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Can labour laws have positive effects?

Professor Krishnamurthy Subramanian’s research paper “Wrongful Discharge Laws and Innovation,” was recently accepted for publication by the top-tier journal Review of Financial Studies. Professor Subramanian presents a brief synopsis of the paper.
Economists usually argue that labour laws impose frictions in the employment relationship and are harmful to economic growth at the macro level. In particular, the argument goes that laws that prohibit dismissal encourage employees to shirk from work and thereby reduce productivity and dampen economic growth in the bargain. In this paper, we ask the question: does such a sweeping generalization apply across all industries? Can this effect differ for industries in the new economy vis-à-vis that for the brick-and-mortar industries? In this overarching theme, we investigate if legal protection against unjust dismissal from employment spurs innovative effort by employees, which encourages firms to choose risky yet value-enhancing innovative activities? We show that wrongful discharge laws—laws that protect employees against unjust dismissal—spur innovation, new firm creation and destruction of existing firms. Wrongful discharge laws, particularly those that prohibit employers from acting in bad faith ex post, limit employers' ability to hold up innovating employees after the innovation is successful. By reducing the possibility of hold-up, these laws enhance employees' innovative efforts and encourage firms to invest in risky, but potentially mould-breaking, projects. We develop a theoretical model to formalize this intuition. We then provide supporting empirical evidence by carefully identifying the causal effect of such laws using the staggered adoption of wrongful discharge laws across the U.S. states. Ours is the first study in the finance, economics and strategy literatures to demonstrate this counter-intuitive effect and develop a theoretical rationale for the same.