An interesting new NBER working paper has a somewhat counter-intuitive finding on the links between employment protection legislation, innovation and growth:

Stringent labor laws can provide firms a commitment device to not punish short-run failures and thereby spur their employees to pursue value-enhancing innovative activities. Using patents and citations as proxies for innovation, we identify this effect by exploiting the time-series variation generated by staggered country-level changes in dismissal laws. We find that within a country, innovation and economic growth are fostered by stringent laws governing dismissal of employees, especially in the more innovation-intensive sectors. Firm-level tests within the United States that exploit a discontinuity generated by the passage of the federal Worker Adjustment and Retraining Notification Act confirm the cross-country evidence.

They conclude:

Using patents and citations as proxies for innovation and a time-varying index of dismissal laws, we found both in a cross-country and within-U.S. setting that stringent dismissal laws seem to foster innovation.

The robustness and strength of our results begs the question whether such laws are in fact necessary to promote innovation. Can firm-level contracts not suffice to provide employees the incentives to innovate? One possibility is that innovation may have externalities and thus institu- tions supporting innovation might be desirable to get socially efficient investments in innovation (Romer, 1986; Aghion and Howitt, 1992). Another possibility is that firm-level contracts lack the force of commitment that laws offer. Since the outcomes of innovation are unpredictable, they are difficult to contract ex-ante (Aghion and Tirole, 1994), which renders private contracts to motivate innovation susceptible to renegotiation. Such possibility of renegotiating contracts dilutes their ex- ante incentive effects. Since laws are considerably more difficult for private parties to renegotiate than firm-level contracts, legal protection of employees in the form of stringent dismissal laws can introduce the time-consistency in firm behavior absent with only private contracts.

Another reason why the law might be necessary to protect employee dismissals and promote innovation is that firms may be run by short-termist or myopic top management. In such firms, poor firm-level governance of top management actions might prevent efficient long-term contracts being written with employees. The law can improve the so-called “internal governance” of firms (Acharya, Myers and Rajan, 2008) by effectively lengthening the horizon of employees and indirectly inducing the top management to provide better incentives to employees by investing for the long run. Assessing whether labor laws are indeed efficient is an important topic for future research. Our results highlight one important positive effect of dismissal laws, namely their ability to spur innovation, that must be factored into such an assessment.

Full text of an earlier draft is available here.