This paper aims at analyzing the impact of Employment Protection Legislation (EPL) on firms’ investment decisions in the presence of financial imperfections. To our knowledge there are not many papers that investigate the joint influence of imperfect financial and labour markets on investment. Exceptions are Belke and Fehn (2000), Rendon (2004), Wasmer and Weil (2002), and Calcagnini and Saltari (2003, 2005).
Traditionally, the impact of financial and labour markets imperfections on investment has been analyzed separately. Parallely, policy design concerning the economic impact of each single market did not fully take into consideration the functioning of the other market. We think that by analyzing how investment reacts to conditions prevailing in both the financial and labour markets may provide a better description of firms’ fixed capital accumulation strategies and a more realistic set-up within which more efficient economic policies may be designed.
Of the two strands of the economic literature that study how imperfections affect investment, the one related to financial markets is likely the most, known, debated and empirically tested. Shortly, in the presence of imperfect financial markets the Modigliani and Miller propositions (Modigliani and Miller, 1958, 1963) fail to hold. Asymmetric information problems, and agency problems, make the cost of internal finance lower than that of external finance. Thus, a hierarchy of financing structure arises (Bond and Meghir, 1994). The consequence of this type of imperfections is that investment decisions become sensitive to the availability of internal funds if firms are financially constrained (Fazzari Hubbard and Petersen, 1988; Whited, 1992, Hubbard, 1998).
Empirically the sensitivity of investment to internal funds has been originally tested by controlling for the firm availability of cash flow in q-type models. More recently, a debate developed about the correct way of how to interpret the size of the cash-flow coefficient (Fazzari et al., 2000 and 1988; Kaplan and Zingales, 1997 and 2000). Specifically, Kaplan and Zingales claim that a higher cost premium for external finance may actually be associated with lower sensitivity of investment to cash flow. Bond and Van Reenen (2003) provide a useful review of this debate. Further, Calcagnini and Saltari (2003 and 2005) suggested to substitute the cash flow variable with a more general variable of firms’ liquidity conditions calculated as the sum of the available free liquid assets and cash flow.
As for the role of labour market imperfections on investment the economic literature and evidence are scanty. One possible way of measuring labour market imperfections is to look at Employment Protection Legislation (EPL) indexes. Higher EPL values mean a more rigid labour market, i.e. firms find it costlier to adjust labour input, and then they are more limited in the kind of policies they can undertake in the presence of shocks. Indeed, as pointed out by Alesina et al. (2005), regulation can increase the cost the firm faces expanding its productive capacity, and limits its capacity to respond to changes in fundamentals. Therefore, a higher EPL should result in a negative impact on investment, by increasing firm’s adjustment costs over time. On the other hand, higher employment protection legislation values also mean higher firing costs and, therefore, higher labour costs. The latter implies a substitution effect of labour with capital, with the consequence of likely higher capital accumulation growth rates. The contemporaneous presence of these two effects often leave the researcher with an unclear sign of the final impact of EPL on investment.
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How does Employment Protection Legislation affect Firm Investment? The European Case
