Employment Flexibility and Capital Structure: Evidence from a Natural Experiment

Abstract

I exploit the variation in labor market programs in Spain to show that the use of more flexible (shorter and cheaper-to-fire) employment contracts increases a firm's debt capacity by reducing its operating leverage and probability of default. I use specific institutional features to separate this explanation from the labor bargaining channel. I further show that the result is stronger for firms that suffer most in bankruptcy, and that in downturns firms downsize using flexible labor, suggesting that employment contract structure is a significant component of expected default costs and of operating flexibility. Finally, firms respond with higher flows of both credit and equity, consistent with flexible contracts also relaxing financial constraints.

Keywords: capital structure, fixed-term contracts, operating leverage, operating flexibility

JEL Classification: D22, G32, J41