Mandatory Severance Pay: Its Coverage and Effects in Peru

In Peru, like in many other developing countries, employers have the legal obligation to compensate workers who are dismissed due to no fault of their own. Is this an efficient mechanism to provide income support to the unemployed? This paper seeks an answer to this question using individual records from a household survey with a panel structure. Relying on five coverage indicators, the paper shows that roughly one in five private sector workers, and one in three private sector wage earners, is legally entitled to severance pay. Coverage is more prevalent among wealthier workers. Results based on several empirical strategies suggest that workers “pay” for their entitlement to severance pay through lower wages. Finally, consumption among unemployed workers who receive severance pay is 20 to 30 percent higher than among those who do not. Consumption among these workers is actually higher than among those who are employed, implying that mandatory severance pay is excessively generous in Peru.