Labour market regulations and capital labour substitution

Numerous papers have been devoted to exploring the impact of labour market regulations on innovation and productivity. They usually find a detrimental impact of regulations on patents, total-factor productivity (TFP) level or TFP growth. Fewer papers have been devoted to exploring the impact of labour regulations on the combination of production factors, although the latter are essential for anticipating the various effects of labour market reforms. The originality of our paper is thus to study the effects of labour market regulations on capital intensity, measured by the total capital-to-labour ratio, capital quality or composition in terms of four capital components, and the share of employment for high skill and non-high skill workers. It has also the advantage to be grounded on a large country-industry panel dataset. On the basis of this country industry unbalanced panel data sample for 14 Organisation for Economic Co-operation and Development (OECD) countries and 18 industries covering the years 1988 to 2007, this study proposes an econometric investigation of the effects of the OECD employment protection legislation (EPL) indicator on four investment components of total capital and two skill components of total labour. Relying on a difference-in-difference econometric approach, we find that an increase in EPL has: (i) positive and significant effects on the non-information and communication technologies (ICT) and construction capital - labor ratio and the share of high-skill labour; (ii) non-significant effects on the ICT capital – labour ratio; (iii) negative and significant effects on the research and development (R&D) capital – labour ratio and the share of low-skilled labour. These results suggest that firms consider that the strengthening of employment protection legislation is equivalent to a rise in the cost of labour, resulting in capital-to-labour substitution in favour of non-ICT and construction capital relatively to ICT and R&D capital, and working at the disadvantage of low-skill relative to high-skill workers. They indicate to the contrary that structural reforms for more labour flexibility weakening this legislation could have a favourable impact on firms’ R&D investment and their hiring of low-skill workers.