Introducing Severance Payment Systems in Japan: A Proposal for Vacancy Decontrol

Abstract

In Japan, the court requires job restoration rather than a severance payment from a firm after it decides that a dismissal has been abusive. This results in a high settlement cost for termination.

This chapter recommends a simultaneous adoption of two proposals for introducing severance payments to reduce settlement costs in Japan. The first applies to existing contracts and proposes to specify levels of severance payments that would replace the current job restoration requirement after the court determines that a case is abusive.

The second applies to new employees either for a recently vacated position or a new position and proposes vacancy decontrol, which allows firms to set the levels of severance payments freely. Within this category, this paper proposes government-assisted vacancy decontrol, a transitional measure, where the government sets a minimum level of statutory severance payment, which is equal to 6 months of wages for a worker who has worked for 20 years, following the Taiwan precedent. After the need for the transitional measure is dissolved, complete vacancy decontrol should be introduced, abolishing the statutory severance payment. We propose that even at this stage, the government should publicly set a default level of the severance payment, which a firm should observe unless an explicit agreement or contract stipulates otherwise. The government should immediately introduce some form of vacancy decontrol for senior workers who have already retired from a regular job.

Appendices

Appendices

1.1 Appendix I: Ponzi Scheme

1.1.1 The Expanding Economy

Consider an economy where people work for only two “years.” In each year, the young and the old generations work concurrently in this economy. In the following, the model year is simply the year, without quotation marks. The calendar year is as written. One year is approximately 20 calendar years in the real economy.

1.1.2 The Expanding Firm Model

Consider a growing firm in this economy, which satisfies the following assumptions.

• (1) This firm employs workers for their lifetime. Thus, the firm employs young workers and retains them in the next year.

• (2) Every year, this firm’s employment of young workers expands at a constant annual growth rate of g.

• (3) In the first year, the firm has 1 old worker.

In the first year, therefore, the firm employs 1 + g young workers, making total employment size 2 + g, as shown in Table 6.2. In the second year, the number of employees of both the older and young generations grow by a factor of 1 + g and the total number of the employees in this firm is (1 + g)(2 + g), also shown in Table 6.2.

Table 6.2 Labor force

Therefore, in year t, the employment size of the young is (1 + g)^t and that of the old is (1 + g)^{t − 1}. The total employment this year is (1 + g)^{t − 1}(2 + g).

• (4) In this firm, the productivity of the young and the old are identical in any given year.

• (5) Productivity does not increase over time, and we assume that the productivity of all workers in any year is 1 throughout the period .

1.1.3 The Merit-Based Wage System

This firm can adopt a merit-based wage system , where the wage rate is equal to its productivity, which is 1. Hence, the total wage payment in each year is the total employment in that year multiplied by one. Table 6.3, which is identical to Table 6.2, shows the wage payments to the young and old generations each year. This table shows that the wage payment of this firm in year t is (1 + g)^{t − 1}(2 + g).

Table 6.3 Merit-based wage payment

1.1.4 The Seniority-Based Wage System

Alternatively, the firm can adopt a seniority-based wage system . In this setting, young workers receive zero wage, receiving the wage payment 2 + r in their old age, where r is the market rate of interest. Note that the remuneration for their work in old age is equal to 1 while the present value then of their remuneration while young is 1 + r. Thus, they add to 2 + r, which they receive in their old age, as is shown in Table 6.4.

In the second year, the young generation again receives nothing. But the old generation receives remuneration for their work in the current year, which is 1 + g, plus the present value of their remuneration in the previous year, which is (1 + g)(1 + r). Thus, the combined wage of this generation in year 2 is (1 + g)(2 + r), as is shown in the second column of Table 6.4.

Likewise, the older generation in year t receives remuneration for that year, which is (1 + g)^{t − 1}, and the present value of their work in the previous year, which is (1 + g)^{t − 1}(1 − r). The total wage payment in year t is (1 + g)^{t − 1}(2 + r). Table 6.3 provides the details .

1.1.5 The Ponzi Scheme

Thus, the wage payments in year t under the two systems are as follows.

• Merit-based wage system : (1 + g)^{t − 1}(2 + g)

• Seniority-based wage system : (1 + g)^{t − 1}(2 + r)

When g is greater than r, the total wage payment by this firm is smaller under the seniority-based wage payment than under the merit-based wage payment system. The employer clearly gains by adopting a seniority-based wage payment system. However, note that under either system, a given cohort receives exactly the same present value of wages. Thus, employers can gain by adopting a seniority-based wage payment scheme over a merit-based payment scheme without damaging the interests of workers.

This implies that the firm would still be better off than under the merit-based system, even if it paid the present value of the wage of the previous year evaluated at a higher discount factor than the rate of interest. If the firm made this choice, both employers and employees would gain through the seniority-based wage scheme.

1.1.6 Productivity Improvement

So far, we have assumed that the productivity does not increase, and the wage rate remains constant. Now assume that the employment growth rate g is 0 in the Expanding Firm Model , and that assumption (5) is replaced by the following.

• (6) Productivity increases at a constant rate α so that each new generation is equipped with new productivity, but each generation retains in old age the level of technology it acquired in its young age.

