Unintended Benefits: How Employment Protection Increases Households’ Stock Market Participation

Tens of thousands of people may face a bleak situation since the wave of tech layoffs is continuing in 2023, with over 25,000 people being laid off by Amazon and Microsoft earlier this year. As a sudden change in one’s life, being laid off may affect not only people’s daily expenses but also their financial risk-taking behaviours, such as the willingness to purchase stocks.

Most U.S. states have adopted “Wrongful Discharge Laws” (WDLs) since the 1970s, which aim to protect employees from unfair layoffs. Many studies have documented the negative influences of WDLs on firms, such as a decrease in profitability and investment rates. However, little is known about the benefits of these laws on households besides some apparent employment protections like reducing layoffs.

“From a societal level, employment protection laws are really good for reducing wealth inequality because they make poor people invest more, as those vulnerable people will be less concerned about being laid off.”

Prof. Chanik Jo

“It is not surprising that most of the documented effects of the employment protection laws are negative, especially for firms as the laws restrict their freedom to dismiss their workers,” says Chanik Jo, Assistant Professor at the Department of Finance at The Chinese University of Hong Kong (CUHK) Business School, adding that he would like to explore more about the positive sides about those laws.

Can employment protection laws reduce people’s labour income risks? If so, can this lead to changes in their investment portfolio decisions? These are some of the questions that Prof. Jo sought to address in a new study titled Unintended Benefits of Employment Protection: Households’ Stock Market Participation.

Decreased Layoffs and Income Risks

To examine how the adoption of WDLs affects households’ financial risk-taking behaviours, Prof. Jo collected detailed data on household demographics and asset information from the Survey of Income and Program Participation (A survey conducted by the U.S. Census Bureau). He then compared the behaviours of households living in states that do and do not adopt the WDLs. While there are three categories of these employment protection laws, this study mainly focuses on the adoption of the good faith exception, which applies in situations when an employer dismisses a worker in retaliation, bad faith, or with malice and it is known to have a significant impact on labour firing costs.

“Previous research found the adoption of WDLs resulted in a significant decrease in employment, which could imply that companies would decrease layoffs to maintain a certain level of labour input,” says Prof. Jo, adding that his research provides empirical evidence for this conjecture. According to the results, the sample mean of layoffs is around 2.05 percent one year before the adoption of the good faith exception; however, the adoption of the new law leads to a 1.1 percent points decline in layoffs, implying a decrease by 53.7 percent relative to the mean.

Since the WDLs can reduce layoffs, is it possible for the adoption to lower the labour income risks? “My findings imply that the adoption of the good faith exception has a significant real effect in reducing left-tail income risk both economically and statistically,” Prof. Jo says, adding that households would expect reduced left-tail income risk after the adoption.

Increased Stock Market Participation

Given the documented negative relationship between labour income risk and the allocation to risky assets, this research hypothesises that the decrease in perceived income risk could induce households to allocate more money to risky investments.

As expected, the results confirmed that employment protection increases the level of stock market participation on both intensive and extensive margins. Prof. Jo explains that the intensive margin refers to a stockholder increasing their holdings; in contrast, extensive margin refers to a non-stockholder becoming a stockholder.

More specifically, the results show a significant 16 to 18.8 percent increase in the share of risky assets in financial wealth for households in states adopting the good faith exception. On the other hand, the adoption also positively affects households’ decision to participate in the stock market, increasing the probability of participation by 13 to 15.5 percent.

But why is stock market participation important for households? The study argued that this was because this risk-taking behaviour played a crucial role in long-term wealth accumulation and welfare gain. The researcher kept track of the prices of stocks that households purchased following the adoption, to examine whether implementing the good faith exception leads households to take more risks and fosters their wealth accumulation. According to the results, the increased risk-taking behaviours of households are beneficial, “It is well known that the stock market participation is crucial for wealth accumulation, because people can have an extra source of income if you invest in stocks,” he says.

Protecting Vulnerable Groups

The research also found that the effects of increasing stock market participation from the employment protection laws are more potent for young, low-income, low-wealth, and less-educated households, as they are more likely to be concerned about their employment status. Meanwhile, the opposite financial risk-taking behaviours are observed when the laws are reversed. Prof. Jo adds that the protection laws won’t affect wealthy people because they are not really worried about losing their jobs. “From a societal level, these laws are really good for reducing wealth inequality because they make poor people invest more, as those vulnerable people will be less concerned about being laid off,” he says.

As employment protection laws can potentially benefit households through stock market participation, Prof. Jo notes that policymakers should thus take this into account when they make decisions on employment protection. “Although most of the existing studies document the negative effects of employment protection laws on firms and investors, there are some bright sides,” he says, adding that this research provides a new perspective and sheds light on something people may not know.

Finally, Prof. Jo notes that the evidence in this study is indirect, and he is trying to collect some direct data which can further support his research findings. Moreover, he says the results of this study can also be a reference for other countries even though it was conducted in the U.S.  “Although it is challenging to measure the stock market participation of multiple countries in a consistent way, one could extend my analysis to the international setting using country-level employment protection reform.”