Debt and Wages: The Role of Labor Regulation

Abstract

In this paper, we investigate how labor regulation interacts with financial leverage to explain the level of compensation firms pay to their employees. Firm leverage increases the risk of displacement of employees and the bargaining power of shareholders, implying opposite effects on the level of pay. Employment protection laws, however, decrease the risk of dismissal of employees and increase their bargaining power, thus moderating any effect of leverage on employees’ compensation. Testing this hypothesis on a large sample of OECD firms over the 1990-2018 period, we document that the correlation between leverage and employee pay is consistently lower in countries with tighter labor laws. Notably, our results hold in a stacked difference-in-difference (stacked DiD) setting exploiting major labor market reforms worldwide. Additional tests show that our results are consistent with both the risk premium and bargaining channels, and cannot be explained by financially constrained firms cutting their labor costs. Overall, we show that labor market regulation at the country-level strongly influences the relationship between financing choices and labor earnings at the firm-level.

Keywords: Wages, Labor Market, Labor Laws, Capital Structure, Adjustment Costs, Bargaining, Risk Premium

JEL Classification: G30, G32, J30