Does employment protection affect wages, inequality, and unemployment? Theory and evidence

Abstract

Purpose -This paper investigates how employment protection legislation (EPL) influences key labor market outcomes - wages, income inequality, and unemployment - addressing long-standing debates over whether stricter dismissal rules promote stability and fairness or hinder flexibility and job creation. Design/methodology/approach-We use a panel of 30 developed and developing countries (1975-2019) and the Labor Regulation Index (LRI) from the Centre for Business Research, which provides broader coverage and richer institutional detail than the OECD's EPL index. To ensure valid inference, we apply estimators robust to cross-sectional dependence and serial correlation. We also build a game-theoretic model of employer-employee interaction with judicial review, capturing how dismissal protection shapes effort, monitoring, and wage-setting. Findings-Stricter EPL is associated with higher wages, reduced inequality, and - contrary to standard predictions - lower unemployment. The model explains this outcome: stronger dismissal protection discourages monitoring, induces firms to raise wages to sustain effort, and thereby reduces unemployment while improving equity. Research limitations/implications- Our analysis focuses on dismissal rules and abstracts from other labor institutions, such as fixed-term contracts or collective bargaining. Future work should extend the framework to dynamic settings with heterogeneous agents and institutional interactions. Practical implications - Findings suggest that moderate, predictable dismissal protections can improve wages, equity, and employment, offering guidance for policymakers balancing flexibility and security in labor markets. Originality/value- This is the first study to integrate new cross-country evidence with a theoretical model in which judicial review of dismissals actively shapes equilibrium behavior. The results highlight how dismissal-related frictions can foster both fairness and efficiency.