Employment Flexibility and Capital Structure: Evidence from a Natural Experiment

Abstract

Using a unique panel data set of manufacturing firms in Spain in 1994–2006, I show that the use of flexible (shorter and cheaper-to-fire) employment contracts promotes debt financing. I build the identification strategy on the intertemporal, cross-regional, and cross-gender variation in government subsidies that differentially encouraged firms to hire workers on the less flexible contracts. A thought experiment of prohibiting an average firm from hiring workers on flexible contracts suggests that such a firm should reduce its debt-to-capital ratio by 7%. These findings suggest that flexible employment contracts reduce operating leverage and the fixity of firms’ costs, increasing financial leverage. The unique institutional environment allows me to isolate this mechanism from collective bargaining and total labor cost channels. I further show that employment flexibility increases firm performance for firms that benefit most from operating leverage reductions and depend more on external financing. The results demonstrate how management can use heterogenous labor contracts to improve firm outcomes. This paper was accepted by Gustavo Manso, finance.