Employment protection, production flexibility and corporate capital spending

Previous literature argues that labour employment protection influences corporate investment through three mechanisms. Using the Labour Contract Law (LCL) in China as an exogeneous shock, we analyse publicly listed companies with regression discontinuity design, and we find that production flexibility plays a mediating role among these mechanisms. On one hand, LCL increases the labour cost of labour‐intensive firms (LIFs); on the other hand, LCL increases capital spending of non‐labour‐intensive firms (NLIFs). These findings are not ascribed to industry differences, are not driven by the boom of the housing market or other contemporary shocks, and are robust to alternative measures and placebo tests. We conjecture that NLIFs can flexibly replace labour with physical capital. As for LIFs, labour and capital must be maintained at a fixed ratio and thus neither labour nor capital can be readily adjusted. Cross‐sectional analyses confirm our conjecture.