In our textbook, Modern Principles, Tyler and I contrast basic U.S. labor law, at-will employment—where employers may terminate workers for any reason not explicitly illegal (e.g., racial or sexual discrimination), without notice or severance—with Portugal’s “just cause” regime, which requires employers to prove a valid reason, give advance notice, pay severance, and endure extensive regulatory and court involvement before terminating any workers.
Portugal’s laws look pro-worker until you realize that making it more difficult to fire also makes it more difficult to get hired: As we write in MP:
Imagine how difficult it would be to get a date if every date required marriage? In the same way, it’s more difficult to find a job when every job requires a long-term commitment from the employer.
As a result, European unemployment rates—especially for youth and high-risk groups (minorities, immigrants, the less-educated)—tend to exceed those in the U.S. and dynamism is lower.
Like Portugal, India makes it very difficult to fire workers, especially for firms with more than 100 employees. As a result, Indian firms are too small to succeed. Rajagopalan and Shah write:
India’s business regulatory framework consists of an overwhelming 1,536 laws, 69,233 compliance requirements, and 6,632 filings at the Union and state levels cumulatively, which Manish Sabharwal has dubbed India’s “regulatory cholesterol.” This regulatory cholesterol incentivizes firms to limit their size or operate in the informal sector to avoid compliance costs, thereby bifurcating the labor market into a small formal workforce and a large group left vulnerable in the informal sector. India’s labor laws are among the most rigid, contributing to jobless growth and increasing informality.
High hiring/firing costs aren’t the only exit barriers. British/American bankruptcy law, for example, aims to reduce the transaction costs of bankruptcy–quickly and efficiently shifting ownership to creditors, for example–in order to maximize the “scrap value” of a firm. Bankruptcy law in other countries often aims to discourage liquidation. Until ~2017, India had no well-specified bankruptcy law. Even today, the bankruptcy law is honored more in the breach as politicians and judges interfere in large bankruptcy proceedings. Thus, it can take more than 4 years to close a firm in India, if all goes well, and much longer if there are intervening factors. As a result, India has a very high percentage of “dormant firms,” firms–often with employees–but zero output.
In No Country for Dying Firms: Evidence from India, Chatterjee, Krishna, Padmakumar, and Zhao use firm‐level data and a structural model to estimate various exit costs and their effects. Their findings: exit barriers reduce entry, investment, and aggregate productivity.
Three points stand out. First, a simple but often overlooked point. Exit costs trap resources in unproductive firms, depriving more efficient firms of the inputs they need to grow. Second, governments typically focus on entry—offering tax breaks, land, and subsidies to attract firms—because ribbon-cutting is politically rewarding. But the author’s models suggest it’s more effective to subsidize exit. Picking winners is hard; picking losers is easier. Of course, direct subsidies for exit are unlikely and unwise but reforms like streamlined bankruptcy, faster courts, and lower firing costs achieve the same goal and the losers self-select.
Third, the authors argue that improving bankruptcy law—more broadly, reducing the cost of capital reallocation—should take time-priority over reducing firing costs. Capital reallocation raises employment by moving resources to more productive firms. Once that groundwork is laid, labor law reform is more likely to succeed and endure politically.
Thus, unusually, these economists offer not just policy prescriptions but politically savvy guidance on sequencing reform.
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