The Third Way: Welcome to the Third World

Unemployment Consequences of Unfair Dismissal Laws

Jason Soon

Introduction

Economic reasoning tells us that making certain behaviour more costly is likely to discourage the said behaviour. This simple insight has found fruitful applications in many areas of human action and one would think that its application to a straightforward area of commercial, profit maximising activity like hiring practices would be relatively straightforward. Yet those who close their eyes to the employment disincentive effects of unfair dismissal laws clearly think not.

The problem with proving that unfair dismissal laws have employment disincentive effects is that it is very difficult to quantify the costs which employers have to incur because of these laws.

Quantifications have been made in various small business surveys of the costs of other non-wage award provisions such as workers compensation, superannuation and parental leave provisions, usually referred to as on-costs. In the case of these entitlements, the cost comprises the addition to the total wages bill by having to provide for these entitlements as well as the costs of complying with the provision of these entitlements. The latter component usually involves time spent in documentation and can be converted into a dollar amount by noting the equivalent hourly wage that has to be paid by the business owner to fulfill this task.

Quantification of the compliance costs of unfair dismissal laws is made difficult because complying with such laws is a more ongoing process than one more characterised by discrete periods when documentation has to be filled in, as is the case with on-costs.

Additionally, the psychological costs incurred by the employer at the prospect of complying with these laws is arguably just as relevant in terms of its effects on whether, at the margin, an employer decides to hire more workers or not. This is more likely to be true for small business employers who have to do most of the paperwork and human resources management themselves than in the case of large employers who can afford to offload these tasks to well-trained experts.

In the case of business taxation regulations, these psychological costs take the form of fear of incurring strong penalties if returns are lodged incorrectly. A similar brooding anxiety undoubtedly envelops the mind of the hapless small business employer who is trying to ensure that he or she does not fall foul of the unfair dismissal laws, given the absurd results of some unfair dismissal cases and the nitpicking intricacies of the law. This is confirmed by a survey by Australian Business Ltd in December 1998 which found that 84 per cent of small business employers were concerned about the potential for an unfair dismissal action when hiring new staff.

Later I will survey some recent research which has risen to the considerable challenge of trying to quantify the effects of unfair dismissal laws. Before that I wish to explain exactly how unfair dismissal laws involve a continuous process of compliance and monitoring and describe its consequential chilling effect on hiring, especially by the less well-resourced small business sector.

The Unfair 'Unfair Dismissal' Laws

Laws at federal and state level, as well as common law interpretations of the employment contract and award provisions have made termination of employment extremely complex. The first act of compliance of an employer is to look at the different layers of the law and work out which applies in which situation. As a general rule, where more than one layer of law deals with the same subject, the federal law prevails but not always. Given this, I will focus on the federal law.

There is little reason to assume that most employers treat their employees unfairly. Such bad management practices, by undermining workplace morale, would be against an employer's interests. Yet unfair dismissal laws starting with those contained in the Industrial Relations Reform Act 1993 seem to work on this assumption, laying down strict procedures which need to be followed when terminating employment.

The Workplace Relations Act 1996 does little to remove this assumption, although the onus of proof placed on employers has been removed. The Act prohibits sackings that are 'harsh, unjust or unreasonable' or on prohibited grounds. These prohibited grounds include such things as temporary absence from work or union membership. The Industrial Relations Commission can order up to six months' remuneration for unfair dismissal, with a $10,000 maximum additional penalty for termination for a prohibited reason.

In determining whether a dismissal was 'harsh, unjust or unreasonable', the Industrial Relations Commission must look at whether:

1. there was a valid reason related to the capacity or conduct of an employee or operational requirements;
2. whether the employee was notified of the reason and the employee had an opportunity to respond to the reason offered;
3. if the employee was warned where the termination was due to unsatisfactory performance;

and other matters the Commission considers relevant.

The first consideration, where the Industrial Relations Commission is charged with evaluating the 'valid reason' posited by the employer requires it to examine business judgements about operational and employee requirements, and where it thinks necessary, overrule the judgement of the employer.

