicated and often it does not serve the interests of the firm.

Germany is an especially interesting case to analyze because the law and its entangled

jurisdiction create a remarkable legal and financial uncertainty, the dismissal procedure is

complicated and time-consuming, and after an unfair dismissal lawsuit it is often impossible

to continue the employment relationship. As a consequence, it has become common to ne-

gotiate ex-post over severance payments instead of relying on the legal system if the firm

has to lay off.

In order to increase labor market flexibility, in 2004 the German government simplified the

dismissal procedure and specified the amount of severance payments if the firm dismisses

the worker for economic reasons. The aim of the legislator was to reduce the incentive of the

dismissed workers to file a lawsuit. Consequently, the legal uncertainty should have de-

creased. In addition, it was the aim to reduce financial insecurity by specifying the amount of

severance payments by law.

1 See Jahn (2005) and OECD (2004) for a comprehensive overview.

3

Recently, research concentrating on decisions of labor courts and the level of compensa-

tion has received increasing attention but is still in its infancy, see Section 2. Contrary to pre-

vious research, this paper investigates whether firms indeed obey the law and meet social

criteria if they have to lay off workers. Furthermore, a stepwise estimation strategy is devel-

oped to account for sample selection bias when examining which workers receive severance

payments and the determinants of severance pay variation. In addition, the dataset used

allows to distinguish between three forms of displacement: individual dismissals, collective

dismissals, and mutual agreements. Finally, the paper investigates whether the reform in

2004 indeed reduced financial uncertainty for the firms by decreasing severance payments.

The paper is organized as follows. Section 2 briefly summarizes the related literature. In

Section 3, the legal framework in Germany and the main hypotheses are outlined. Section 4

introduces the dataset and is devoted to the estimation strategy which combines two Heck-

man selection models in order to take sample selection issues into account. Section 5

presents the results and Section 6 concludes.

2 Literature

Since the pioneering study of Lazear (1990), which shows that without market imperfections

a compulsory severance payment can be neutralized by an appropriately designed wage

contract, the theoretical and empirical investigation of the labor market consequences of em-

ployment protection has exploded. The bulk of the literature analyzes the macroeconomic

effects of statutory employment protection, especially of firing taxes, compulsory severance

payments and notice periods. Firing taxes reduce the quasi-rent of a match while severance

payments prima facie redistribute the rent in favor of the worker (Jahn 2002). Especially the

effect of compulsory severance payments in imperfect markets has recently received atten-

tion.

Stähler (2006), Galdón-Sánchez and Güell (2003), Goerke (2002) and Fella (2000) inte-

grate compulsory severance payments into the shirking model of Shapiro and Stiglitz (1984).

Fella (2000) shows that the unemployment rate decreases and worker welfare increases if

the severance payment goes to the dismissed worker. In contrast to these findings, Galdón -

Sánchez and Güell (2003) argue that a compulsory settlement increases the unemployment

rate, if third parties, such as a court in the case of a claim for wrongful dismissal, cannot easi-

ly distinguish between a dismissal for economic reasons and a dismissal due to misbehavior.

Goerke (2002) compares compulsory settlements for individual and collective dismissals. In

particular, settlements payable for collective dismissals may increase aggregate employ-

ment. Stähler (2006) allows for judicial mistakes when the court decides over severance

payments. Increasing the level of severance payments may increase employment for small

4

judicial mistakes and may dominate the effect of firing taxes which leave ambiguous effects

on employment.

Garibaldi and Violante (2005) argue theoretically and empirically that the transfer compo-

nent of firing costs has a larger impact than the tax component if wage rigidity is endogen-

ous. With a panel dataset of OECD countries they show that the transfer component of em-

ployment protection legislation may be considerably larger than the tax component. Thus

from a quantitative standpoint, the transfer component cannot be ignored.

Why do parties involved in a dismissal not always settle, avoiding the wasteful judicial

costs of going to court? Galdón-Sánchez and Güell (2000), Ichino et al. (2003) and Goerke

and Pannenberg (2005) explicitly model the litigation process under the presumption that the

rules of the law are very general, leaving room for a wide range of possible interpretations by

the parties and the judge. Galdón-Sánchez and Güell (2000) investigate two types of dismis-

sals; dismissals for misconduct and for economic reasons and two reasons for conflicts,

namely disagreement between the agents or strategic behavior of the agents. They analyze

under which conditions cases are bilaterally settled or taken to court. It seems that the gap

between severance payments for fair and unfair dismissals is the key factor determining

court outcomes. Ichino et al. (2003) concentrate on dismissals for misconduct. Using data

from a large Italian bank, they find some evidence that jurisprudence may be affected by the

underlying labor market conditions and may tend to be particularly unfavorable to employers

when unemployment is high.

Bertola et al. (1999) also provide some evidence that the size of severance payments is

not independent from labor market conditions in some European countries. Berger and Neu-

gart (2006) confirm that judges have ample room for discretionary decisions when it comes

to a lawsuit in Germany. They prove that court activity varies systematically with the ideologi-

cal leaning of the government nominating the judge. Therefore, the outcome of a lawsuit may

also depend on the region in which the case is taken to court. As a consequence, labor court

activity and unemployment are significantly positivly correlated.

