Labor Protection and Capital Structure of SMEs: Evidence from China's Social Insurance Law

Our study exploits the implementation of the Social Insurance (SI) Law as an exogenous increase in labor protection to investigate its impact on capital structure for Small and Micro enterprises (SMEs) in China. Based on a research period from 2008 to 2015, the empirical results show that the SI Law enactment exerts a significantly negative effect on SMEs' leverage levels, confirmed by various robustness tests. Mechanism analysis indicates that the substantial increase in labor costs following the SI Law implementation, subsequently decreased firms' leverage levels due to reduced debt capacity, consistent with the modified pecking order theory. Heterogeneity analysis reveals that the negative effect is more pronounced among SMEs with higher labor intensity, more financial constraints, and in regions with greater social supervision. Further analysis shows that, local governments increased cash subsidies to SMEs after the SI Law, mitigating the decline in debt financing. These subsidies primarily target overstaffed SMEs as compensation for their social contribution, highlighting the interdependence between SMEs and local governments.