1. Assessment of the policy context in Estonia

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1 Reform of Severance Pay Law Statements and Comments Lauri Leppik PRAXIS Center for Policy Studies 1. Assessment of the policy context in Estonia 1.1 Labour market situation Estonia is commonly characterised as a small open economy. The total number of employed persons in Estonia amounted to persons in 2005 (data of the Labour Force Survey). The employment rate was 64% in age group The unemployment rate in the third quarter of 2006 dropped to 5.4%, which is the lowest level in the last decade. Employment situation has steadily improved over the last 5 years (starting from 2000), backed by strong economic growth. High economic growth rates in a range of 7-8% annually over the period and reaching 10.5% in 2005 have recently lead to a shortage of labour force. Considering the relatively strict immigration rules towards third country nationals and still relatively low attractiveness for intra-community labour migration, this has resulted in a high competition for labour between companies and has fuelled wage growth in last years. However, recent data (after 2001) on labour turnover is lacking. Masso et al (2004) estimated that gross job flows (job creation and destruction) in amounted to nearly 25% of total employment per year. This would mean about 70 thousand new jobs created annually and about the same number destroyed. Higher jobs flows were observed in micro firms employing less than 10 employees and in economic sectors of trade, construction and business services. Masso et al (2004) ascribe the relatively high rate of labour reallocation (high compared to Western Europe, albeit lower than in Austria) in the second half of 1990s to fast restructuring of economy. However, they also note that by 2001 restructuring of the labour market was over while the labour turnover rates remained unchanged. According to an assessment made by Eamets and Masso (2005), the overall strictness of employment protection legislation in Estonia is close to the average of EU countries. At the same time, according to their evaluation, individual and collective dismissals are relatively heavily regulated. Nevertheless, effective flexibility is increased by problems of enforcement there has been considerable evidence of violations of statutory regulations at enterprise level. In addition, they note that effective coverage by the regulations is relatively low. 1.2 Severance payments Severance payments are prescribed by the Employment Contract Act and Civil Service Act. Table 1. Severance pay regulation in Estonia under the Employment Contract Act Employment duration Amount of severance pay up to 5 years 2 times of the monthly wage 5 10 years 3 times of the monthly wage over 10 years 4 times of the monthly wage 33

2 As can be observed, the rates of severance payments for persons with long tenure are 3 times smaller compared to pre-reform Austrian rates, while access to severance payments is easier than in the old Austrian system as also persons with short duration of employment are eligible. However, the contingency, when severance pay is due, is relatively narrow. Employers are liable for severance pay in case of liquidation of the enterprise and in case of redundancies initiated by the employer. No severance pay is due in case the employment contract was terminated on employee s initiative or on the basis of a mutual agreement between the employer and employee, or in case of fixed-term contracts 2. Furthermore, the employee is not entitled to severance pay, if the employment contract was terminated by the employer, but due to loss of trust, unsatisfactory results of the trial period, long-term incapacity for work, breach of duties (violation of terms of the employment contract) by the employee, indecent act or act of corruption by the employee. If the contract was terminated by the employer because the employee was found to be unsuitable for the job (due to low professional skills or reasons of health), the severance pay amounts to only one monthly salary. This long list of exceptions provides employers ample of opportunities to evade or reduce severance payments, e.g. by negotiating mutual agreement, forcing to resign voluntarily or finding the person unsuitable for the job. The problems of enforcement of employment protection legislation are reflected in the relatively high number of complaints by employees to labour inspectors. In 2000, the number of respective complaints in Estonia was 5.4 per 1000 employees, whereas the average for EU15 was 2.1. Severance payments for civil servants are more generous, in particular for civil servants with a long tenure, and here also the contingency is more relaxed. Table 2. Severance pay regulations in Estonia under the Civil Service Act Employment duration Amount of severance pay up to 3 years 2 times of the monthly wage 3 5 years 3 times of the monthly wage 5 10 years 6 times of the monthly wage over 10 years 12 times of the monthly wage Until 2003, the Estonian labour law made no differentiation between individual and collective dismissals. From 2003, the notion of collective redundancies has been introduced, covering dismissals effected by an employer over a period of 30 days, where the number of redundancies is at least: 5 employees, in case of employers employing up to 19 employees; 10 employees, in case of employers employing employees; 10% of employees, in case of employers employing employees; 30 employees, in case of employers employing at least 300 employees. The definition of collective redundancy in Estonia thus meets the requirements of the EC legislation (directive 98/50/EC), but additionally covers also smaller enterprises, employing less 2 However, it shall be noted that the share of fixed-term contracts in Estonia is relatively low 2.6% of all employment relationships which is one of the lowest among the EU countries. 34