The impact of uncertain court rulings on privately negotiated severance payments has

been taken theoretically into account by Goerke and Pannenberg (2005). They show that the

outcomes of bargaining in dismissal conflicts depend on workers and firm characteristics and

the taxation of severance payments.

The studies of Grund (2004, 2006) and Goerke and Pannenberg (2005) are more in line

with the present study. They use data from the German Socio-Economic Panel (GSOEP) to

estimate the probability of receiving compensation and the incidence of severance payments

for the period 1991-2002 and 1991-2003, respectively. Both studies show that the probability

of receiving compensation increases with tenure, family responsibilities and firm size. The

results of the incidence of severance payments are less clear cut. Merely tenure and the

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wage at the last job have a significant effect on the amount of severance payment. In addi-

tion, Goerke and Pannenberg (2005) estimate the effect of an increase in taxation of the se-

verance payment. They show that the change had not only a negative effect on the probabili-

ty of receiving severance payments but also on the amount of severance payment.

Both studies have one shortcoming in common. They do not control for potential selectivi-

ty bias. If the firms obey the law, they will first of all dismiss workers which are less protected

by the regulation. Therefore to estimate the determinants of the level of severance payments,

it has not only taken the probability of receiving severance payments into account but also

the probability of being dismissed.

In addition, this paper tries to shed light on two further questions: First, until 2000 the

questionnaires of the GSOEP regarding the reasons for termination of the last job have

changed several times. The questionnaires in 1999 and 2000 do not allow to distinguish be-

tween individual dismissals (lay offs) and collective dismissals (plant closing). Before 1999

the questionnaires did not clearly ask whether the employment contract was dissolved as a

consequence of a mutual agreement. Therefore, whether the way to dissolve an employment

contract has an effect on the probability of receiving severance payments and the amount of

severance payment could not be answered in previous studies.

Second, from the political point of view it is interesting to investigate whether the reform in

2004 indeed had an effect on the probability of receiving compensation and the incidence of

severance payments. The study addresses this question as well.

3 Legal Framework and Hypotheses

Employment protection legislation applies to workers employed in firms with more than five

and since 2004 more than ten workers and with a tenure of more than six months.2

A lay off is only justified if the firm can state a suitable reason for termination. According to

law a dismissal is considered to be fair in cases of personal misconduct, e.g. thievery, lack of

personal capabilities, mostly long-lasting sickness, or for economic reasons. To justify dis-

missals for misconduct or lack of personal capabilities, jurisdiction and case law set high

standards and therefore they are rarely considered to be fair by the court. As a consequence,

most firms dismiss workers for economic reasons or offer severance payments to dissolve an

employment relationship even though the true reason lies in the behavior or the capability of

the worker (Rüthers 2002, Thau 1999, Bauer 2002).

Firms displacing workers for economic reasons cannot simply adjust their workforce ac-

cording to the volatility of the business cycle. Instead they have to prove a long-lasting se-

vere decline of orders which will persist in the future and that lay offs cannot otherwise be

2 A comprehensive description of the German employment protection legislation can be found in

Jahn (2002, 2005).

6

avoided. In addition, the judge has to weight the interest of the worker to keep his job against

the interest of the employer to dissolve the employment relationship. But even if the firm can

justify the lay off with business needs, it cannot dismiss the worker whose job became re-

dundant.

In a second step the firm has to compare workers with similar skills and rank them accord-

ing to social criteria. The worker with the lowest rank must be dismissed first. Jurisdiction and

since 2004 the law specify as social criteria age, tenure within the firm, family responsibilities,

and disability (see Table 1). However, the law does not weight these criteria, and many ex-

ceptions exist. In addition, judges enjoy a high degree of independence in interpreting legal

rules (Berger and Neugart 2006). Ranking workers is therefore a complex task, especially for

larger firms because so many workers must be compared. As a consequence, even trained

and experienced labor law experts are not able to predict with certainty whether a dismissal

may be justified, even though the firm successfully proves that the redundancy made can be

justified by economic reasons (Willemsen 2000).

As a consequence of this legal uncertainty, firms are tempted to evade a judicial settle-

ment when making a dismissal decision as the following figures prove: In 2003, 65 percent of

all lawsuits ended with an amicable settlement, 24 percent with an out-of-court agreement

and only 11 percent finally were decided by the judge (Höland et al. 2005). Obviously, bar-

gaining after a dismissal is important when making a firing decision.

The law does not unambiguously set the level of compensation and mandatory severance

payments do not exist. Instead, severance payments are the result of ex-post bargaining if a

lay off may be considered to be unfair. Severance payments can be the outcome of three

types of dismissals:

Unfair lay offs: Workers who believe they have been unfairly dismissed can file a lawsuit

and claim to be re-instated again. After a compulsory conciliation procedure the trial begins.

