Defusing leverage: liquidity management and labor contracts

This study employs Italian administrative data to investigate how the use of permanent and fixed-term labor contracts influences the transmission of aggregate shocks to firms’ fundamentals. We explore how firms strategically manage their labor-induced operating leverage by adjusting the composition of contracts in their workforce. Our findings reveal two key insights. First, a higher labor share is associated with increased volatility in cash flows following unexpected real shocks, indicating the presence of operating leverage through labor costs. Second, firms with a greater proportion of temporary contracts exhibit lower variability in cash flows and profits. This smoothing effect is more pronounced in firms with a higher labor share attributed to the permanent workforce. We complement our analysis by examining the 2001 labor market reform that lifted restrictions on the creation of temporary contracts. Our results demonstrate that firms, following the staggered implementation of the reform, increased their utilization of temporary contracts while reducing average labor compensation. Furthermore, we find that, only among firms with an ex-ante more rigid labor cost structure and in more concentrated labor markets, the earlier transition to a more flexible workforce composition led to a sizable increase in profit margins and a decrease in the cross-sectional standard deviation of profits.