DP7171 | Labor Laws and Innovation

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Can stringent labor laws be efficient? Possibly, if they provide firms with a commitment device to not punish short-run failures and thereby incentivize the pursuit of value-maximizing innovative activities. In this paper, we provide empirical evidence that strong labor laws indeed appear to have an ex ante positive incentive effect by encouraging the innovative pursuits of firms and their employees. Using patents and citations as proxies for innovation and a time-varying index of labor laws, we find that innovation is fostered by stringent labor laws, especially by laws governing dismissal of employees. We provide this evidence using levels-on-levels, changes-on-changes, and finally difference-in-difference regressions that exploit staggered country-level law changes. We also find that stringent labor laws disproportionately influence innovation in those sectors of the economy that are more innovation intensive. Finally, we find that while the overall effect of stringent labor laws is to dampen economic growth, laws that govern dismissal of employees are an exception: dismissal laws promote economic growth, consistent with the evidence that they encourage firm-level innovation.