Employment protection legislation in the time of the financial crisis

Marco Leonardi, Giovanni Pica, Julián Messina, 4 March 2010



A large literature has established that employment protection legislation affects job flows by reducing both workers’ hiring and firing, its effects being stronger during downturns and in declining sectors (see for example a discussion on this site Koeniger and Prat 2007). In the course of the sharp decline in available credit as a result of the present financial crisis, it is natural to wonder whether financial constraints exacerbate or lessen the effects of legislation.

Intuition suggests that the ability to adjust the capital stock or to adopt new technologies in the face of stricter employment protection legislation is likely to be different in firms that have access to credit with respect to those facing restrictions. Financially constrained firms may, for example, be unable to channel all their internal resources to productive investments if legislation raises labour costs and workers’ bargaining power. If this was the case, employment protection legislation would hit particularly bad during the present crisis because it would hinder the adjustments firms need to make to cope with the recession.

Employment protection legislation, investment and labour productivity

While the effect of employment protection legislation on the gross reallocation of workers is negative (associated with less creation and less destruction of jobs), there are theoretical reasons to expect an ambiguous effect on both the capital-labour ratio and productivity.

Typically, the presence of dismissal costs raises the cost of adjusting labour services. For this reason, firms may have incentives to distort their production choices toward the more flexible input, thus substituting labour for capital. However, em-ployment protection legislation may also strengthen workers’ bargaining power and exacerbate the “hold-up” problem typical of investment decisions, resulting in less investment per worker. The idea is simple, both firms and workers know that their investment decisions are to some extent irreversible. Since firing is costly, workers can appropriate a bigger part of the returns of these investments. Firms, anticipating this appropriation, have fewer incentives to invest. Hence, for a given technology, stringent firing costs might result in a lower capital stock per worker. In the longer run, however, when firms can adapt their production techniques, higher employment protection legislation should favour the adoption of more capital-intensive technologies. The final result on investment (and consequently on the capital-labour ratio) is therefore ambiguous and may depend on workers’ bargaining power and on the time span of the data.

Employment protection legislation will also typically have an ambiguous effect on labour productivity; if dismissal protections induce firms to retain (some) unproductive workers, this causes a decline in labour productivity, all other things being equal. Offsetting this factor, employment protection favours long term employment relations, thus inducing human capital accumulation which might result in higher productivity.

How do employment protection legislation and financial frictions interact?

Unfortunately, the economic literature is virtually silent on the interactions between employment protection legislation and financial frictions. There is no study, neither theoretical nor empirical, investigating the direct effect of employment protection legislation and credit market imperfections on capital and investment. Some work has been done on this interplay and the effects on employment and turnover (Wasmer and Weil 2004).

In a recent paper with Federico Cingano (Federico et al. 2010) we use a firm-level panel of EU countries and analyse the interaction between employment protection legislation and financial market imperfections from an empirical standpoint.

We look at whether the legislation’s impact is greater in industries where, in the absence of regulations, job reallocation would be higher. The analysis shows that, on average, it reduces investment per worker (along the intensive margin), capital per worker and measured labour productivity (value added per worker) in high reallocation sectors relative to low reallocation sectors.

In order to put to test whether financial market imperfections affect firms’ responses to shocks in countries and sectors that are differently affected by employment protection legislation, we use two popular – albeit imperfect – firm-level proxies of financial constraints: cash-flow and net liquid assets. These measures may be criticised on several grounds. First, cash-flow may proxy for unobserved profit opportunities. Second, constrained firms with profitable investment opportunities may accumulate liquid resources precisely because they know that they may have little or no access to the credit market. For these reasons, we also use firm size, within firms belonging to the same cohort, as an alternative proxy for financial constraints.

The analysis shows that employment protection legislation reduces the capital-labour ratio, but less so in firms with higher internal resources. This finding is confirmed when using firm size as a proxy for financial constraints. Using firm size, we also find that stricter employment protection legislation reduces value added per worker (labour productivity) relatively more in financially constrained firms. Analogously, our results show that, after an increase in employment protection legislation, the propensity to invest increases only in large firms while decreasing in smaller ones. These results favour the interpretation that firms with insufficient access to credit in high employment protection legislation environments are unable to substitute labour – the relatively expensive factor – for capital. Consequently, the negative effect of employment protection legislation on productivity is reinforced among firms that are financially constrained.

Implications for policy

Our findings suggest that policies that aim at improving firms’ access to credit may alleviate the negative impact of labour market frictions on efficiency, facilitating capital deepening. The obvious policy implication of employment protection legislation being more harmful for liquidity constrained firms, or for sectors and countries where access to external credit is more difficult, is that policies aimed at alleviating the effects of employment protection legislation should first target those sectors or countries. Alternatively, policies that aim at softening financial constraints should be first directed to countries and sectors where either employment protection legislation is more stringent or the need for reallocation is higher. It is also true, however, that employment protection legislation provides insurance to workers against labour market risk (see for example a discussion on this site, Chowdry 2009), which is more valuable in countries with less developed financial markets, where other insurance mechanisms are absent (Bertola, 2004). Hence, from the point of view of overall welfare, employment protection policies should be jointly evaluated with financial market frictions in the classic efficiency-equity trade-off.


Bertola, Giuseppe (2004), “A Pure Theory of Job Security and Labour Income Risk”, Review of Economic Studies, 71(1):43-61.

Chowdry, Anis (2009), “The Great Recession of 2008-2009 and Labour Market Flexibility – Which way now?”, VoxEU.org, 17 December.

Cingano, Federico, Marco Leonardi, Julian Messina and Giovanni Pica (2010), “The Effect of Employment Protection Legislation and Financial Market Imperfections on Investment: Evidence from a Firm-Level Panel of EU countries”, Economic Policy, 25(61):117-163.

Koeniger, Winfried, Julien Prat (2007), “Employment protection and labour market turnover”, VoxEU.org, 29 August.

Wasmer, Etienne and Philippe Weil (2004), “The Macroeconomics of Labour and Credit Market Imperfections”, American Economic Review, 94(4):944-963.

Topics: Labour markets
Tags: Employment Protection Legislation, financial crisis, productivity

Assistant Professor of Economics at the University of Milan

Senior Economist, Office of the Chief Economist for Latin America and the Caribbean at the World Bank

Assistant Professor of Economics at the University of Salerno