Firing Cost and Firm Size: A Study of Sri Lanka’sSeverance Pay System

Sri Lanka's Termination of Employment of Workmen Act (TEWA) requires that firms with 15or more employees justify layoffs and provide generous severance pay to displaced workers,with smaller firms being exempted. Athough formally subject to TEWA, firms in ExportProcessing Zones (EPZs) may have been partially exempt from TEWA due to lax enforcementin that sector. A theoretical model shows that firms subject to TEWA will tend to mass at orbelow the threshold of 14 workers until they get an atypically large productivity shock thatwould propel them beyond the threshold. EPZ firms will be largely unaffected by the law. Inaddition, EPZ firms receive preferential tax treatment and exemptions from customs duty.Consequently, firms that anticipate rapid growth will have an incentive to locate in the EPZsector. We test these predictions using 1995-2003 panel data on the universe of all private,formal sector firms in Sri Lanka. We find that at all sizes, EPZ firms are more likely to addemployees than nonEPZ firms. Above the threshold, nonEPZ firms are more likely to shedworkers while EPZ firms are more likely to add workers. Once passing the threshold, nonEPZfirms grow faster than nonEPZ firms below the threshold, consistent with a theoretical predictionthat only atypically productive nonEPZ firms would cross the threshold. Finally, evidence isconsistent with the the hypothesis that TEWA restrictions retard the growth of nonEPZ firmsbelow the threshold, but only some of the evidence passes tests of statistical significance. Thecombined impacts of retarded growth below the threshold, the need for a large productivityshock to cross the threshold, and slower employment growth above the threshold suggest that theTEWA failed to lower unemployment. Instead, it slowed employment growth of nonEPZ firmsand induced other firms to seek the EPZ sector in order to evade the law.[...]