Court decisions can take time; in 2006 14 percent of all 231,588 settled lawsuits lasted long-

er than 6 months. If the firm loses the lawsuit, it has to continue wage payments from the day

of termination notice through to the date when the lawsuit is settled which is considered as

one source of the tremendous financial uncertainty. However, after adjudication it is often

impossible to continue a cooperative employment relationship. As a consequence, re-

instatement to the previous job can only rarely be observed (Höland et al. 2005, Pfarr et al.

2005). Provided both parties agree, the judge can dissolve the employment contract if the

firm pays a compensation set by the judge. As an orientation, courts use a severance pay

factor of 0.5, which means one half of a monthly gross wage for each year the worker was

employed by the firm. Given the discretionary power that judges enjoy in the German labor

court system, they may chose to set the compensation above or below this rule of thumb,

7

depending on their political preferences, the likely consequences for the worker or the re-

gional unemployment rate.

Collective dismissals: In the case of collective dismissals or plant closings, works councils

bargain a social plan for all redundant workers. Works council presence tends to increase

sharply with establishment size, from about 9 percent in firms with 5 to 20 employees to

about 90 percent in large firms with more than 500 employees (Addison et al. 2003). The

bottom line for the negotiations is the severance pay factor of 0.5, but compensations are

usually higher since the bargaining power of works councils exceeds that of an individual

worker (Jahn and Schnabel 2003).

Mutual agreements: Firms increasingly offer redundancy pays and release workers from

work in exchange for a mutual agreement dissolving the employment contract. The rationale

for the firm is to reduce legal and financial uncertainty, to prevent an unfair dismissal claim,

and to avoid wage payments until the case is settled by the court. However, to offer a mutual

agreement may signal that firms anticipate they will lose the lawsuit. In this case, the fallback

position of the worker is the amount of severance payment that the judge is likely to recom-

mend. Therefore the offer should usually be higher than the severance pay factor of 0.5.

Up to 2003 the legislator has judged bargaining about severance payments and mutual

agreements as a means to circumvent employment protection legislation. Therefore workers

accepting a mutual agreement were not eligible for unemployment benefits for the first 12

weeks in case of a subsequent period of unemployment. Hence, the severance payment also

has to cover unemployment benefits if the parties have to assume that the worker will be-

come unemployed after being displaced.

In light of the increasing critique of the employment protection legislation, the growing

number of cases brought to court, and an increasing trend to negotiate over severance pay-

ments the government decided to integrate mutual agreements into the law from January

2004 on (see Table 1). Since then a firm can offer ex-post severance payments if it dis-

misses the worker for economic reasons. In this case, the minimum compensation amounts

to one half of a monthly gross wage for each year the worker has been employed by the firm;

the severance pay factor of 0.5 previously used as a rule of thumb by the courts. After receiv-

ing the termination notice which must explicitly refer to the new legislation, the worker can

decide whether he wants to file a lawsuit or accept the offer. If the worker signs the mutual

agreement, he loses the right to claim but remains eligible for unemployment benefits from

the first day of unemployment on. The idea of the legislator was not only to decrease the

number of lawsuit but also to lower the financial and legal uncertainty for both parties.3

3 In 1965, British policymakers passed the Redundancy Payments Act mandating lump sum pay-

ments to workers who are to be laid off. As in Germany, the Act was an effort to reduce uncertainty due to time-consuming judiciary processes to spur labor market flexibility. As a consequence of the new Act, the number of lay offs increased significantly in the UK. The considerable boost in redun-

8

Against this expectation Jahn and Walwei (2005) and Jahn (2005) have objected that the

reform may have increased the bargaining power of the worker. The reason is that the law

now sets a minimum standard for the amount of severance payment which was previously

subject to ex-post bargaining. After receiving the termination notice, the worker still can de-

cide to take the case to court. Because the firm already offered the compulsory severance

payment, it is likely that the judge will at least recommend the severance pay factor of 0.5. In

contrast to the legal situation before 2004, the judge will be more hesitant to undercut the

severance pay factor of 0.5 because it is now stipulated by law as a bottom line. To ensure

that the redundant worker trades his right to sue against a severance payment, the worker is

likely to receive after a lawsuit in any case; firms have to offer higher compensations. As a

consequence, the amount of severance payment should have increased after the reform.

With respect to the probability of being dismissed, the probability of receiving severance

payments and the incidence of severance payment the following hypotheses can be summa-

rized:

1. If firms indeed obey the law and social criteria affect the dismissal decision of the em-

ployer, then older workers, employees with longer job tenure, handicapped persons and

persons with family responsibilities should have a lower dismissal probability. The dis-

missal probability should be higher in firms below the threshold at which employment pro-

tection legislation applies; it should decrease with increasing firm size because works

councils are more likely present in larger firms who usually rule in favor of the worker. Fi-

nally, larger firms may more often be able to offer redundant workers a job in another di-

vision.

2. Social criteria should influence the probability of receiving compensation for two reasons:

First, it is more likely that the worker receives a voluntary severance pay offer if the firm

anticipates that it will lose the trial in case the worker goes to court. This will be more like-

ly if the dismissal decision does not meet the social criteria defined by law. Second,

whether a worker receives compensation may also depend on his decision to claim which

is a prerequisite to receive compensation if the worker does not receive a voluntary offer

by the firm. This may depend on the credibility of the reason stated in the termination no-

tice, on whether the workers believe that social criteria are met and finally on whether the

local judge, who has some discretionary power, is known to decide more in favor of or

against workers’ interests.

