Financial Distress and the Cost of Labor: Evidence from a Natural Experiment

Abstract

Employees bear significant costs in bankruptcy. Theoretical models predict they will accept lower wages in the face of financial distress to avoid such costs. Using a natural experiment, I test this theory and find an exogenous increase in default risk causes a decrease in employee wages. The effect is economically meaningful: the reduction in aggregate annual wages equals 10% of the firm’s earnings and 33% of its interest expense. As expected, it is concentrated in financially vulnerable firms and those with fewer agency conflicts. Employees thus represent an important financial resource for firms in the midst of financial distress.

Keywords: Labor, Finance, Negotiations

JEL Classification: G32, G33, J31