The argument for this, assuming that we accept the objectives of unfair dismissal law, is presumably that we should not allow unfair employers to get away on ex-post facto rationalisations. But how certain can we be that the Commission will not err significantly in the direction of overruling legitimate dismissals such that it has a chilling effect on the hiring practices of fair-minded employers?

The possibility of many errors being made is boosted once we take account of the substantial risk and uncertainty involved in litigation. This risk and uncertainty is likely to translate in the minds of employers, especially small business employers who do not have sufficient resources to continue litigation, into a corresponding probable dollar amount of loss. Weighting this factor in their minds, they might then opt to settle with the complaining employee even if the small business has a legitimate case.

Dismissing employees according to the procedures laid down in legislation presupposes detailed record keeping and documentation and extensive counselling.

As an example of the detailed record-keeping involved, the Workplace Relations Act 1996 prescribes the period of notice which must be given to employees before termination of employment. For instance a period of continuous service of more than 1 year but not more than 3 years requires a period of notice of at least 2 weeks. It is at least 3 weeks for employees who have been in continuous service for more than 3 years but not more than 5 years. The amount of pay in lieu of notice is also prescribed. Formulae for working out the term of continuous employment must factor in the leave taken.

To give notice, the longest period prescribed by either the award the employee is covered by, the Workplace Relations Act or the term of contract of employment, must be chosen.

Returning to the 'harsh, unjust or unreasonable' test, the consideration that the Commission must give to whether the employee had sufficient warning of unsatisfactory performance imparts further documentation requirements. The NSW Employers Federation advises members in its Employers' Handbook that it is best to follow a four step counseling procedure as follows:

1. counseling and verbal warnings to bring to the attention of the employee the undesired behaviour;
2. a counseling session and written warning;
3. a counseling session and final written warning; and
4. termination only as the final resort.

As was previously argued, the prescriptiveness of the laws means that those employers who feel the need to dismiss employees who are genuinely incompetent or insubordinate will have to expend resources to ensure compliance and thus minimise the risk of a lawsuit. The alternative is possibly expensive litigation if they get things wrong.

The possible conflicting obligations between unfair dismissal laws and anti-discrimination laws may also prove to be a problem in some cases. For example, if a firm employs a worker who has persistently exhibited discriminatory conduct, it may attract an anti-discrimination suit from other workers for failing to maintain a non-discriminatory workplace. If the firm decides it best to dismiss the offending employee as promptly as possible in order to avoid a complaint being lodged, this may conflict with the requirements of the unfair dismissal law.

The NSW Department of Industrial Relations reports that the number of unfair dismissal cases in NSW has fallen from an average of 384 a month in 1997 to 340 a month in 1998. This trend is encouraging but still means that more than 4000 cases a year. In NSW, 94 per cent of matters were conciliated by the NSW Industrial Relations Commission or otherwise settled. The average time of settlement was 90 days. This imposed a very large cost on small businesses. The average 2400 cases went to arbitration on an average processing time of 180 days.

In 1996-97, the median amount of time it took for a case to be finalised by a hearing in the Court after being filed with the Commission varied from 130 days in South Australia to 234 days in Tasmania, with a national median of 185 days (see Table 2).

Streamlining under the Workplace Relations Act has reduced the number of dismissal cases filed to the Commission. In the first six months of 1998, the total of

State and Federal applications regarding dismissals was 8310, 18 per cent less than for the same period in 1996 and two per cent less than in 1997.

There were 2694 cases filed before the federal Industrial Relations Court in 1996-97, compared with 9080 in 1995-96. This decrease is due to changes in filing procedure and the introduction of the Workplace Relations Act, which has reduced recourse to the court system.

From January 1996, over 300 new cases per month were referred from the Commission to the Industrial Relations Court. There were 1200 claims a month filed with the Court or, following the change of procedure, to the Court and the Commission, from October 1995 to December 1996 (Industrial Relations Court of Australia Annual Report 1996-97).

By making dismissals more costly in terms of both time and money, unfair dismissal laws reduce the demand for labour. The higher the costs of firing, the more akin the act of hiring a worker becomes to making an irreversible investment (such as buying a new machine), and consequently the more cautious the employer, particularly the small business employer, becomes in making this decision.

