Does labour market flexibility matter for investment? A study of manufacturing in the OECD

This study examines whether a more flexible labour market – defined here in terms of the strictness of labour regulations regarding the flexibility of employers to adjust levels of employment in response to changing economic conditions – helps to promote a higher level of fixed capital formation in an economy. Theory generates ambiguous predictions concerning the sign of the relationship between investment and the labour market regulation regarding hiring and firing workers, although a positive relationship may be expected. Using an index of labour market regulation compiled from surveys of business executives in 19 Organization for Economic Co-operation and Development (OECD) economies, an econometric analysis is carried out to examine the effects of labour market flexibility on the level of investment in the manufacturing sector. The findings support the proposition that freeing-up regulatory constraints on employers' use of labour helps to create a more favourable environment for investment.