On the short-run effects of labor market reforms

While several countries have recognized the need of introducing flexibility to their labor markets, there are different ways of doing so. Using a small open economy with tenure-dependent separation taxes, this paper compares introducing a full reform with two partial alternatives: (1) the introduction of temporary contracts, and (2) the elimination of separation costs from all new hires while freezing them on the workers that were hired prior to the reform. The first alternative can achieve a first-best long run outcome but leads to a sharp initial recession. The second alternative generates a similar long run outcome but avoids the recessionary adjustment.