This has particularly severe impacts on the long term unemployed. Workers who have been out of the labour market for a long time may turn out not to have the necessary skills for performing the job they were hired for. Thus there is a higher probability that they may later have to be dismissed than is the case with other job-seekers. Given the added risks introduced by the unfair dimissal laws, employers might decide it is simply not worth the trouble and avoid long-term unemployed job-seekers altogether. A similar argument might be made for young job-seekers and workers from socially disadvantaged minority groups, especially those without further education.

Theoretically it is possible to sidestep the high adjustment costs of unfair dismissal laws by changing other work conditions such as wages or working hours. However in Australia, at least, these other aspects of the labour market are also subject to close regulation and are therefore relatively inflexible compared to countries like the US.

More inflexibilities could be introduced if courts expand their reach to catch practices amounting to 'constructive dismissals'. A 'constructive dismissal' could be found where some employees are hired for shorter hours or assigned simpler and lower paying tasks. In these cases, the reasons for the employer's decisions may be more subtle and it would be harder to differentiate between a legitimate decision and an unfair one.

Unfair dismissal laws ultimately affect the employment prospects of all job-seekers. In the long term, the climate of legal uncertainty created by the unfair dismissal laws will mean that instead of responding to increased demand by hiring more workers, employers will increase their capital intensity and use more careful and begrudging selection procedures.

Recent Research on the Effects of Unfair Dismissal Laws

There have not been many empirical studies on the effects of job security provisions like the unfair dismissal laws on unemployment. This partly owes to the difficulty of quantifying the inflexibility introduced by job security provisions.

In the case of job security provisions like unfair dismissal law, a further ambiguity is introduced by the fact that such laws will also have the obvious effect of reducing the inflow into unemployment. That is, such laws may increase long term unemployment, but they also achieve their aims of affording some protection to labour market insiders, at least to the extent that business flexibility is not so compromised as to lead to more business failures later on, to the detriment of all. This will then show up in the statistics as lower short term unemployment and higher long term unemployment. This explains why results of past studies have not been that clear cut.

Bearing these caveats in mind, we can turn to some important quantitative studies. A 1990 study by Lazear used data on severance pay and periods of notice required before employment termination from 22 developed countries from 1956 to 1984.

One problem with this data, as Lazear acknowledges, is that these two specific provisions are used as a proxy for an entire system of employment regulation. Severance pay and periods of notice are prescribed in Australian unfair dismissal law, but do not form the whole of its obligations. However to the extent that data on these two obligations, like the others, increase firing costs and are more quantifiable than other obligations, they can be of some use. Another weakness acknowledged by Lazear is that the rules covered in the data changed once or twice during the period in each country.

Lazear found that after an econometric regression analysis against the employment rate, the number of hours worked per week and labour participation rate that there was a significant negative relationship between severance pay and these three variables i.e. the higher the severance pay, the lower the employment rate, numbers of hours worked per week and labour participation rate.

A more recent study by Di Tella and MacCulloch tries to overcome some of the inadequacies in data encountered by the Lazear study. It uses data based on surveys of businesspeople in 21 OECD countries from 1984 to 1990. In the survey used, an average of 1531 top and middle managers were asked to evaluate the flexibility their enterprises enjoyed in 'adjusting job security and compensation standards to economic realities'. They were asked to rank this flexibility from 0 to 100 where 0 signified none at all and 100 a great deal. The 1990 survey question was changed slightly to 'Flexibility of management to adjust employment levels during difficult periods.' Note that, henceforth, when I refer to labour market flexibility, I mean flexibility as defined above.

The data used in the study is unavoidably subjective. However the benefit is that unlike the Lazear study which uses some measurable aspects of employment regulations as a proxy for the complete regulatory system, this subjective data can take better account of the immeasurable aspects of the regulatory system. This includes dimensions like the degree of enforcement of different aspects of employment law which is otherwise ignored in more objective data. Businesspeople should be in a better position to judge the net effect of the regulatory system on their hiring decisions and incorporate that into their evaluations of prevailing laws.

