Labor Laws and Innovation

Abstract

Can stringent labor laws be e¢ cient? Possibly, if they provide firms with a commitment device to not punish employees' short-run failures and thereby spur the pursuit of value-maximizing innovative activities. In this paper, we provide empirical evidence that strong labor laws indeed appear to have an ex ante positive incentive effect by encouraging the innovative pursuits of firms and their employees. Using patents and citations as proxies for innovation and a time-varying index of labor laws, we find that innovation is fostered by stringent labor laws, especially by laws governing dismissal of employees. We provide this evidence using levels-on-levels, changes-on-changes, and finally difference-in-difference regressions that exploit staggered country-level law changes. We also find that stringent labor laws disproportionately influence innovation in the more innovation-intensive sectors of the economy. Finally, we find that while the overall effect of stringent labor laws is to dampen economic growth, laws that govern dismissal of employees are an exception: stringent laws governing dismissal promote economic growth, consistent with the evidence that they encourage firm-level innovation.