Elena Simintzi, Vikrant Vig, and Paolo Volpin
Labor Protection and Leverage
Review of Financial Studies | Volume 28, Issue 2 (Feb 2014), 561-591

The recent financial crisis and the subsequent global recession have once again brought the contentious topic of employment protection to the fore of the policy debate. Policymakers around the world are contemplating how to reform the rules that govern industrial relations. While some countries, such as the US, are moving towards greater labor protection, continental European countries are discussing how to amend their current labor laws in an attempt to boost potential growth. These recent developments demonstrate the need to revisit the role of labor in shaping corporate behavior and pin down the economic channel through which labor may affect firms' economic activities.

We examine the effect of labor protection on firms' capital structure decisions. Our intuition is a simple one: an increase in employment protection of labor increases restructuring costs and therefore, increases costs of financial distress at a given level of debt. Therefore, firms will now chose to hold less debt as a result of higher employment protection. This intuition follows from a simple trade-off model of capital structure in which firms trade-off the benefits of debt (debt tax shields) and the costs of debt (costs of financial distress). Pro-labor employment legislation increases the latter as labor contracts become debt-like contracts. Wages are fixed costs (i.e. operating leverage) and have to be paid every month since employees cannot be fired, resembling coupon payments of bonds. Thus, a crowding out effect is generated with operating leverage crowding out financial leverage.

Employment protection legislations

Employment protection legislations are laws which determine how difficult and costly it is to fire workers. These laws govern regular contracts, fixed-term (temporary) employment and collective dismissals, according to definitions provided by the OECD. To construct our measure of employment protection legislation that varies across countries and over time, we hand collected data on the major labor reforms across 21 OECD countries over the 1985-2007 period from a wide range of sources. In particular, we focus on changes in the procedural requirements that need to be followed when firing an employee with a regular employment contract, the notice and severance pay requirements, the prevailing standards of (and penalties for) “unfair” dismissals, the conditions under which temporary contracts can be offered, the maximum number of successive renewals and the maximum cumulated duration of these contract, the notification requirements provided by law in case of collective dismissals and the associated delays and costs for the employers.

To give an example, in 1991 a law on collective redundancies was passed in Italy. The employer has the duty to inform union representatives about the reasons for the proposed layoffs. In particular, the employer needs to show the unions that it is not possible to take alternative measures to the intended dismissals. The employer also needs to describe the measures that are planned to mitigate the social consequences of the collective dismissal. The unions may request an examination of the reasons for the layoffs and the possibilities of utilizing the workforce in different ways within the firm. If the parties fail to reach an agreement, the next step is a conciliation phase conducted by the Labor Office. Failure to follow the procedure properly is penalized by the obligation to reinstate the employees who have thus been dismissed unlawfully.

Overall, there are 21 major reforms in our sample period. Some countries have no major reform (Canada, Finland, Ireland, Japan, New Zealand, and the UK), while others have two major reforms (Austria, France, Italy, the Netherlands, Portugal, and Sweden). Nine of the reforms led to an increase in employment protection, while twelve led to a decrease in employment protection. Distinguishing between reforms that increased and those that decreased employment protection, we produced an indicator that takes values Rk,t =  + 1 (if EPL went up in country k in year t), Rk,t =  – 1 (if EPL went down in country k in year t), and Rk,t = 0 otherwise. Our indicator, EPLR, is defined recursively starting from EPL_{k,1985}^{R}=0. Thus, for any given country k in year t:  EPL_{k,t}^{R} = EPL_{k,t-1}^{R}+ R_{k,t}

It is worth clarifying that this indicator is a good indicator over time within a country and is designed to capture the long-run effects of changes in employment protection legislation. However, it is not comparable across countries, namely a higher value in one country than in another does not imply that employment is greater in the first country compared to the second one.

