Employment Protection Laws and Corporate Liquidity Management

Abstract

This paper investigates the relation between employment protection and corporate liquidity management (i.e., cash holding and cash saving decisions). Theory suggests that employment protection increases firms' labor adjustment costs. We use difference-in-difference estimation method exploiting changes in employment protection laws as a source of variation in labor adjustment costs in 20 countries over the period 1990-2007. We find that, in response to an increase in employment protection, firms increase their cash buffers and propensities to save cash from the funds raised internally and externally. The effect is stronger for firms with relatively small size, high cash flow volatility, and high labor intensity. Overall, our findings suggest that firms' precautionary motives for cash savings increase as labor adjustment costs and therefore operating leverage increases.