Firing the Wrong Workers: Financing Constraints and Labor Misallocation

This paper studies the effect of firms’ financing constraints on the decision of which workers to fire. Firms need to consider wages, current and expected productivity as well as firing and hiring costs when firing a worker. Financing constraints distort this inter-temporal trade-off leading firms to sub-optimal firing decisions. In particular, financially constrained firms may fire the wrong type of workers (e.g., workers with steeper productivity profiles or lower firing costs) relative to unconstrained firms. We provide empirical evidence of this distortion using matched employer-employee data from the Swedish population between 1990 and 2010. Financing constraints are identified using a regression discontinuity approach on the determination of a public discrete credit rating and a within firm-year estimator. Negative firm shocks are identified from firm-specific trade patterns and exchange rate fluctuations. Our empirical results reveal an important new misallocation effect of financial frictions that operates within firms across different types of workers.