Evaluating fixed-term employment contracts

In February 2009, Portugal sought to promote the use of open-ended employment contracts by reducing the range of circumstances under which fixed-term contracts (FTCs henceforth) could be used by large firms. Before this date, new establishments were free to hire under FTCs. After February 2009, such flexibility applied only in the case of firms with fewer than 750 employees. Large firms could still hire under FTCs in new establishments in specific cases.

This reform reversed the trend of previous policies that promoted fixed-term contracts while leaving open-ended contracts largely unchanged, namely in dismissals. The previous trend may have contributed towards segmented or two-tiered labor markets. In these cases, workers can experience significant churning across multiple FTCs, leading to higher unemployment. Hence, restricting fixed-term contracts might be desirable.

Drawing on linked employer-employee longitudinal data and regression discontinuity methods, the paper finds that the reform was successful in reducing the number of FTCs in the new establishments of large firms (top right panel in the Figure). However, this was partly because the number of new establishments also declined in large firms (top left panel in the Figure). Moreover, permanent contracts in new establishments of large firms did not increase and, in some specifications, even decreased (bottom left panel in the Figure). When considering both FTCs and permanent contracts together, we find that employment declined significantly (bottom right panel in the Figure) for the affected firms.

Our results indicate that the FTC restriction did not encourage large firms to hire under permanent contracts suggesting that there is a limited degree of substitutability between FTCs and permanent contracts. Some jobs that may be created under FTCs will not necessarily emerge if the FTC legal framework is not available, at least when the alternative involving permanent contracts may have undesirable properties for firms.

We also find evidence of spillovers to smaller firms, which were not directly targeted by the reform: small firms more exposed to large firms, because of their common geographical and or sectoral location, tend to benefit more from the reduced hiring of FTCs of the latter, and end up hiring more workers. These and other results point to the importance of accounting for equilibrium effects to evaluate employment laws. It is unlikely that reduced form estimates of employment legislation effects that rely on the assumption that the control group is not affected by the reform yield reliable evaluations. We also find that the restrictions on FTCs are detrimental to the welfare of unemployed workers because they have fewer opportunities to find jobs when these restrictions are implemented. Moreover, such drop in welfare reduces the outside option of all employees and consequently also their welfare.

Overall, the results indicate that flexibility at the margin, allowing firms to hire temporary workers, significantly improves labor market efficiency in our context.

Click here to go to the paper by Pierre Cahuc, Pauline Carry, Franck Malherbet, Pedro Martins.