By increasing operating leverage, employment protection reduces the ability of financially constrained firms to perform R&D projects. Using the adoption of wrongful-discharge protections by state courts across the U.S. as a source of exogenous variation in the cost of adjusting labor downwards, we show that it increases operating leverage of R&D performing firms. When these firms are financially constrained, the court decisions reduce R&D investment and amplify the procyclicality of R&D investment. Capital expenditures, however, are not affected regardless of the level of financial constraints. To show that wrongful discharge laws impact investment decisions by increasing operating leverage, we construct an industry layoff elasticity measure as a proxy for the exposure to the shock, and compare operating leverage and investment responses of the firms with different levels of exposure. Last, we show that high R&D firms hoard cash by issuing more equities in response to the court decisions.

Keywords: R&D investment, employment protection, financial constraints, liquidity management​