1. Introduction
The labor market imperfections caused by employment protection (EP) legislation and the effect of wages on firm performance have been popular topics in labor research for many years. EP, for instance, has been shown to affect the employment levels [
1,
2,
3] and productivity levels of firms [
4,
5], while paying high wages is seen as a way to build human capital [
6] or as a way for managers to buy off conflicts within the firm, which could be value-destroying [
7]. More recently, the hiring and firing costs introduced by employment protection are also seen as a market imperfection that can affect a firm’s decision-making process in general. As a consequence, EP and wages have been examined in connection to, for instance, firm investment [
8,
9,
10], the location decisions of multinationals [
11,
12], venture capital investments [
13,
14], debt policy [
15,
16], innovation [
17,
18], valuation and performance [
19,
20] and merger and acquisition activity [
21,
22,
23].
As all of the issues listed above may be related to a firm’s success and, ultimately, to its survival chances, this paper focuses on the link between employment protection and wages and the likelihood that a firm enters into bankruptcy. The ex-ante expected effects of EP and wages on firm failure are not clear. On the one hand, firms with less EP obligations are more capable of adjusting to new circumstances [
24] and are able to allocate human capital more efficiently [
25]. In addition, low EP companies are less hindered by fixed hiring and firing costs and have a lower operating leverage level [
15,
26]. Based on these arguments, a firm is expected to be less likely to fail if it is more flexible in terms of employee contracts. On the other hand, companies that are subject to many EP obligations and are therefore less flexible may also have a lower probability of entering into bankruptcy, as EP and the paying of higher wages promotes the adoption of skills by employees and may increase the stakes of the employees in the company [
17,
27]. The resulting higher human capital costs of bankruptcy may increase both the incentives of employees to guard their interests and their efforts to keep the firm viable and retain their jobs.
This paper adds to the existing literature in three ways. First, to the best of our knowledge, we are the first to examine the effects of wages and employment protection in a failure prediction setting. Although many papers advocate the use of non-financial variables in failure models [
28,
29,
30], employment protection has not yet been studied in connection with firm failure. Second, we are able to create firm-specific variables that show to what degree a firm is subject to EP while, because of data limitations, the existing literature mainly has to resort to country-level EP indexes [
15,
21,
24]. The use of country-specific EP variables implicitly assumes that the level of labor protection is the same for all types and categories of employees in a given country and that a company does not have the ability to choose to what extent it is subjected to protection rules. This assumption is violated if several labor contract categories with different labor protection rules exist. In that sense, studies that use country-level variables are confronted with an omitted variable problem. The Belgian setting of this study has the advantage that it allows for creating company-specific EP variables, since Belgian firms are obliged to report not only financial- but also workforce-related data. As a result, we are able to construct two variables that show how flexible a firm is in terms of labor contracts. A few papers created a firm-specific variable based on the distinction between temporary and permanent workers [
26,
31]. This paper not only makes use of this difference between temporary and permanent workers, but it also exploits the legal difference between two core types of employment contracts: the better protected white-collar employees and the less protected blue-collar workers. Third, while the majority of the existing literature focuses on large quoted companies (again, often because of data availability issues), this paper focuses on small- and medium-sized enterprises. Examining labor contract flexibility and wages in large firms may introduce noise, as quoted and large companies often have employees in many countries and consequently have to comply with the labor protection rules and wage levels of these different countries. Furthermore, SMEs have less access to the capital markets, are financially more constrained than large firms, are on average less diversified and may experience more volatility in earnings, all of which makes them more likely to be affected by the rigidity caused by stringent EP rules.
The sample consisted of 29,596 Belgian small- and medium-sized firms, of which 1585 firms entered into a bankruptcy or formal reorganization procedure between 2011 and 2019. As in the work of Shumway [
32] and Campbell, Hilscher and Szilagvi [
33], the probability that a firm failed was estimated using a discrete time hazard model. The results indicate that, ceteris paribus, firms that used relatively more protected contract types and paid higher wages were less likely to fail, which is consistent with the view that building human capital is beneficial for firm survival. The results were robust for several different choices in model specifications and variable definitions.
The remainder of this paper is organized as follows.