Firm size should have a positive effect on the probability of receiving severance pay-

ments as well. It is more likely that a works council is present and bigger firms can more

easily bear the financial burden. Moreover, in bigger firms the personal relationship be-

dancies in Britain during the 1970s may be an indication that firms are indeed prepared to bear higher firing costs as long as they are able to calculate ex-ante the costs of a displacement (Booth and McCulloch 1999, Oswald and Turnbull 1985).

9

tween the employer and the dismissed worker is weaker. Therefore redundant workers

may be more prone to bring the case to court or claim severance payments. Filing a law-

suit is time-consuming and may be associated with emotional stress. Hence, it is likely

that the expected severance payment, calculated on the basis of the severance pay fac-

tor, may have a positive impact on the probability to suing the employer and therefore re-

ceive compensation.

3. Severance payments are to be seen as having an insurance function if the unemploy-

ment risk is not full insurable (Alvarez and Veracierto 2001). Judges may account the un-

employment risk of the worker in their decisions for damages corresponding to past and

expected future financial losses. Having found a new job at the end of the notice period

therefore weakens the workers’ bargaining position and judges are often more benign

and may decide in favor of the firm. Therefore, it is likely that the probability of receiving a

severance payment and its incidence should be lower for workers who already have

found a new job at the end of the notice period.

4. Firm size is likely to increase the amount of severance payment. For larger firms it is

nearly impossible to meet social criteria. Therefore, compared to smaller firms, the like-

lihood to lose a lawsuit is higher. As a consequence, it can be expected that larger firms

will be more prone to offer at least a severance payment in the range of the severance

pay factor or even higher. Moreover, because of the strategic position of the workers, it

can be expected that the highest severance payments will result from mutual agree-

ments, followed by collective dismissals and traditional lay offs.

5. Finally, as already argued above, the reform should have increased the amount of sever-

ance payments because it strengthened the workers’ bargaining position.

4 Data and Empirical Approach

The paper uses data from the GSOEP, a longitudinal representative household survey of

people living in Germany. Whether a dismissal in the previous year is followed by a mutual

agreement is reported from 2000 on, see Section 2. The sample therefore covers the period

2000-2006, information on employment characteristics are added from 1998 on. Workers

between 18 and 65 years of age who lost their jobs as a consequence of lay offs, plant clos-

ings or who signed a mutual agreement are included. Workers with tenure of less than six

months, apprentices, self-employed and civil servants are excluded because different dis-

missal rules apply to these groups. The variables used in the analysis and selected summary

statistics are described in Table 2.

To explain the determinants of receiving redundancy pays and the incidence of a sever-

ance payment, a stepwise estimation strategy is applied. First, the probability of being dis-

missed is estimated. For the redundant workers, it is determined whether they receive a se-

10

verance pay. If the second hurdle – receiving compensation – is cleared, the determinants of

the level of severance payments are estimated. Theses hurdles are stepwise interdependent

and we have to control for potential selection bias.

Workers receiving severance payments are not a random selection of all dismissed em-

ployees. It is plausible that firms first dismiss those workers who are not protected by law and

therefore have a low probability of receiving any redundancy pay at all. A second selectivity

problem is at hand with respect to the amount of severance payments observed only for

workers who received compensation. Once the bargaining has started, the amount of sever-

ance payment depends on how displacement occurs (lay offs, plant closings, mutual agree-

ment), the probability of receiving compensation and, indirectly, of being dismissed.

Therefore, two Heckman sample selection models are combined with one selection equa-

tion for each of the models:4 First a bivariate probit selection model is applied to estimate the

compensation probability conditional on the probability of being dismissed. To receive con-

sistent estimates for the parameters for the amount of severance pay, this estimation is used

to construct the inverse Mills ratios. These are included in the second Heckman selection

model estimated by maximum likelihood conditional on who receives compensation. This

procedure controls stepwise for being dismissed and receiving compensation.

The amount of severance payment of a worker i, is , is estimated as

(1) iii xs εβ +=* if

where ix is a vector of controls and iε an idiosyncratic error term.

However, the model needs to account for the probability of receiving compensation, *ic ,

and, indirectly, of being dismissed, *id . The corresponding selection equations are given by

>=

=otherwiseunobservedisc

difccd

i

iiii

,0

0,1 ** and

>=

=otherwiseunobservediss

cifssC

i

iiii

,0

0,1 **

These probabilities can be specified as latent variable models.

(2) iii zc ηδ +=*

(3) iii wd υγ +=* .

4 The basic assumptions of the Heckman model can be found in Wooldridge (2002).

11

ii zw and are vectors of controls, iη , and iυ are idiosyncratic error terms, respectively,

δ in equation (2) is estimated by a bivariate probit model with sample selection. To receive

consistent estimates of the parameters, this estimation is used to construct the inverse Mills

ratios, which are included in the second Heckman equation (1). This procedure corrects

stepwise for being dismissed and receiving compensation. 5

The appropriateness of this approach relies on the identifying ability of the exclusion va-

riables. They need to identify the propensity of being dismissed and the propensity of receiv-

ing compensation. Identification in the former case is obtained by using job satisfaction.

