Capital Structure and Employment Flexibility

Abstract

This paper uses a unique panel dataset to establish a causal relationship between the use of flexible contractual arrangements with labor and capital structure of the firm. Using the exogenous inter-temporal variation from government subsidies, I find that hiring more temporary workers leads firms to have more debt. Since temporary workers, unlike permanent ones, can be fired at a much lower cost during their contract duration, or their contracts may be not extended upon expiration, a firm can more easily meet its interest payments and avoid bankruptcy when faced with a negative shock. I interpret this result as evidence of flexible workforce decreasing operating leverage which, in turn, promotes financial leverage. The economic magnitude of the effect is large. A thought experiment of completely prohibiting an average firm from offering temporary employment contracts would suggest that it should reduce its debt level by 4.9 percentage points, which is about 8% of the average debt level across firms. Given the overwhelming extent of labor reforms in continental Europe in recent years that touch upon the incentives to use different employment contracts and are aimed at offering more job security to workers, it is important to understand how such policies would affect firms.