Section 2 reviews the relevant literature on the topic and derives the hypotheses.
Section 3 explains the methodology, defines the variables and discusses the sample and the descriptive statistics. In
Section 4, the empirical results are presented, while
Section 5 concludes the paper.
2. Literature and Hypotheses
Employment protection legislation can be described as any set of rules that restricts the employer’s ability to fire an employee without delay or cost. Some examples of these rules are trial periods, notices of termination, severance payments, administrative procedures, difficulty of dismissal and additional measures for collective dismissals [
27]. Therefore, firms that are subject to less EP obligations, by definition, incur less hiring and firing costs when they want to make adjustments to their workforce composition [
34,
35].
The flexibility resulting from less stringent EP may play an important role in firms in times of financial distress. It is frequently argued that labor-flexible firms may mitigate fluctuations in customer demand and volatility of returns more easily, as they can adjust their workforce and curtail wage expenditures more quickly in comparison with a firm with high EP obligations [
24,
36,
37,
38]. A firm’s human capital may be allocated more efficiently if there is more labor contract flexibility, since there are fewer costs imposed on the employer when hiring and firing employees [
25,
39]. Evidence of the advantages of EP flexibility in a changing environment can be found in the work of Boeri and Jimeno [
40] and Kugler and Pica [
41]. These authors showed that firms more frequently make adjustments to their workforce compositions in regimes with less restrictive EP rules. Further, Cuñat and Melitz [
42] argued that firms in a volatile sector have a comparative advantage in international trade when they are located in a less restrictive EP country. They find that volatile sectors are larger in countries with more labor flexibility.
Kuzmina [
26], Serfling [
43] and Simintzi, Vig and Volpin [
15] examined another way in which firms in a less restrictive EP setting may be able to react more efficiently to changing circumstances. They stated that EP increases a firm’s operating leverage by imposing more fixed hiring and firing costs on the firm, consequently raising the firm’s fixed costs of conducting business. Labor costs indeed have been shown to be more fixed in nature in a restrictive EP environment [
44,
45], leaving less opportunity for the firm to make adjustments when necessary. Since firms that are subject to less employment protection obligations may be able to react more efficiently to a shock or to changing circumstances in the business environment, they may be less likely to fail. The arguments above lead to the first hypothesis:
Hypothesis 1a (H1a). Firms that employ more employees with flexible labor contracts are, ceteris paribus, less likely to fail.
By contrast, another line of reasoning argues that firms may also be more likely to fail when they are less exposed to EP regulation. This reasoning builds on two arguments. First, employees that are better protected by EP could be more willing to invest in skills and know-how because they do not face the possibility of being dismissed without any compensation or protection, which would render the workers’ investments in company-specific knowledge of no value [
17,
27,
36,
46,
47]. Empirical evidence of this effect can be found in studies that look at the effect of EP on innovation, which is an activity that is known to thrive on knowledge. Acharya, Baghai and Subramanian [
48] found that the introduction of wrongful discharge laws, which protect employees against dismissal, indeed increase employee effort in innovation and consequently spur innovative activity and foster entrepreneurship. Griffith and Macartney [
17] also examined the effect of labor regulations on innovation and found that stricter EP leads to more innovation as well. Since Pennings, Lee and Van Witteloostuijn [
49] showed that firms with more skills are less likely to fail, this line of reasoning suggests that firms that are subject to lower EP obligations and, consequently, have fewer incentives to invest in knowledge and skills—which were valuable resources in Barney’s [
50] resource-based view of the firm—are more likely to go bankrupt.
Secondly, Berk, Stanton, and Zechner [
51] stated that employees may face large human costs of bankruptcy, as they have to search for a new job when the firm in which they work fails. Empirical evidence of this effect can be found in the work of Graham, Hyunseob, Li and Qiu [
52], who pointed out that the bankruptcy costs borne by employees can be considerable. Additionally, Berk et al. [
51] argued that employees who are more entrenched in the firm will bear more of the human costs of bankruptcy. Employees may be more entrenched if they are better protected by the law, as they may lose their superior job security the moment the firm fails. Employees in a stricter EP setting may therefore face larger human costs of bankruptcy than employees that are less protected. This may increase the incentives for well-protected employees to keep the firm healthy and in going concern. This leads to another version of the first hypothesis, namely Hypothesis 1b:
Hypothesis 1b (H1b). Firms that employ more employees with flexible labor contracts are, ceteris paribus, more likely to fail.