3 than 20 employees, in which case 5 redundancies is sufficient to qualify under the definition. This makes the Estonian definition of collective redundancy one of the most liberal in Europe (Võrk et al 2005). While the statutory severance pay rates are the same both in case of individual and collective dismissals, the financing is different. Severance pay in case of individual dismissals remains under employers liability, whereas in respect of collective redundancies employers are subject to compulsory social insurance, which then partially takes over employer s responsibilities. In case of collective redundancy, the Unemployment Insurance Fund (UIF) compensates a part of statutory redundancy fees, corresponding to: 1 monthly wage in case of continuous employment with the current employer up to 5 years; 1.5 monthly wage in case of continuous employment with the current employer 5 10 years; 2 monthly wage in case of continuous employment with the current employer over 10 years. The scheme covers both employees working under employment contract as well as civil servants. As can be observed, in the former case, the UIF compensates 50% of collective redundancy payments, while in case of civil servants with long tenure the share compensated by the UIF constitutes only one-sixth of statutory payments. The payments are financed from a collective redundancy and insolvency sub-fund of the UIF, which forms from employers contributions, currently 0.3% of payroll. In fact, the same sub-fund is simultaneously a guarantee institution responsible for payment of workers outstanding claims in case of employer s insolvency, i.e. these claims are also financed from the same contribution. The insurance scheme may be characterized as a partially funded defined-benefit scheme. In a situation of favourable economic developments the sub-fund of the UIF has generated significant reserves over the first 5 years of operation, amounting to 546 million EEK (35 million EUR) by the end of The reserves have been invested under a conservative investment strategy, mainly in fixed-interest instruments. In 2005, the revenues of the UIF sub-fund amounted to 256 million EEK (16 million EUR), while expenditures were only 76 million EEK (5 million EUR). From 2006 the contribution rate was reduced from the former 0.5% to the current 0.3% of payroll. In spite of the rather liberal definition of collective redundancy, the actual number of beneficiaries has been rather low. Furthermore, the number of recipients has been declining due to good economic situation. Table 3. Recipients of collective redundancy payments from the UIF Year Number of beneficiaries (first half)

4 By estimation, the number of recipients of collective redundancy payments covers only 3-6% of all annually terminated employment contracts 3. The scheme was introduced in 2003 to ease the financial burden of employers in need of restructuring. However, the scheme, while facilitating restructuring of enterprises, entails a moral hazard risk. Even though the co-payment of employers in case of collective redundancies is 50% (in case of redundancies under the Employment Contract Act), in some circumstances employers are tempted to terminate contracts with more employees to fulfil the minimum numbers and qualify for payments from the UIF. In spite of the liberal definition of collective redundancies, micro-employers employing less than 5 employees do not qualify for redundancy payments from the UIF, whereas the contribution rate is the same as for other employers 4. A further problematic feature is the high overlap of severance payments and unemployment insurance benefits 5. In 2005, about 46% of recipients of unemployment insurance benefits received also severance payments (either for individual or collective redundancy). This has created a particular insider-outsider problem, as some employees enjoy a relatively high level of social protection, while the majority of dismissed persons get neither severance pay nor unemployment insurance benefit (Leetmaa et al 2004). To summarize, the particular problems of the Estonian case of severance payments are: Frequent evasion of severance payments by employers in case of individual dismissals; Moral hazard risk associated with the partial compensation of collective redundancy payments from the UIF; Overlapping of severance payments and unemployment insurance benefits. A further problem is the big surplus of the UIF, which is indicating an efficiency loss too high contributions are collected while social justice problems remain. 2. Assessment of the transferability of the Austrian policy on severance payments Given the problems outlined above in respect of the Estonian system of severance payments, the Austrian solution at the first sight may look tempting. In terms of (social) insurance, the new Austrian severance pay scheme is a fully funded system with individual savings accounts. The respective Estonian scheme combines employers liability with a partially funded collective scheme. In operational terms, a direct policy transfer would entail: 3 See numbers derived from calculations by Masso et al (2004) above. 4 However, it shall be noted that the employers contribution 0.3% of payroll covers two risks: collective redundancies and insolvency. While micro-employers can not qualify for redundancy payments, their insolvency risk is considerably higher than for larger firms. Obviously, this may be partly due to the fact that they are not eligible for restructuring support in the form of redundancy payments from the UIF. 5 Unemployment insurance compensates 50% of the former wage of the employee for the first 100 days of unemployment, thereafter the benefit rate declines to 40%, payable up to 180 days per contingency. 36

