EPL and capital-labor ratios

Employment protection (EPL) has a well known negative impact on labor flows as well as an ambiguous but often negative effect on employment. In contrast, its impact on capital accumulation and capital-labor ratio is less well understood. The available empirical evidence suggests a hump-shaped relation between capital-labor ratios and EPL: positive at very low levels of EPL, and then negative. We explore the theoretical effects of EPL on physical capital in a model of a firm facing labor frictions. Under standard assumptions, theory always implies a motononic negative link between capital-labor ratios and EPL. For a positive link to arise, a very specific pattern of complementarity between capital and workers protected by EPL (senior workers, as opposed to unprotected new entrants, or junior workers) has to be assumed: EPL increases the share of senior workers in employment and by complementarity, leads to higher investment in physical capital. Further, no standard production technology is able to reproduce the inverted U-shape pattern of the data. An extension of the model with specific skills investment is able to reproduce the inverted U-shape pattern. EPL protects and therefore induces investments in specific skills. Under complementarity between capital and specific human capital, physical capital and senior workers having accumulated specific human capital are de facto complement production factors and EPL may increase capital demand at the firm level. Further, the size of this effect varies with the intensity of employment protection: it is low at low levels of EPL, high at higher levels of EPL, hence generating the non-monotonicity. The paper concludes that labor market institutions sometimes have a positive role in a second-best environment.