Labor Protection and the Dynamics of Corporate Cash Holdings

Abstract

Using a sample of 87,288 firm-year observations between 1969 and 2003, we find that the speed of adjustment of a firm’s cash holdings toward its optimal level is significantly reduced following the staggered adoption of state-level labor protection laws. This effect is more pronounced for firms subjected to financial constraints or financial distress. We further find that being far away from the optimal cash holdings hurts corporate profitability, and tougher labor protection deteriorates this real effect. Our results are robust to a series of tests, e.g., using GMM, instruments, PSM, or alternative samples. Overall, our study shows that stringent labor protection increases cash adjustment costs and, hence, affects the dynamics of corporate cash holdings.

Keywords: labor protection, speed of adjustment, corporate cash holdings, adjustment costs, good faith exception, trade-off theory

JEL Classification: G32, J63, K31