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Country Focus: French Labor Market Reform: Partial Versus Comprehensive Steps

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
July 2006
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High unemployment and sluggish job creation have prompted much of Europe to pursue labor market reforms. Will a strategy of partial labor market reform pay off for France? Luc Everaert and Jianping Zhou (both IMF European Department) analyze the pros and cons, and find that partial reforms facilitate job creation in the short run, but are unlikely to reduce unemployment over the longer term. Still, partial reforms could be a step forward if the political will is there to use them as a springboard for broader reforms.

France, like most industrial countries, protects employees from dismissal through a combination of legal and administrative rules and financial penalties applying to employers. Some protection is justified to ensure that companies bear some of the cost to society of their individual firing decisions. Think, for example, of a firm that experiences quarterly peaks in its activity. Such a firm could lay off its workers temporarily every quarter and thus force society to subsidize the firm through unemployment benefits for these workers. Overly strict job protection, however, also has downsides. It increases the potential costs of hiring and so may increase unemployment even though it protects those who have jobs. Indeed, countries with strict employment protection tend to experience relatively high unemployment (see chart).

When protection does not work

High levels of employee protection have translated into high levels of unemployment.

Data: Organization for Economic Cooperation and Development.

Debating change

To reduce unemployment and stimulate job creation, France, like other European countries, has been discussing how to liberalize labor markets. Traditionally, the French labor market has provided two types of employment: permanent contracts (contrats à durée indéterminée) and fixed-term contracts (contrats à durée indéterminée). Employment protection for workers hired under permanent contracts is very strict, and the use of the fixed-term contract is highly restricted (see box).

Seeking to introduce more flexibility, the French government launched a debate that featured broad consultation with social partners and consideration of a wide range of alternatives. Some proposals advocated partial reform, such as relaxing legal restrictions on the use of fixed-term contracts and removing firing restrictions from these contracts. Others argued that a complete overhaul of the system was needed. This would mean merging permanent and fixed-term contracts into a single contract, with minimal legal and administrative procedures; basing severance pay on the duration of employment; and developing a system of experience-rated unemployment contributions (that is, firms with a history of high layoffs would contribute more to the unemployment insurance system).

In the end, the government opted for partial reform, which left protection for permanent employment contracts unchanged. In August 2005, the authorities introduced a new employment contract for small companies (le contrat nouvelle embauche). Under the new contract, firms with fewer than 20 employees can now hire workers for up to two years without hiring and firing restrictions.

Restrictions for permanent and fixed-term contracts

Despite the recent implementation of partial labor market reforms, France retains two principal types of employment contracts: permanent and fixed-term.

Permanent contracts are designed for lifetime jobs. Dismissal is costly—not so much because severance pay is high but because the process is subject to lengthy administrative procedures and legal restrictions. For example, firms can lay off workers to restructure and preserve competitiveness, but they cannot lay off workers to improve performance or increase profits.

Fixed-term contracts can only be used when firms face temporary increases in production or need to replace permanent workers who are on leave. These contracts can last for up to 9 months and be renewed only once. In practice, these contracts have an average duration of less than three months. With payment due for the entire period if the worker is dismissed before the end of the contract term, employers may be hesitant to use these contracts for longer periods.

The short and long of it

Can such partial reforms succeed in creating new jobs? In the short run, introducing flexibility does facilitate job creation. Indeed, small enterprises signed half a million new employment contracts between August 2005 and May 2006. Most of these jobs, however, would have been created regardless of the new contract. Recent estimates point to only about 30,000 net additional jobs. And, given that the new contracts last for two years, it is still too early to tell whether these jobs will lead to permanent ones.

The study suggests, though, that partial reform may be ineffective in reducing unemployment over the longer term and may have negative consequences for workers’ welfare and productivity. Easing restrictions on fixed-term or temporary jobs fosters both job creation and job destruction, while strict employment protection legislation discourages both. Hence, the overall effect on unemployment of reform, whether partial or comprehensive, seems ambiguous.

However, when model simulations are run with parameters reflecting the features of the French labor market, the results suggest that when reform is partial the job destruction effect dominates in the long run. In fact, it is estimated that France’s specific partial reform could raise the unemployment rate by almost 1 percentage point (see table, Scenario 1). The chief effect of partial reform, then, is a significant increase in turnover of fixed-term or temporary workers, but without a proportionate reduction in the length of time individuals remain unemployed.

Conversely, a reform that simultaneously reduces the firing restrictions of all contracts would lower the unemployment rate by about 1 percentage point (Scenario 2). Even better, if all contracts are merged into a single one and firing restrictions are reduced, the unemployment rate would drop by about 2 percentage points (Scenario 3). Of course, as with all model-based simulations, caution is advised in interpreting the magnitude of the estimates. In particular, if high minimum wages keep wages from reflecting high hiring costs, and inefficient employment services slow down the matching of vacancies with unemployed workers, the gains from comprehensive reforms may not be as large as predicted.

The direction of the study’s findings is well established, however, and is supported by evidence from the experiences of other countries, in particular Spain. When Spain expanded the use of fixed-term contracts in the 1980s, the number of these contracts rose exponentially, and this initially reduced the unemployment rate. After a few years, however, the unemployment rate began to rise again, eventually exceeding its prereform level. At that stage, the Spanish authorities introduced comprehensive reforms that relaxed restrictions on permanent contracts, and unemployment has been trending down since then.

Recent simulations by Pierre Cahuc and Stephane Carcillo (2006) of the likely long-term effect of the new, single contract suggest that the French reforms are expected to produce a 0.3 percentage point decline in unemployment.

Reforms and their potential effects

Broader reforms are likely to make a larger dent in unemployment rates.

(percentage

point change)
Scenario 1.Reduce firing restrictions by 50 percent on fixed-term contracts.0.9
Scenario 2.Reduce firing restrictions by 50 percent on permanent labor contracts.-0.9
Scenario 3.Merge contracts into a single one and reduce firing restrictions by 50 percent.-1.8

The next steps

Proponents of partial reform contend that such an approach may have the merit of gradually building support for reform and serving as an intermediate step toward complete reform. In France, this was clearly the government’s intention. Indeed, in early 2006 it proposed another new labor contract with identical features (contrat première embauche (CPE)) intended this time for young workers (age 26 and under)—mainly to tackle the very high youth unemployment rate. However, there is a danger that, should partial reform fail to deliver notable employment results or to generate public support, the position of those opposing reform would be strengthened. This seems to have happened in France: after weeks of protests from students and labor unions, the CPE initiative was withdrawn.

What should France do now? On economic grounds, the case for complete rather than partial reform seems solid. Reducing employment protection across the board, in particular by replacing legal and administrative regulations with straightforward financial incentives (that is, severance pay and experience-rated unemployment contributions) would reduce the unemployment rate. From a political economy perspective, a window of opportunity exists to build on the success of the small enterprise contract to expand reform, but the public will need to be better informed of its benefits and of the need for it.

Luc Everaert and Jianping Zhou

IMF European Department

For more information, see IMF Working Paper No. 06/108, “Reforming Employment Protection Legislation in France,” by Jianping Zhou. Copies are available for $15.00 each from IMF Publication Services. See page 224 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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