Defusing Leverage : Liquidity Management and Labor Contracts

Rigidities in firms’ payroll structures are likely to increase the transmission of shocks to firms’ cash flows and profitability. By using Italian administrative data on workers careers and firms’ balance sheets, we study how the use of permanent and fixed-term labor contracts affects this pass-through. We document how firms use the contract composition of their workforce to manage the risk determined by their labor-induced operating leverage. First, we confirm that a higher labor share is associated with more volatile cash flows following unexpected real shocks, a telling indication of operating leverage at work through labor costs. Second, we show that firms with a greater share of temporary contracts are characterized by a smoother time-series behavior of their cash-flows. In particular, the smoothing effect is stronger for firms with higher labor share related to the permanent workforce. We complement this analysis with the study of the 2001 labor market reform that lifted constraints on the creation of temporary contracts. Exploiting the staggered implementation of the reform across different collective bargaining agreements, we show that, following the reform, firms increased on average their share of temporary contracts and decreased average labor compensation. In addition, we show that, only among firms with an ex-ante more rigid labor cost structure, earlier transition to a more flexible workforce composition led to a 1 percentage point increase in profit margins (against a -1.6pp average variation around the event) and a 5 percent decrease in the cross-sectional standard deviation of profits