Maximum duration of fixed-term labor contracts in recessions

Policy makers and academics put great effort in understanding and minimising the negative employment effects of business cycles. This paper evaluates one policy option in this regard: greater flexibility in the maximum duration of fixed term contracts during recessions. Its simple rationale is that, when faced with an uncertain outlook (and restrictive permanent contracts), firms may be more likely to dismiss fixed-term contracts if the only legal alternative is to convert them. By allowing more time in recessions until this ‘in or out’ decision, employment levels may increase.

Our empirical evidence is based on the evaluation of a new law introduced in Portugal in the midst of a recent recession, which increased the maximum duration of fixed term contracts from three to four and a half years. We find a considerable take up of this measure, as conversions to permanent contracts drop by 20%. However, we do not detect significant short-term effects on overall employment, possibly because of data limitations. On the other hand, we find that worker churning is reduced significantly, as mobility of eligible fixed-term workers to other firms drops by 10%. Our analysis is based on counterfactual impact evaluation methods, applied to matched employer-employee panel data, covering a large subset of the eligible workers.

In conclusion, we find that longer, more flexible fixed term contracts can promote jobs, in terms of less worker mobility and longer matches, at least in recessions. Our findings highlight the potential of greater flexibility in the parameters of fixed term contracts - and possibly other labour market regulations - over the business cycle to minimise employment fluctuations. Such rules could successfully complement those in macroeconomics, especially given the challenges that many countries currently face in their monetary policies.

Click here to go to the paper by Pedro S. Martins.