We analyze the effects of government-mandated severance payments in a rich life-cycle model with search-matching frictions in the labor market, risk-averse agents and imperfect insurance against idiosyncratic shocks. Our model emphasizes a tension between worker-firm bargains and consumption smoothing: entry wages are tilted downwards as a response to future severance payments, which runs counter to having a smooth consumption path. Consequently, we find that severance payments produce mostly negative welfare effects. We use the model to characterize the determinants of these welfare losses. We show that even when optimized jointly with unemployment insurance benefits, large government-mandated severance payments should be avoided.
This Working Paper was published in Review of Economic Dynamics.
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