All OECD countries have either legally mandated severance pay or compensations imposed by industry-level bargaining in case of employer initiated job separations. According to the extensive literature on Employment Protection Legislation (EPL), such transfers are either ineffective or less efficient than unemployment benefits in providing insurance against labor market risk. In this paper we show that mandatory severance is optimal in presence of wage deferrals motivated by deterrence of opportunistic behavior of workers. Our results hold under risk neutrality and in general equilibrium. We also establish a link between optimal severance and efficiency of the legal system and we characterize the effects of shifting the burden of proof from the employer to the worker. Our model accounts for two neglected features of EPL. The first is the discretion of judges in interpreting the law, which relates not only to the decision as to whether the dismissal is deemed fair or unfair, but also to the nature, economic vs. disciplinary, of the layoff. The second feature is that compensation for dismissal is generally increasing with tenure. The model also rationalizes why severance is generally higher in countries with less efficient judicial systems and why small firms are typically exempted from the strictest EPL provisions.