Replacing g in Table 6.3 with α provides the output levels of each generation employed by this firm and the total output for each year. By reinterpreting Tables 6.3 and 6.4 as representing the merit-based and seniority-based wage systems respectively, where productivity increases at a rate α, we again find that the firm can gain by employing the seniority-based wage scheme.

Table 6.4 Seniority-based wage payment

Furthermore, assume that the productivity increase given by α and the employment growth given by γ occur simultaneously, and we denote the sum of γ + α as g. Tables 6.3 and 6.4 then provide the combined wage payments in each case. If we expect both productivity and employment levels to grow at some constant rate, then g in Tables 6.3 and 6.4 is the growth rate of the total wage payments in the firm where we expect both the employment level and the wage rate to increase.

In this situation, the gap between g and r can be substantial. For instance, during the period 1956–73 in Japan, the average growth rate per calendar year of secondary industry was 12.1%, while the average interest rate per calendar year on savings was 2.3%. The average annual gap is then 9.8%. Assume that one year in this model is 20 calendar years (as between age 30 and 50). Hence the 12.1% growth rate in a calendar year will approximately equal 242% growth rate in a model year, yielding g = 2.42.³⁸ On the other hand, the 2.3% interest rate on savings for the calendar year will translate to 45.6% interest rate in the model year, yielding r = 0.46.³⁹ If firms discount the payment of premiums at a factor between g = 2.42 and r = 0.46, both employers and employees would significantly gain from this scheme. Thus, the firm is motivated to spontaneously adopt the combination of lifetime employment and a seniority-based wage system when it believes that g > r will prevail in the forecastable future.

Importantly, the seniority wage system is effectively a Ponzi scheme and the reason the firm can gain from this system. Under this system, the firm owes a debt to the young generation each year. Thus, the firm is indebted to the next generation each year. This means that the firm is eventually indebted to generations in the infinite future. The firm can then make a profit because it never has to return the debt to the generations in the infinite future. This profitability, however, relies on the presumption that g > r will continue.

However, the Ponzi scheme breaks down when the expectation of everlasting expansion is not actualized. That is exactly what has been happening in Japan over the past 20 years.

1.2 Appendix II: Non-firm-Specific Human Capital

If a person accumulates general (non-firm-specific) human capital and if the skills improve accordingly, his wage rate will increase in a competitive economy under the merit-based system, where the wage rate is equal to the productivity of each worker. Thus, just because the wage level increases as the worker ages, does not mean that the wage structure is determined under a seniority-based wage system , which is where the wage rate becomes higher than the productivity as the worker’s work duration becomes longer.

However, a worker who wishes to invest in such skills must accept very low wage levels when young. Given capital market imperfections, however, each worker may not be able to borrow from the bank to get by on a low wage during the investment period. Hence, it would benefit a worker if the firm makes an implicit contract with the worker to pay a wage rate higher than the productivity when young, in return for a commitment to remain in the firm. Therefore, in this case, the firm lends money and retrieves the return later, which is the opposite of the Ponzi scheme . Let us call this the case of investment in the general human capital with an educational loan (GEL).

Suppose that the GEL , not the Ponzi scheme , is the only reason for the commitment to long-term employment. Then the wage rate would be below productivity after the worker completes the acquisition of general skills. Hence, the wage structure under this scheme is not a seniority-based wage as defined earlier; the wage rate would be less than productivity after the worker completes the acquisition of general skills. To prevent workers from resigning before returning their debt, created during investment in human capital , there is an incentive for firms to have a written agreement that secures a certain period of employment under this scheme.

However, in practice, most firms in Japan already employ a lifetime employment system based on the Ponzi scheme , and GEL is only an additional cause for any long-term commitment. Under the Ponzi scheme, wages will increase, and there is a handsome exit payment for long-time workers. Therefore, there is no incentive for workers to quit for reason of GEL . Based on these grounds, there is no need for a written contract guaranteeing long-term employment. Alternatively, for the case of general human capital , workers will not forgo much by losing their job because their skills are marketable and firms wish to retain these workers as long as possible. However, this willingness weakens when there is a crisis, and the very existence of the business is threatened.

1.3 Appendix III: Employee’s Public Pension and Dismissal Premiums

In both Taiwan and Japan, an employee’s public pension does not contribute to the dismissal premium. In Taiwan , all employees are eligible for the “labor pension” benefit at age 60 years, regardless of their length of service and the lack of employment continuity under the New Pension Scheme established in 2005. Thus, the level of pension benefit after retirement is unaffected by whether there has been a change in employer during the employee’s career resulting from resignation or dismissal.

Just as Taiwan has a statutory portable labor pension , Japan has a statutory portable pension called the Employee’s Pension System. They are similar in the following two respects.

• 1. Pension rights are equal regardless of resignation or dismissal.

• 2. Payments are in the form of the annuity starting at a statutorily determined age, although Taiwan provides an option of a lump-sum payment in addition to the annuity.⁴⁰

Therefore, in both Taiwan and Japan , the employee pension does not contribute to the dismissal premium .