5 broadening the definition of contingency to include individual dismissals; creation of individual accounts; shifting to full pre-funding. However, in qualitative terms such a reform would entail transition from a defined-benefit scheme to a defined-contribution scheme. Obviously, the two central questions to be answered shall be: whether such a reform would be reasonable and whether it would be feasible in the Estonian context? The Austrian type of reform would likely have the effect of broadening the coverage of severance payments and tackle the current problems of employers evasion. This could be seen as a significant improvement in terms of social justice. Compulsory contributions collected by the Tax Office would be considerably more difficult to evade than individual severance payments to particular employees. The question of shifting from a defined-benefit scheme to a defined-contribution scheme is a bit more philosophical, but also operationally more cumbersome. The question here is whether a defined-contribution scheme would be more efficient than the defined-benefit scheme to shoulder labour market risks for employees? Clearly, a definedcontribution scheme is financially more stable as well as more sustainable than the definedbenefit scheme. The question is, to what extent sustainability comes on account of adequacy and efficiency. Apparently, the risk of redundancy is not equally spread across individuals and economic sectors. In case there is considerable heterogeneity in risk materialisation, a defined-benefit scheme needs a considerably lower contribution rate to finance the same average benefit than a definedcontribution scheme. In simple terms, in case there is considerable variation in the risk of job separation, some employees would exhaust their accounts quite quickly, whereas other employees would not use their accounts until retirement 6. Existing evidence (see Masso et al 2004) indicates that there have been considerable differences in job destruction rates, depending on employer s size and economic sector. Job destruction rates vary from 18% in case of micro employers with less than 10 employees to 9-10% in case of large employers with more than 100 employees, and from 15-16% in construction and agriculture to 9-10% in manufacturing and public services. To put it more bluntly, in a defined-benefit scheme medium and large employers (employing more than 100 employees), in particular the state as an employer and large manufacturing firms, partly subsidize severance costs of small employers. Due to redistribution (or in other words, solidarity) between employers, in such a scheme small employers pay a contribution, which is less than the experience-rated contribution would be. 6 In the Austrian case, one of the side-aims of the reform was to introduce a funded element in the pension system. In the Estonian context this is less relevant, since the pension reform has introduced from 2002 a fully funded second pillar based on defined-contribution principle and individual savings accounts, where employees accumulate 6% of gross wage on a monthly basis. 37

6 In case of transition from defined-benefit to a defined-contribution scheme, the question would arise on what basis the contribution rate is determined. In case the current benefit level is seen as a target, a considerable increase in the contribution rate would be needed. (Furthermore, if the effective coverage of the scheme is increasing, that would have an additional push-effect on the contribution rate). Alternatively, employees in smaller enterprises would end up with considerably smaller separation payments. Potentially, transition from the current defined-benefit scheme to a system of individual accounts could be cushioned by using the reserve funds of the UIF either to establish so-called initial capital on workers accounts or to cushion the increase of the contribution rate for the first years after reform. 3. Concluding notes In the Action Plan for Growth and Jobs , the Estonian government has outlined its position that high severance costs (including redundancy fees) of employers are a major factor contributing to labour market inflexibility. In this respect, the government has envisaged the reviewing of the impact of non-wage labour costs on employment and possibly, reduction of statutory redundancy fees, while at the same time providing more space for additional compensations under collective agreements. Whereas a more in-debt analysis of the situation is certainly desirable, revision of severance payments could include also their interplay with unemployment insurance benefits. Considering social justice problems and economic inefficiencies of the current arrangement, the Estonian severance pay system is clearly in need of reform. Whether the Austrian model shall be followed is another question. Perhaps, instead of a complete new overhaul of the system, inefficiencies of the system can be reduced by parametric reforms of the current defined-benefit arrangement. These reforms could include broadening of the contingency to individual dismissals thus eliminating moral hazard risks, while increasing access to severance payments. However, co-payments by employers shall be maintained. At the same time, for recipients of severance payments, longer waiting period could be introduced before unemployment insurance benefits become payable. 38

7 References Eamets, R., Masso, J. (2005). The Paradox of the Baltic States: Labour Market Flexibility but Protected Workers? European Journal of Industrial Relations, Vol.11 No.1 pp Leetmaa, R., Leppik, L., Liimal, P. (2004). Töötuskindlustus teooriast ja praktikast. [Unemployment insurance: on theory and empirical evidence]. Tallinn: PRAXIS. Masso, J. Eamets, R., Philips, K. (2004). Where have all the jobs gone? Gross job flows in Estonia. Tartu University. Võrk, A., Leppik, L., Leetmaa, R. (2005). Kollektiivsete koondamiste andmete ja praktika analüüs: uuringu lõppraport. [Analysis of data and practices on collective redunduncies: final report of a study]. Tallinn: PRAXIS. 39

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