Unemployment Risk Affects Corporate Financing Strategy
By Ashwini Agrawal, Assistant Professor of Finance
In particular, managers are reluctant to take on very risky financing strategies if it means that they will have to pay greater wages to compensate labor for working in a less stable company.
The authors argue that workers require greater compensation for jobs that are highly risky, all things considered. That is, workers are more willing to accept lower salaries in exchange for more stable employment prospects. Managers take the relationship between wages and unemployment risk into account when they make financing decisions. In particular, managers are reluctant to take on very risky financing strategies if it means that they will have to pay greater wages to compensate labor for working in a less stable company.
To empirically identify the link between worker unemployment risk and corporate financing decisions, the authors document changes in unemployment insurance (UI) benefit laws across 50 states in the US from 1950 to 2008. A number of prior studies have found that increases in public UI assistance lowers workers’ unemployment costs, and hence reduces the wage burdens faced by firms. The authors find that when managers become less saddled by employee wage demands, firms are more able to shift their capital structures towards risky debt financing, since bankruptcy is less threatening to workers.
More specifically, the authors find that doubling UI benefits causes firms to increase debt-to-asset ratios by at least 4 percent. The effects are particularly large for firms that employ low-wage workers and experience frequent layoffs, such as construction and manufacturing companies. Furthermore, the increases in debt financing yield significant tax savings for firms, due to the tax deductibility of interest payments.