Workers with lower job satisfaction prior to dismissal may have lower productivity. It can be

assumed that employers who have to choose between two otherwise identical workers would

try to get rid of a worker with lower job satisfaction. But job satisfaction may not influence the

probability of receiving compensation.

In the second case, the identification strategy relies on whether a worker had a dismissal

experience in the previous three years.6 After a dismissal experience, the worker may be

better informed about the respective litigation. This may result in strategic behavior to in-

crease the compensation probability. As argued above, the probability of receiving compen-

sation may decline, if the worker has already found a new job after the notice period has

ended. A widespread strategy to increase the compensation probability is for example to

reduce search efforts for a new job before the case is settled or to hide the fact that the

worker has already found a new job (Willemsen 2000). But this procedural knowledge may

not directly influence the amount of severance pay.

5 Results

The estimation includes 47,678 persons, whereas 2,198 were dismissed during the observa-

tion period, see Table 2. About half of the persons have been laid off, one out of four were

either dismissed as a consequence of plant closings or terminated their job by signing a mu-

tual agreement. In total, 404 workers reported that they received compensation but only

about 90 percent revealed the amount of severance payments. On average, 18 percent of

5 If one assumes that the probability of being dismissed and the amount of compensation is not in-

dependent, a double hurdle model would be the adequate estimation strategy (Maddala 1983). But firms are only able to roughly calculate one part of the expected costs of dismissing a worker, namely the direct severance payment based on the severance payment factor. But the firm faces a large uncertainty with respect to the costs arising due to continued wage payments until the case is settled. The reason is that the firm hardly can predict whether the labor court will rule in favor of the firm or the worker when making the separation decision. I am grateful to Jeffrey Smith, Katja Görlitz and an anonymous referee for this helpful comment.

6 The threshold of three years is chosen because employment protection legislation was last amended at the end of 1996. Procedural knowledge of workers being dismissed in 2000 was only valuable if they had a dismissal experience after 1997 or in the past three years. In addition, in Germany case law and jurisdiction is evolving fast. Therefore, it has to be assumed that procedural knowledge underlies a high depreciation.

12

the workers being dismissed received severance payments, whereby this fraction is lower for

workers laid off (17 percent) compared to workers being dismissed as a consequence of

plant closings or who signed a mutual agreement (both around 20 percent).7 On average,

laid-off workers received a compensation of about 9,700 Euro. If the worker lost his job be-

cause of a plant closing, he received 16,800 Euro on average. Workers who signed a mutual

agreement realized 24,000 Euro. The severance pay factor amounts to 0.76 in case of mu-

tual agreements, 0.69 in case of a plant closing and 0.53 if the worker is laid off. Moreover,

Table 2 documents that the variance of the severance pay factor received is highest for mu-

tual agreements indicating that indeed financial insecurity is present. If we assume that se-

verance payments paid for lay offs are more likely the outcome of a lawsuit while severance

payments bargained in mutual agreements are not, then the difference between the sever-

ance pay factors can be interpreted as a premium to avoid legal uncertainty.

For comparison, Table 3 displays the estimations using binary probit approaches to esti-

mate the probability of being dismissed (Model 1) and the probability of receiving compensa-

tion (Model 2) as well as an OLS estimation to determine the amount of severance payments

(Model 3).

According to law and the first Hypothesis, the dismissal probability should be lower for

older workers, for workers with longer tenure, severe disabilities and family responsibilities;

the latter measured by the interaction term “married and child living in the household”. This is

confirmed by Model 1 in Table 3 estimating the dismissal probability. To measure the impact

of the firm size, we had to use the stated firm-size classes in the dataset. Therefore the

change of the threshold at which employment protection legislation is applied in 2004 could

not be taken into account.8 Again, we receive the expected pattern: the dismissal probability

decreases considerably with firm size. This is an indication that larger firms may be more

able to offer redundant workers another workplace as is also stipulated by law.

Children living in the household increase the dismissal probability. It is also worth noting

that workers who have been sick for more than 6 weeks in the previous year have a signifi-

cantly higher dismissal probability. One possible interpretation might be that firms try to get

rid of workers who might receive the disability status soon. Alternatively, these can be seen

as dismissals due to lack of personal capabilities which is one of the reasons which may jus-

tify a dismissal. The significant coefficient of the expected severance payment, calculated

7 It is worth to mention that in the dataset about 7 percent of all retired workers received severance

payments. It is well known that firms dismiss older workers up to three years before they reach the retirement age. During this period, the worker is usually eligible to receive unemployment benefits but is not obliged to search for a new job. The difference between the amount of unemployment benefits and the wage is then paid as a severance payment if the worker signed a mutual agree-ment.

8 Anyway, workers might not be exactly informed about the number of workers employed at their firm at the time they lose their job.

