How does employment protection legislation affect labor investment inefficiencies?

Abstract

This paper analyzes how labor investment decisions are affected by the operational risk related to different dimensions of employment legislation (general, regular, and temporary employment protection). Labor investment efficiency is usually described as efficient investing and resource management; employment protection legislation can be regarded as an obstacle that increases hiring and firing costs, representing a source of operational risk and leading to lower output and financial flexibility. This study uses data from 612 companies from 30 countries between 2011 and 2019 (4044 observations) and a dynamic panel data estimator to investigate the relationship between employment protection legislation and labor investment inefficiencies. Our results show that general employment protection legislation reduces inefficiencies, whereas regular and temporary specific employment protection laws increase the incentive to overinvest. Our findings can be explained by the agency theory and the ways in which different aspects of employment protection legislation create operational risk.