Worldwide evidence

To gauge the effect of employment protection legislations on leverage, we exploit intertemporal variations of employment protection legislations across countries. In our sample, US firms represent about one third of the treated sample, followed by France (with 15%) and Germany (with 11%). We compare firms' leverage in countries that are subject to a change in employment protection (henceforth treated firms) with firms in countries that have no such change (henceforth control firms).

Our empirical design, also known as difference-in-differences (DID), can be best illustrated by the following example. Suppose there are two countries, A and B, undergoing legal changes at times t=1 and t=2, respectively. Consider t=0 to be the starting period in our sample. From t=1 to t=2, country B initially serves as a control group for legal change; and after that it serves as a treated group for subsequent years. Therefore, most countries belong to both treated and control groups at different points in time. This methodology is robust to the fact that some groups might not be treated at all, or that other groups were treated prior to 1985, which is our samples start date.

We find that firms reduce their use of debt following legal changes that increase employment protection. Figure 1 presents a graphical representation of our main finding. We plot the within firm variation in leverage, as a function of changes in employment protection legislation. More specifically, Figure 1 shows the average annual leverage (measured by book value of debt over book value of total assets) in years t=-3 to t=+3 for the group of treated firms and for the comparison group of control firms, after removing the effect of firm-specific characteristics and time-varying industry conditions, which might otherwise be responsible for our results. Because of these necessary controls for a robust analysis, the annual leverage for both treated and control firms floats around zero. The treated firms have relatively higher leverage before a change in EPL and relatively lower leverage after the change, as compared to their long-run average. No such change happens to control firms. The reduction in leverage between the year before the reform and the year after is 124 basis points for a unit increase in EPL.

1: Firm Leverage around Employment Protection Legislation Changes
The figure plots the within-firm variation in leverage, as a function of changes in employment protection legislation, net of firm-specific characteristics and time-varying industry conditions. The average annual leverage for the group of treated firms (solid line) in years t=-3 to t=+3 is compared to the one for control firms (dotted line). t=0 corresponds to the year of the reform.

Our formal regression analysis leads to similar findings: the effect of an increase in EPL on total debt over assets is a reduction of 187 basis points, or 9% relative to the median leverage. The effect of an increase in EPL on long-term debt over assets is a reduction of 113 basis points, or 10% relative to the median long-term leverage.

Since the economic effect we are emphasizing in this paper goes through the labor channel, it is natural to expect that firms that have high labor turnover to be more likely affected by a change in EPL. Given these firms require higher labor turnover for their operations, increases in employment protections would impact these firms more negatively. So we divide the firms within a country according to the degree of labor turnover and we evaluate the differential effect of the EPL reform across these firms. The point of such an exercise is not to estimate the direct effect of EPL on leverage, but its differential effect across firms that differ in terms of labor turnover. As expected, we find that an increase in EPL has a greater negative effect on leverage in firms with higher labor turnover.

Our underlying assumption in this analysis, also supported by the data, is that treated and control firms are only randomly different firms. We perform a series of additional tests to make sure our findings are robust and we convincingly document that our results are not consistent with alternative interpretations. For example, we show that employment protection legislations are not sensitive to economic conditions (such as economic growth, recession, or unemployment rates). We restrict our sample of control firms to neighboring countries only. In this way, we can control for shocks that are common to a region, and our results become statistically stronger. We also control for other reforms that may be occurring at the same time as the change in employment protection and for other labor market characteristics. We also control for corporate and personal taxes, an important determinant of firm's capital structure decisions according to the literature, and the statistical significance of our results remains unchanged. Collectively, our analysis mitigates a potential concern that some unobserved variables may be driving the results.


Using firm-level data from 21 OECD countries over the 1985-2007 period, we find that leverage decreases when employment protection increases. Our intuition that can explain this finding is that pro-labor regulations, by making it difficult to adjust labor force, increase labor market rigidity. Thus, labor claims resemble debt claims, where wages can be construed as coupon payments on debt. This transformation of labor claims into debt claims crowds out firm's leverage. These findings provide supporting evidence for the critics of employment protection laws by showing that labor friendly regulation may have negative real effects via a finance channel.