Australia's average score of labour market flexibility is recorded as 38.45. This is the third lowest ranking of flexibility of the 21 OECD countries surveyed, lower even than the Scandinavian countries usually cited as bastions of collectivised labour relations. This may seem counterintuitive but not surprising when it is remembered that the spirit in which the law is enforced may be more important than the letter of the law.

The authors of the study caution that a lower ranking in one country may simply reflect the fact that people in other countries use a different cardinal ranking system i.e. they have different expectations. They also note that their data set of seven years is considerably less than Lazear's data from 29 years.

Nonetheless, a further strength of the Di Tella and MacCulloch study is that it adjusts for the differences in the unemployment compensation system of the countries surveyed to ensure that the effects of labour market flexibility are better isolated in their results.

The main findings of the study are as follows:

• Countries with flexible labour markets have higher employment rates. For example, it was found that if French labour markets were as flexible as those in the US, the employment rate in France would increase by 1.6 per cent. This means that flexibility accounts for almost 14 per cent of the different employment rates of the two countries;
• The employment effects of increased flexibility on the female employment rate are larger than for the male employment rate in the short run but less so in the long run;
• There are positive and significant effects of flexibility on labour force participation rates. Paradoxically, this increased participation rate may lead to a less strong result on employment rates initially as more outsiders enter the labour market. However to regard this as a bad thing is to be guilty of a serious statistical fetish usually attributed to economic rationalists, considering the demoralising effects of non-participation in the labour market.
• There is also evidence of a positive relationship between flexibility and the average number of hours worked per week, something which would probably be of little comfort to those who think that those in jobs are overworked as it is. However, when combined with increased opportunities for the unemployed, this should not be easily dismissed.
• The researchers are cautious to point out that when the data is adjusted to take account of factors not considered inside the model, the correlation between unemployment and flexibility is indeed negative but insignificant. Nonetheless the raw results are quite compelling. For instance, it was found that labour market flexibility explained 47 per cent of the different unemployment experiences of the US and France.
• A similar relationship between the proportion of long term unemployed and flexibility (negative but insignificant) holds when the data is adjusted for outside factors. Nonetheless a similar adjustment also yields a significant relationship between unemployment persistence and labour market inflexibility. It was found that unemployment is more persistent in countries with less flexible labour markets.
• Another finding which is especially relevant to debate about the sequencing of microeconomic reform has to do with the effects of openness. It was found that the effects of openness to trade on wages is lower, the greater the flexibility of the labour markets. That is, a country that opens up to trade should make its labour market more flexible if it wants to experience a smaller reduction in real wages. Given the commitment of most major parties today to free trade and the infeasibility of maintaining a Fortress Australia mentality in any case, this should give greater impetus to labour market reform, especially to those concerned about increasing disparities of income in Australia.

Conclusion

Unfair dismissal laws are not a costless exercise in compassion. They are seen by employers as a potential source of compliance costs and litigation risks which attach onto each new employee. Thus they are likely to discourage hiring of new workers if other alternatives are available such as buying more machines. This is likely to be more so to the extent that unfair dismissal laws render labour hiring decisions into virtually irreversible investment decisions. The first people to fall by the wayside as the result of such laws are those who most need to be given a chance to enter the labour market, namely the young, unskilled and long term unemployed.

Though the effects of job security provisions like unfair dismissal laws are difficult to measure, recent attempts at quantifying these effects have yielded some statistically significant evidence that such provisions decrease employment rates and increase the average duration spent in unemployment.

Appendix

Bibliography

Australian Industrial Relations Commission and Australian Industrial Registry, Annual Report 1997-98.

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Bierhanzl, E. and J. Gwartney, 'Regulation, Unions and Labour Markets,' Regulation 21(3): 40-53.

Birmingham, Amanda 1997, 'A Guide to the Workplace Relations Act 1996', Australian Bulletin of Labour 23(1): 33-47.

DiTella, R. and R. MacCulloch 1998, 'The Consequences of Labour Market Flexibility: Panel Evidence Based on Survey Data,' email attachment draft.

Industrial Relations Court of Australia, Annual Report 1996-97.

Lazear, E. 1990, 'Job Security Provisions and Employment,' Quarterly Journal of Economics 55: 699-726.

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