Dual labour markets and the tenure distribution: Reducing severance pay or introducing a single contract

• We evaluate the effects of the 2012 Spanish labour market reform.
• We concentrate on the changes introduced regarding employment protection.
• This reform reduces unemployment by 10.5% and job destruction by 7.5%.
• It smoothes the tenure distribution due to the decrease in the severance cost gap.
• We find that a single contract is cheaper and more effective to decrease duality.

This paper evaluates Spain's 2012 labour market reform concerning the reduction in severance pay from 45 to 33 days of wages per year of seniority and the introduction of a new subsidised permanent contract. We also compare this policy with the introduction of a single open-ended labour contract with increasing severance payments for all new hires. We use an equilibrium search and matching model to generate the main properties of this segmented labour market. Our steady-state results show that this reform will reduce unemployment (by 10.5%) and job destruction (by 7.5%). However, in terms of wage subsidies, the cost of implementing this reform will be very high. A cheaper and more effective way to decrease the duality in the labour market could be to eliminate temporary contracts and introduce a single contract. Unemployment and job destruction in this case could be reduced by 31.5% and 35%, respectively. Most interestingly, tenure distribution could be even smoother than under the designed reform, as 22.5% more workers could have tenures of more than three years and there could be 38.5% fewer one-year contracts. The transition shows that both policy measures would benefit a majority of workers: only 7.4% would experience a decrease in tenure under the approved reform (5.5% in the transition to the single contract) due to the improvement in job stability.