Employment Flexibility and Capital Structure: Evidence from a Natural Experiment

Using a unique panel data set of manufacturing rms in Spain in 1994-2006, I show that the use of exible (shorter and cheaper-to-re) employment contracts promotes debt nancing. I build the identication strategy on the intertemporal, cross-regional, and cross-gender variation in government subsidies that differentially encouraged rms to hire workers on the less exible contracts. A thought experiment of prohibiting an average rm from hiring workers on exible contracts suggests that such a rm should reduce its debt to-capital ratio by 7%. These ndings suggest that exible employment contracts reduce operating leverage and the xity of rms' costs, increasing nancial leverage. The unique institutional environment allows me to isolate this mechanism from collective bargaining and total labor cost channels. I further show that employment exibility increases rm performance for rms that benet most from operating leverage reductions and depend more on external nancing. The results demonstrate how management can use heterogenous labor contracts to improve rm outcomes.