How much protection should employees have in the workplace? Evidence shows that while regulations often protect people from harm, they can also have unintended negative consequences. New research tries to understand the costs and benefits by studying the effects of regulations around at-will employment, the legal doctrine that allows employers to terminate any employee without warning, and for any reason, without the risk of legal liability. Researchers found that employment protections to limit at-will employment had a negative effect on business investment and sales growth. This should not be taken to mean that employment protections should be abolished, they argue. There is a long literature showing how these protections increase people’s job security and economic stability, which has positive effects on individuals, families, and communities. Rather, they say that as policy makers determine how much employment protection to mandate, they need to account for how businesses as well as employees respond, in order to assess the total welfare costs and determine what tradeoffs are acceptable.
U.S. presidential candidate Bernie Sanders recently announced a plan to overhaul U.S. labor law that included ending “at-will employment” — the legal doctrine that allows employers to terminate any employee without warning, and for any reason, without the risk of legal liability. At-will employment has long been at the center of debates over how employees should be treated — how much freedom companies should have in firing people, and how much protection people should have in the workplace. Evidence shows that while regulations often protect people from harm, they can also have unintended negative consequences. One question is, how much protection is too much? In our research, we tried to understand the costs and benefits by studying the effects of regulations around at-will employment. Our results highlight one tradeoff to consider.
Employment at-will is largely unique to the U.S., and it has been the foundational rule in the country for over a century. But even so, policymakers have long recognized its potential risks, and the federal government has passed laws, such as the Civil Rights Act of 1964, the Pregnancy Discrimination Act of 1978, and the Americans with Disabilities Act of 1990, to prevent discriminatory firing. In the 1950s, many states also began passing legislation to limit at-will employment and protect employees not covered by federal laws from unfair dismissal practices. Many studies have shown that these regulations undoubtedly benefit workers. We wanted to understand how these regulations influenced businesses — specifically, business investment and growth.
Restricting employers’ ability to fire workers can have two opposing effects on investment. On the one hand, insulating workers from wrongful termination and the fear of being fired may allow them to focus on their responsibilities, take innovative risks, and build skills that improve their current employer’s performance. These effects can lead to increased productivity and new or more attractive opportunities, leading to an increase in investment.
On the other hand, regulations that make it harder for firms to fire workers reduce operating flexibility and make it costlier to divest or scale back poorly performing projects. In terms of the traditional Net Present Value (NPV) analysis taught in business schools, making it harder to cut investments reduces the expected terminal cash flows of projects, resulting in fewer projects with positive NPVs and hence reduced business investment overall. A reduction in operating flexibility could also constrain investment by making it harder for a firm to raise external capital, such as debt.
To determine which of these effects wins out, we looked at how business investment decisions changed after states adopted one particular form of employment protection — the “good faith” exception to at-will employment. The good faith exception, based in common law, is arguably the most far reaching of the state-level exceptions to at-will employment. Broadly interpreted, it makes it illegal for employers to discharge a worker out of bad faith, malice, or retaliation, and serves to protect an employee’s contractual rights. For example, under this law, an employee could sue her employer for wrongful termination if the employer fires her just before a commission is due or right before her pension vests. Employees can also sue to recover lost earnings and obtain compensation for any pain and suffering. And judges may award punitive damages. According to our data, between 1974 and 1998, 14 states adopted the good faith exception, with two states subsequently reversing their decision during this period.
To establish a causal link between at-will employment regulation and business investment, we exploited the adoption of this law, comparing changes in investment in states that adopted the exception with changes in investment in states that did not. (This method helped us control for other factors — like different legal institutions, business conditions, or infrastructures — that might be correlated with investment.) We obtained data on 11,254 unique public U.S. corporations between 1969 and 2003, and measured business investment by looking at their capital expenditures — money spent on fixed assets such as land, buildings, and equipment. We focused on capital expenditures because capital accumulation is an important driver of business and economic growth.
We found that the adoption of the good faith law had a negative effect on investment. Compared to investment rates of firms in states that did not adopt the exception, firms located in states where it was adopted decreased investment as a percentage of assets, from an average of 8.3% before adoption to 7.8% about a year afterward, which corresponds to a decrease of about $6 million (in 2009 dollars) in investment for the average firm. This decline in investment appears about one year after the law’s adoption and tends to persist throughout our study period. This was accompanied by a decrease of 3.1% in the average annual sales growth rate. These results held after we included a wide range of controls for firm, state, and industry characteristics.
But what is it about increased protections that made investment go down? Previous academic research predicts that greater employment protection discourages investment by making it harder for firms to secure external capital and/or by making investments less profitable (since they’d be harder to scale back). We put both of these explanations to the test.
If greater employment protection made it more difficult to get external financing, we should find that business investment declined more among firms that needed external capital to fund investment and firms that already faced a high cost to getting external capital. We used several measures to proxy for these types of firms and saw mixed results. Therefore, we cannot conclude that lower investment results from employment protection crowding out access to capital.
In contrast, we found strong supporting evidence that greater employment protection made it harder for firms to downsize projects, reducing operating flexibility and decreasing investment. For example, we found that firms were far less likely to divest assets and lay off employees following a decrease in profits after the law was adopted. We also obtained more granular data on where these firms and their establishments were located; we found that when firms did lay off employees or close plants in response to a decrease in profits, they were more likely to do so in states that had not adopted these laws.
Overall, our study highlights one downside of less flexible labor markets resulting from greater employment protections. Our results show that when states curbed at-will employment, what followed was lower corporate investment in fixed assets, resulting in a slowdown in firm growth during our study period. As for what happened to investment after this period, it’s hard to determine how the decline we see contributes to overall investment over the last 15 years. Because we focused on a narrower setting to establish causality, it’s more difficult to generalize up to the aggregate level or infer whether similar policies enacted today would have the same effect as they did during our sample period.
Our study should not be taken to mean that employment protections should be abolished. There is a long literature showing how being protected from unexpected or unfair firing can increase people’s job security and economic stability, which has positive effects on individuals, families, and communities.
We also discovered a positive effect of these protections in our supplementary analyses. We found that, unlike capital expenditures, firms increased their research and development expenditures by about $2.6 million, on average, after the good faith exception was adopted. This supports other research documenting increased innovation after the adoption of these laws. What this suggests is, while employment protection discourages investment in fixed assets, by making it harder to divest projects in the future, it seems to promote more investment in intangible assets, by encouraging employees to engage in innovative risk taking that could create value.
As policy makers determine how much employment protection to mandate, they need to account for how businesses as well as employees respond, in order to assess the total welfare costs and determine what tradeoffs are socially desirable or acceptable.