Do high dismissal costs lead to more innovation? Evidence from OECD panel data

Structural reforms in labor markets have been launched in most OECD countries in order to create conditions for an innovative economy. The EU, for example, identifies more flexible labor markets as one driver of becoming „the most dynamic and competitive knowledge-based economy” (Lisbon Strategy 2000, 2005). We observe a gradual change of employment protection legislation which captures the size of dismissal costs since 90s. In a model with a step-by-step innovation process with a technology gap, a higher dismissal cost induces innovation for firms both at the technology frontier (neck-and-neck) and for firms that are far from frontier (technology followers). We test this hypothesis based on panel data from 13 manufacturing industries in 15 OECD countries over the time period of 1990 to 2006. Contrast to the theoretical prediction, our preliminary results show a negative relationship between employment protection legislation/dismissal costs and innovation (which is measured by patent intensity), suggesting that softening employment protection legislation is beneficial for innovation. We are fully aware that patent intensity may include strategic patenting behavior which may not reflect the true level of innovation. We are also aware the potential endogeneity concern with regard to our measurement of technology distance/gap and we are still in the process of addressing the above issues.