13

using the severance pay factor, indicates that the dismissal decision is at least indirectly in-

fluenced by the expected dismissal costs and may justify the estimation approach.

Table 4 presents the results after applying the stepwise estimation approach described in

Section 3 and confirms that indeed sample selection is present.

Model 4 shows the results for the probability of receiving compensation and the corres-

ponding marginal effects after taking into account the dismissal probability. The way of dis-

solving the employment contract has no influence on the compensation probability. Only the

variable age is significant. Contrary to the second Hypothesis, the remaining social criteria do

not influence the probability of receiving compensation. One possible reason could be that

the judge proves in a first step whether the reason stated in the termination notice for dis-

missing a worker is justified. For example, firms are often not able to convince the court that

the downturn of orders will persist in the future and that lay offs cannot be avoided otherwise.

If the firm is not able to convince the court, the judge will, irrespective on whether the firm

has met social criteria, decide in favor of the worker. Provided both parties agree, the judge

can dissolve the employment relationship if the firm compensates the worker. This result may

be seen an indication that the high legal insecurity following from the ambiguous definition of

the reasons for termination and, in a second step, of the social criteria creates an incentive to

file a lawsuit if there is any doubt.

Especially larger firms face greater difficulties in justifying lay offs and can more easily

carry the financial burden. Model 4 confirms that the probability of receiving compensation

indeed increases with the size of the firm.

An important factor determining the compensation probability is the expected severance

pay as presumed in Hypothesis 2 and not the tenure with the employer by itself. Filing a law-

suit, consulting a lawyer, or bargaining for a severance pay are often linked with high emo-

tional stress, opportunity costs, and costs of becoming stigmatized for having sued a pre-

vious employer. In addition, re-instatements are rare. If the expected financial return is low,

workers may not be prepared to claim their due.9 Also lawyers will not be willing to accept a

case if the amount in dispute determining their remuneration is small.

That the compensation probability for workers who have already found a new job at the

end of the notice period is significantly lower is in line with Hypothesis 3. It seems that judges

indeed account in their decision the damage a dismissal will cause for the worker. There is

no indication that the probability of receiving compensation depends on the way the employ-

ment contract is dissolved. Finally, the insignificant coefficient of the reform dummy indicates

that the recent reform of the employment protection legislation had no effect on the compen-

sation probability. Obviously, firms did not respond to the new regulation by offering more

often redundancy pays.

9 In Germany, legal costs of suing an employer are not likely to play an important role because they are often covered by unions or by defense insurances.

14

Model 5, Table 4 presents the results for the incidence of severance payments after con-

trolling for the dismissal and compensation probability. Model 5 confirms that the way of dis-

solving the employment contract affects the size of severance pay, which is highest if the

contract is dissolved by a mutual agreement, followed by collective dismissals and traditional

lay offs (see Hypothesis 4).

The expected severance payment is an important factor explaining the size of compensa-

tion as well as age and being married. Working previously in a large firm with more than 200

employees increases the compensation as well. But having found a new job has no influence

on the bargaining position of the worker; at least not on the size of the severance payment.

In addition, Model 5 proves that severance payments have increased considerably after

the reform in 2004. This result confirms our expectation that the reform strengthened the

bargaining power of the workers by setting a minimum standard for the amount of severance

payments. Interestingly enough, it seems that all workers benefitted from the recent reform.

The severance payments increased irrespective of the way the worker is dismissed, as the

insignificant interaction terms mutual*reform and plantcl*reform show.

6 Conclusions

It is often claimed that firms do not follow the rule of the law when reducing their workforce.

The paper contradicts this view showing that social criteria specified by law and jurisdiction

have an identifiable effect on the dismissal probability.

Nevertheless, if parties involved in a dismissal disagree, bargaining about severance

payments may be attractive to avoid costly and nerve-racking legal disputes. Workers’ return

from signing a mutual agreement may be higher than from filing a lawsuit in view of the fact

that the chances for re-instatement are low. Nevertheless, a dismissal leaves a scar and the

worker will never find out whether he was in the right. On the other hand, firms may gain fi-

nancial security and avoid continuing wage payments from the day of termination notice

through to the date when the lawsuit is settled. But for this they have to pay a premium in the

form of higher compensations.

The recent reform had no effect on the compensation probability. The reason is that the

new legislation did not reduce their legal and financial uncertainty following a dismissal deci-

sion. On the contrary, after the reform the amount of severance pay the worker can realize

after a dismissal increased. The reason is that after receiving the termination notice the

worker can decide whether he accepts the offer or takes the case to court. Obviously, the

reform indeed increased the bargaining power of the worker.

The high variance of the severance pay factor and the fact that social criteria hardly influ-

ence the compensation probability and the incidence of severance payments is an indication

for the high legal and financial uncertainty. It can be doubted whether this bargaining process

15

is efficient. Hence, it in no surprise that not only politicians but increasingly also scholars ad-

vocate for mandatory severance payments which are not subject to ex-post bargaining.

