Tenure-Dependent Severance Costs and Labor Market Dynamics over the Life Cycle

We study the labor market effects of tenure-dependent severance pay systems that tie firing costs to workers’ accumulated earnings histories. We develop an overlapping-generations search-and-matching model in which firms face increasing separation costs over the employment relationship. Using administrative employer–employee data from Brazil, we estimate the model and show that tenure-dependent severance costs induce labor hoarding among low-productivity, long-tenured workers who would not be hired if unemployed. These distortions are strongest late in the life cycle, when firms optimally delay separation to avoid severance obligations, while simultaneously imposing higher hiring thresholds on older unemployed workers with shorter continuation values. These forces imply that tenure-based severance policies protect employment histories rather than productivity, shaping labor market dynamics over the life cycle and generating allocative inefficiencies.