Wrongful Discharge Laws and Innovation

We show that wrongful discharge laws - laws that inhibit the common-law doctrine of "employment-at-will" - spur innovation. In our model, wrongful discharge laws make it costly for firms to arbitrarily discharge employees. This enables firms to commit to not punish short-run failures of employees and thereby encourage employees to exert greater effort in risky but potentially mould-breaking projects. We provide supporting empirical evidence using the staggered adoption of wrongful discharge laws across the U.S. states. Using difference-in-difference tests, we show that firms and employees in the affected states engage in greater innovation, measured by the number of patents filed, citations to these patents, and the number of patents and citations per employee and per dollar of R&D expense. Using a novel dataset, we also document a "creative destruction" in the affected states: we find more new firms being created and more existing firms being destroyed, with an increase in both job creation and job destruction