Labor Laws and Innovation

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The "insurance effect" of strong anti-dismissal laws leads employees to increase their investment in innovative projects relative to their investment in routine projects.

Although certain labor laws may inhibit firms from firing employees who fail to meet expectations, those same laws evidently benefit firms by encouraging their employees to engage in more innovative pursuits. In Labor Laws and Innovation (NBER Working Paper No. 16484), co-authors Viral Acharya, Ramin Baghai, and Krishnamurthy Subramanian analyze data from five countries from 1970 to 2002 and find that stringent laws governing dismissal of employees foster innovation and economic growth, especially in the more innovation-intensive sectors. The authors add that firm-level tests arising from the federal Worker Adjustment and Retraining Notification (WARN) Act of 1989 in the United States confirm the cross-country evidence. Because the WARN act was applicable only to firms with 100 or more employees, the authors can compare what happens in firms subject to the Act versus firms that were not. Acharya, Baghai, and Subramanian measure innovation for an industry in a given year by the number of patents applied for and subsequently granted, the total number of subsequent citations to those patents, and the number of firms filing for patents in that year and industry. Their data come from the U.S. Patent and Trademark Office (USPTO) and cover patents granted to both U.S. and foreign firms. The index of labor laws employed by the researchers details the evolution of differences in employment protection legislation in the United States, United Kingdom, France, Germany, and India since 1970. These five countries account for 72 percent of the patents filed with the USPTO during the sample period.

The researchers find that stronger dismissal laws lead to greater innovation, relatively more of which occurs in the innovation-intensive industries than in the traditional industries. Crucially, stronger dismissal laws also lead to greater country-level economic growth. The authors find that laws governing dismissal of employees are the only dimension of labor laws that enhance firm-level innovation and country-level economic growth.

To illustrate why this may be the case, the authors present a theoretical example in which a firm chooses between a routine project and an innovative one - the innovative project presents a higher risk but would generate significantly higher profits if it succeeds. For example, a pharmaceutical company could choose to invent a new drug instead of manufacturing a generic one. The firm hires an employee to work on the project and may wish to replace this employee if the project fails, but dismissal laws impose limits on their ability to do so. Because innovative projects are riskier, employees faces a greater risk of dismissal when working on innovative projects. However, the lower threat of termination induced by stronger dismissal laws acts as a commitment device for the firm not to punish the employees, even if the project is unsuccessful. This "insurance effect" of strong anti-dismissal laws leads employees to increase their investment in innovative projects relative to their investment in routine projects. Thus when dismissal laws are stringent, the firm accordingly finds innovative projects to be more value-enhancing than routine projects. This example provides a potential explanation for the finding that stringent dismissal laws encourage innovation, particularly in the more innovation-intensive industries.

-- Matt Nesvisky