Labor Laws and Innovation

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.