Do laws that make it harder to dismiss employees stimulate innovation and growth?

Yes, say Viral Acharya, Ramin Baghai and Krishnamurthy Subramanian.

Stringent labor laws can provide firms a commitment device to not punish short-run failures and thereby spur their employees to pursue value-enhancing innovative activities. Using patents and citations as proxies for innovation, we identify this effect by exploiting the time-series variation generated by staggered country-level changes in dismissal laws. We find that within a country, innovation and economic growth are fostered by stringent laws governing dismissal of employees, especially in the more innovation-intensive sectors. Firm-level tests within the United States that exploit a discontinuity generated by the passage of the federal Worker Adjustment and Retraining Notification Act confirm the cross-country evidence.

In other words, when a company faces few legal restrictions on firing employees the fear of being dismissed may cause employees to innovate less. This may have an impact on profitability and growth. The authors test this hypothesis in a number of ways, first looking at cross-country data and than at the effects of the WARN act in the US. The WARN act test is especially interesting. The WARN Act was passed in 1988 and came into effect in 1989. It required private companies with more than 100 employees to give workers 60 days' notice before instituting mass layoffs. So Acharya et al. ask whether companies subject to the WARN Act subsequently had greater rates of innovation (defined by patent filings) than those that were not subject to the Act. They compared the change in patent filings before and after the act in companies with 95-99 employees to those with 100-105 employees and got the graph on the left: following the act, companies with 100-105 employees increased patent filings significantly relative to the control group. To test whether this was just an anomaly they did the same experiment with companies above and below a 50 employee cutoff line (right graph). As predicted, there is no difference between these groups of companies because WARN applies to neither group.



This is not my field, but it seems to be a really nice, careful piece of research. It would seem to have applications to the issue of the impact of unions as well. Obviously, as Acharya et al. note, when unions protect their weakest performers from dismissal there is a reduction in efficiency ex post. But ex ante, protection from dismissal through unions should encourage employees to innovate in ways that can enhance a company's profitability. Obviously in most environments patent filings aren't the appropriate measure of innovation, but a teacher can innovate by trying out new teaching methods, a state employee can suggest different ways of organizing the office, an auto worker can suggest new quality control techniques.

[Update: but when unions negotiate strict workplace rules innovation might be suppressed. Perhaps the ideal union would protect workers from dismissal while preserving flexibility of work assignments.]

On the other hand, a tenured professor can spend his morning blogging instead of revising his paper on the Great Inflation...