Dual Labour Markets and the Tenure Distribution: Reducing Severance Pay or Introducing a Single Contract ∗ J. Ignacio Garc´ ıa P´ erez † U. Pablo de Olavide Victoria Osuna U. Pablo de Olavide May 5, 2014 Abstract This paper evaluates Spain’s 2012 labour market reform concerning the reduction in severance pay from 45 to 33 days of wages per year of seniority and the introduction of a new subsidised permanent contract. We also compare this policy with the introduction of a single open-ended labour contract with increasing severance payments for all new hires. We use an equilibrium search and matching model to generate the main properties of this segmented labour market. Our steady–state results show that this reform will reduce unemployment (by 10.5%) and job destruction (by 7.5%). How- ever, in terms of wage subsidies, the cost of implementing this reform will be very high. A cheaper and more effective way to decrease the duality in the labour market could be to eliminate tempo- rary contracts and introduce a single contract. Unemployment and job destruction in this case could be reduced by 31.5% and 35%, respectively. Most interestingly, tenure distribution could be even smoother than under the designed reform, as 22.5% more workers could have tenures of more than three years and there could be 38.5% fewer one-year contracts. The transition shows that both pol- icy measures would benefit a majority of workers: only 7.4% would experience a decrease in tenure under the approved reform (5.5% in the transition to the single contract) due to the improvement in job stability. Keywords: Permanent and Temporary contracts; Severance Payments; Job seniority; Tenure distri- bution; Job destruction; Entrepreneurs’ Permanent Contract; Single open-ended labour contract. JEL-Code: J23, J32, J63, J64, J65, J68 ∗ This paper was previously entitled “The effects of introducing a single open-ended contract in the Span- ish labour market”. We gratefully acknowledge the support from research projects PAI-SEJ513, PAI-SEJ479, P09-SEJ4546, ECO2012-35430, P09-SEJ688 and ECO2010-21706. Our thanks to S. Bentolila, J.J. Dolado, F. Felgueroso, M. Jansen, J.F. Jimeno for all their comments and to the audience at the conferences “Increas- ing labour market flexibility” (IAB, Nueremberg), “Dual labour markets and the Single Contract” (IZA, Mi- lan), EALE 2012 (Bonn), ECOMOD 2012, the VII Workshop in Public Policy Design (Girona), the XXXVII Simposium of Economic Analysis (Vigo) and Madmac (CEMFI, Madrid). We also thank the editor and two anonymous reviewers for very useful remarks and questions. The usual disclaimer applies. † Corresponding author: Department of Economics, U. Pablo Olavide. Ctra de Utrera Km 1, 41013, Sevilla, Spain. Email: jigarper@upo.es