Employment Protection Reduces Productivity

Legislation that makes it difficult for employers to dismiss workers may provide increased job security, but this does not come costlessly. According to new research by Professors David Autor, William Kerr and Adriana Kugler, published in the June 2007 issue of the Economic Journal, the adoption of such ''employment protection'' leads to lower productivity, lower entry of new firms and lower employment turnover.

What's more, while that third outcome of employment protection may appear to be good news for workers – after all, job stability increases – it is a mixed blessing. Job seekers will need to spend longer looking for employment and, recognising these delays, incumbent workers may in turn be discouraged from seeking better jobs.

Business leaders and policy-makers often claim that labour market rigidities (generally referred to as employment protection) reduce productivity and competitiveness by altering production choices from their unconstrained best.

Laws and regulations that impede worker dismissal may cause firms to retain unproductive workers to avoid termination sanctions and to pass over the opportunity to hire productive new workers due to the downside risk of potentially having to terminate them later.

The researchers test these hypotheses using the adoption of employment protection regulations by state courts in the United States. The country has long had a legal presumption that workers and employers may freely terminate their employment relationships ''at will'' – that is, without notification, financial penalty or requirement to demonstrate good (or any) cause.

This legal doctrine – referred to as ''employment-at-will'' – was first articulated by the Tennessee Supreme Court in 1884 and was subsequently adopted into common law by almost all state courts by the mid-1930s. Over the last three decades, however, the state courts have adopted numerous restrictions on the rights of employers to terminate workers at will. These employment protections generated a flood of litigation in adopting states and increased employer uncertainty and potential costs in discharging workers.

The researchers study the impact of these employment protections by contrasting changes in employment and productivity in manufacturing establishments located in states where courts adopted employment protections relative to analogous changes at manufacturing establishments located in states where courts did not adopt such protections during the same time interval. Thus, manufacturing establishments located in non-adopting states serve as a comparison (or ''control'') group for manufacturing establishments located in adopting (or ''treated'') states.

The analysis yields four main results:

  • First, states'' adoption of employment protection reduces manufacturing establishment employment turnover by 5-12%.
  • Second, adoption of employment protection reduces the entry rate of new manufacturing establishments by 7-13%. This reduction in entrepreneurial activity may indicate that firms are seeking greener pastures elsewhere, perhaps in other states or nations.
  • Complementing this finding, the study finds that establishments also engage in ''capital deepening'' – that is, increasing their ratio of capital to labour – indicating an effort to substitute machinery for workers.
  • Finally, employment protections are estimated to lower overall manufacturing productivity at affected establishments by 1.5-2.3% – equivalent to roughly the productivity growth achieved in a typical year. Since productivity growth is ultimately the engine of rising prosperity, this economic cost is significant.

In considering these results, it is important to bear in mind that this research does not evaluate the benefits that employment protections confer, such as increased job security and attendant peace of mind. Indeed, some workers, politicians and judges may feel that these benefits are well worth the attendant economic effects.
But what can be concluded from this research is that employment security does not come costlessly. Thus, policy-makers should consider that, when it comes to job security mandates, there can be too much of a good thing.

''Does Employment Protection Reduce Productivity? Evidence from US States'' by David Autor, William Kerr and Adriana Kugler is published in the June 2007 issue of the Economic Journal.