The literature presents two opposite possibilities for the relationship between wage levels and survival chances as well. The human capital view of remuneration starts with Akerlof’s [
6] concept of reciprocity, which implies that satisfied employees will pay back their satisfaction through higher effort for their employer. Employee-friendly firms have been shown to be better innovators [
53] and have more productive workers, superior financial performance [
54] and valuation [
19]; in other words, paying higher wages increases costs, but it can raise the return on investment on labor [
55]. Next to raising the human costs of bankruptcy (see above), offering better compensation packages also increases employee loyalty and reduces turnover and absenteeism [
56], which should help the long run viability of the firm. Zhou [
57] considered several reasons why exporting firms pay higher wages, including that paying higher wages leads to better quality of goods produced due to lower shirking costs. Moreover, higher wages may also be related to higher education levels and a larger skill set of the workers [
58,
59]. Verwijmeren and Derwall [
60] also argued that firms that invest in employee well-being have a lower probability of bankruptcy. All of the above leads to Hypothesis 2a:
Hypothesis 2a (H2a). Firms that pay higher wages are, ceteris paribus, less likely to fail.
However, due to agency problems arising from the separation between shareholders and management, paying high wages may not always be positive for a firm’s performance. Managers may hire too many employees to engage in empire building and may overpay and delay layoffs to avoid conflicts and maintain employee support [
24] or to avoid hostile takeovers and whistleblower behavior [
7]. Cronqvist, Heyman, Nilsson, Svaleryd and Vlachos [
61] found that more entrenched managers pay higher wages to get private benefits, such as being able to spend less effort in wage bargaining and having better social relations with their employees. If these types of inefficiencies are common, the link between remuneration and failure chances may be negative. Labor costs are also a cost component that is relatively sticky; wages are likely to be related to seniority, which could be a reflection of human capital accumulation [
62], but this is also linked to employment protection, as severance payments increase with the time spent in a contract. As a result, firms with high wage obligations may be less flexible in adjusting their cost structures in times of distress, which could be associated with lower survival chances. The arguments listed above lead to Hypothesis 2b:
Hypothesis 2b (H2b). Firms that pay higher wages are, ceteris paribus, more likely to fail.
5. Conclusions
Although the literature is increasingly paying attention to the effects of employment protection and employee satisfaction on a firm’s performance, especially for large quoted firms, the association between labor contracts and wages and the likelihood of corporate failure has not yet been examined. This paper aimed to fill this gap in the literature by adding contract and wage variables to a failure prediction model for a very large sample of Belgian SMEs. The literature argues that flexibility in labor contracts and the level of employee compensation may be both positively or negatively related to firm performance and survival, depending on the underlying motivations of both the firms and the managers. We consistently found evidence in support of the literature’s more positive (building human capital) view of labor protection and employee compensation: ceteris paribus, the higher a firm’s relative use of better protected white-collar contracts, and the higher the compensation per employee it pays, the better its chances of survival.
Our findings have clear implications for all economic agents that may benefit from being able to predict corporate failure (such as banks, suppliers, clients and governmental agencies): relying solely on well-known financial ratios as predictors may not paint a complete picture of a firm’s likelihood to survive. However, a clear limitation of the study is that its design is not well suited to prove causality between employment practices and failure. As is common in the bankruptcy prediction literature, we focused on showing the existence of links between variables and failure probabilities. To better understand the underlying process and be able to pinpoint causality, additional information would be needed. The literature on human resources management provides potential moderating variables which could be taken into account. For instance, it could be hypothesized that the impacts of the contract type and wages are influenced by the quality and flexibility of the HR practices within the firm. It may also be the case that the importance of the effects we found depended on the firm’s characteristics, which we were not able to control in the current study, such as the export intensity of the firm or its reliance on creativity and know-how. Linking our dataset to a survey of HR practices, an export database or a patent database may therefore open interesting avenues for further research.