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17

Table 1: Major changes of employment protection legislation in 2004

before Jan 2004 after Jan 2004

Threshold at which EPL applies 5 employees 10 employees

Social criteria only by jurisdiction tenure with the firm, age, alimony

duties and disability

Mutual agreement integrated into the Protection against Dismissal Act

No yes

Eligibility for unemployment benefits after accepting a mutual agreement

after 12 weeks From the first day of unemployment on

Minimum standard for severance payment if dismissal is consi-dered to be unfair

no, only rule of thumb, by jurisdiction severance pay factor of 0.5

18

Table 2: Summary statistics and description of variables

Variable Description Obs. Mean Std. Dev. Min Max

comp compensation 2,198 0.18 0.39 0 1diss dismissed 47,678 0.05 0.21 0 1lnsevp log amount severance pay 375 8.87 1.25 5.54 12.51sevp_lay severance pay lay off (€) 181 9,685 12,304 256 86,919sevp_pcl severance pay plant closing (€) 100 16,849 25,476 484 174,200sevp_mut severance pay mutual agreement (€) 94 23,558 38,318 335 270,793spfac_lay severance pay factor lay off 181 0.53 0.59 0.01 4.89spfac_pcl severance pay factor plant closing 100 0.69 0.65 0.01 3.11spfac_mut severance pay factor mutual agreement 94 0.76 0.77 0.01 5.74lay off lay off (reference) 2,198 0.52 0.50 0 1plantcl plant closing 2,198 0.25 0.43 0 1mutual mutual agreement 2,198 0.24 0.42 0 1male gender (male) 47,678 0.54 0.50 0 1age age 47,678 42.02 10.07 19 65marital married 47,678 0.67 0.47 0 1child child in household 47,678 0.40 0.49 0 1foreign nationality (Non-german) 47,678 0.09 0.29 0 1west region (West 47,678 0.77 0.42 0 1tenure job tenure (years) 47,678 10.90 9.25 0.5 49.5disable disabled 47,678 0.06 0.24 0 1sick sick more than 6 weeks in previous year 47,678 0.05 0.22 0 1part part-time 47,678 0.22 0.42 0 1blue blue-collar worker 47,678 0.36 0.48 0 1edu years of education 47,678 12.21 2.53 7 18firm1 firm size < 5 47,678 0.08 0.27 0 1firm2 firm size 6 – 20 47,678 0.13 0.34 0 1firm3 firm size 21 – 200 (reference) 47,678 0.32 0.47 0 1firm4 firm size 201 – 2000 47,678 0.25 0.43 0 1firm5 firm size > 2000 47,678 0.23 0.42 0 1lnincome log gross income (deflated by CPI) 47,678 7.54 0.71 3.19 10.38exsp expected severance payment 47,678 14,182 17,890 17 292,867lnexsp log expected severance payment 47,678 8.79 1.42 2.83 12.59new job new job at the end of the notice period 2,198 0.25 0.44 0 1job satisfactionjob satisfaction (0 unsatified - 10 satisfied) 47,678 7.03 1.94 0 10dissexp previous dismissal experience 2,198 0.24 0.42 0 1reform reform 47,678 0.41 0.49 0 1gdp real gdp 47,678 1.10 1.08 -0.2 3.2nace1 agriculture (reference) 47,678 0.01 0.11 0 1nace2 production sector 47,678 0.38 0.49 0 1nace3 services sector 47,678 0.61 0.49 0 1year00 2000 (reference) 47,678 0.10 0.31 0 1year01 2001 47,678 0.16 0.37 0 1year02 2002 47,678 0.16 0.37 0 1year03 2003 47,678 0.16 0.37 0 1year04 2004 47,678 0.16 0.37 0 1year05 2005 47,678 0.13 0.34 0 1year06 2006 47,678 0.12 0.32 0 1

19

Table 3: Probability of being dismissed and of receiving compensation; determinants of amount of severance pay

Probability of being

dismissed Probability of receiving

compensation Amount of

severance pay (1) Probit (2) Probit (3) OLS dependent variable dismissed compensation ln severance pay plantcl -0.019 0.190 (0.105) (0.105) mutual -0.175 0.417*** (0.115) (0.135) male 0.145*** -0.151* 0.204 (0.028) (0.088) (0.124) age -0.056*** 0.062** 0.054 (0.008) (0.025) (0.037) foreign -0.017 -0.122 0.198 (0.040) (0.132) (0.189) west -0.124*** 0.113 0.101 (0.026) (0.086) (0.107) tenure -0.043*** -0.038 0.048 (0.009) (0.031) (0.041) disabled -0.136*** 0.180 -0.175 (0.047) (0.144) (0.193) sick 0.688*** 0.212** 0.151 (0.038) (0.105) (0.115) marital -0.051 0.081 0.320** (0.033) (0.102) (0.132) child 0.185*** 0.081 -0.050 (0.041) (0.131) (0.182) mar*child -0.168*** -0.050 -0.215 (0.050) (0.162) (0.218) part -0.221*** 0.009 0.091 (0.041) (0.120) (0.157) blue -0.072** -0.215** -0.238 (0.029) (0.093) (0.127) edu -0.001 0.007 0.038 (0.006) (0.017) (0.021) firm size: < 5 0.262*** -0.843*** -0.213 (0.038) (0.152) (0.371) firmsize: 6-20 0.169*** -0.395*** -0.018 (0.031) (0.100) (0.151) firmsize: 201 – 2000 -0.170*** 0.372*** 0.293*** (0.032) (0.096) (0.110) firmsize: > 2000 -0.239*** 0.187 0.427*** (0.035) (0.116) (0.126) lnincome -0.088** -0.036 0.364 (0.041) (0.149) (0.230) lnexsp -0.081** 0.462*** 0.466** (0.033) (0.119) (0.181) new job -0.215** -0.104 (0.093) (0.117) job satisfaction -0.090*** (0.005) reform -0.967*** -0.031 0.334 (0.069) (0.267) (0.213) plantcl*reform -0.242 0.167 (0.192) (0.221) mutual*reform -0.116 -0.043 (0.200) (0.243) N 47678 2198 375 (Pseudo) - R2 0.133 0.207 0.630 *, **, *** indicate significance at the 0.05, 0.01 and 0.001 level. Standard errors are robust, weights are used, industry dummies, year dummies, the real gdp growth rate, age square, tenure square and an overall constant are included.

