When, in a relationship between two parties, the law favors one party over the other, it chooses to give preference to one right over another and consequently reduce the costs of one party at the expense of the other. Labor legislation in many countries is designed to protect employees; thus, the greater regulatory and cost burden falls on employers.

When assessing whether the provisions of labor law provide employees with the right incentives to perform their duties in an optimal manner, we set out to examine whether those provisions create the right environment and incentives for employers to invest and maximize their companies’ productivity.

The costs of low productivity are not borne by the employee, but by the employer. When an employee performs below the required level, the company incurs losses or profit margins decline. Employees are rarely directly affected by this, unless the reduction in productivity is substantial and leads to staff reductions or the closure of the company. It is important to understand how these costs can affect employer behavior.

Employers, like employees, know that to terminate an employment contract without just cause, they must pay the amounts corresponding to severance pay and advance notice compensation, which, depending on the employee’s salary and length of service, can be very high. They also know that proving the “just causes” established by the labor law applies is almost impossible.

This situation has several consequences. First, and most obviously, companies may find themselves trapped in an employment relationship with employees whose output is low but whose contracts are difficult to terminate due to the high costs involved. The employer is therefore left with a workforce that is underperforming and cannot be replaced immediately for financial reasons.

The company is using its resources inefficiently, as it must pay a salary to an employee who is underperforming, rather to an employee producing at an optimal level. This inefficiency occurs because, as explained above, making such a replacement represents a high cost for the employer.

Another consequence is that, in anticipation of the situation described above, companies adjust their behavior and seek alternative forms of hiring in which their risks and costs are reduced, or at least not increased. The incentive to hire is negatively affected.

We can call this readjustment “suboptimal hiring”: companies hire fewer people than they need, since they must count as hiring costs for each employee not only the salary to be paid and other mandatory charges (social security, pension, etc.), but also the eventual costs of terminating the contract. With this solution, the company is unable to increase its production and operates below its optimum level because it does not have enough staff. This dynamic is also reflected when employers pay wages below the real value of the work performed, seeking to reduce the costs of eventual termination. This type of hiring also causes social harm, as it either increase unemployment, which is detrimental to potential employees, or the employees hired undervalued.

Another adjustment that employers make to be able to hire the number of employees they need is to sign fixed-term or short-term contracts. Labor law presumes that all employment contracts are for an indefinite period; however, employers will seek ways (as is already done in practice) to keep employees on fixed-term or project-based contracts that can be terminated without having to pay the compensation established by law. Employers will invest resources in legal advice to create hiring structures that allow them to circumvent penalties for termination of employment contracts established by labor legislation.

This behavior leads to an increase in black market hiring, because employees accept these types of conditions in their employment contracts, losing the protections designed for them by the legislature. In other words, the law causes companies to invest resources in finding ways to evade it, which ultimately harms the very people the regulation seeks to protect.

If the legislation were different, suboptimal hiring would be reduced. Those employees who perform their work best would be hired and would work, the company would use its economic resources to compensate them adequately, and this would lead to healthy competition among employers to have the most efficient and productive employees, which they would achieve by necessarily offering good working conditions.

From this article and the previous one, we can conclude that labor legislation does not create sufficient incentives for employees to perform their work efficiently and that it causes companies’ resources to be allocated inefficiently. These failures ironically translate into significant harm to those whom the legislation seeks to protect. Therefore, labor legislation that is less protective of employees and generates lower costs for employers would translate into benefits for the former.