20

Table 4: Estimation results

Probability of receiving compensation Amount of severance pay (4) Heckman bivariate probit (5) Heckman ML coeff. marg. effects sel. equation coeff. sel. Equation dep variable compensation dismissed ln severance compensation plantcl -0.017 -0.006 0.297** -0.060

(0.097) (0.037) (0.144) (0.102) mutual -0.142 -0.055 0.479*** -0.248** (0.108) (0.043) (0.176) (0.115) male -0.189** -0.072** 0.144*** 0.053 -0.179** (0.083) (0.031) (0.027) (0.164) (0.088) age 0.071*** 0.027*** -0.056*** 0.094* 0.062* (0.024) (0.009) (0.008) (0.053) (0.025) foreign -0.110 -0.042 -0.017 0.207 -0.061 (0.124) (0.049) (0.039) (0.200) (0.134) west 0.143* 0.055* -0.124*** 0.185 0.093 (0.081) (0.031) (0.025) (0.141) (0.087) tenure -0.020 -0.008 -0.043*** 0.058 -0.050 (0.029) (0.011) (0.008) (0.047) (0.031) disabled 0.206 0.076 -0.136*** -0.035 0.244* (0.134) (0.049) (0.045) (0.208) (0.146) sick -0.064 -0.025 0.687*** -0.119 0.223** (0.142) (0.053) (0.034) (0.137) (0.103) marital 0.092 0.035 -0.051 0.331** 0.112 (0.095) (0.037) (0.032) (0.142) (0.102) child 0.012 0.005 0.185*** -0.040 0.028 (0.127) (0.049) (0.038) (0.205) (0.133) mar*child 0.014 0.005 -0.168*** -0.183 0.001 (0.154) (0.059) (0.047) (0.246) (0.164) part 0.090 0.034 -0.222*** 0.125 -0.001 (0.117) (0.043) (0.040) (0.187) (0.119) blue -0.171* -0.066* -0.072*** -0.319** -0.182* (0.090) (0.037) (0.028) (0.161) (0.094) edu 0.006 0.002 -0.001 0.047* 0.005 (0.016) (0.006) (0.006) (0.025) (0.017) firm size: < 5 -0.860*** -0.332*** 0.262*** -0.803 -0.814*** (0.142) (0.050) (0.036) (0.726) (0.156) firmsize: 6-20 -0.427*** -0.168*** 0.169*** -0.339 -0.407*** (0.094) (0.038) (0.030) (0.289) (0.100) firmsize: 201 - 2000 0.416*** 0.153*** -0.170*** 0.486** 0.350*** (0.090) (0.036) (0.031) (0.226) (0.097) firmsize: > 2000 0.268** 0.100** -0.239*** 0.543*** 0.162 (0.110) (0.039) (0.034) (0.186) (0.118) lnincome 0.019 0.007 -0.088** 0.408 -0.088 (0.140) (0.053) (0.038) (0.258) (0.152) lnexsp 0.443*** 0.170*** -0.081*** 0.674** 0.510*** (0.111) (0.048) (0.031) (0.324) (0.121) new job -0.189** -0.072** -0.183 -0.198** (0.088) (0.036) (0.169) (0.093) job satisfaction -0.090*** (0.005) mills ratio 2.319*** (0.875) dissexp 0.084 (0.081) reform 0.339 0.128 -0.131*** 0.678** 0.017 (0.279) (0.097) (0.037) (0.313) (0.140) plantcl*reform -0.220 -0.084 -0.048 -0.153 (0.178) (0.069) (0.259) (0.187) mutual*reform -0.108 -0.042 -0.153 0.083 (0.184) (0.071) (0.272) (0.200) N 47,678 2,194 ll -9,403,167 -1,342,136 lambda -1.014 rho -0.411** -0.886*** *, **, *** indicate significance at the 0.05, 0.01 and 0.001 level. Standard errors are robust, weights are used, industry dummies, year dummies, the real gdp growth rate, age square, tenure square and an overall constant are included.