Working Paper - Restructuring Costs and Innovation

Executive Summary

The relationship between the “cost of failure” and innovation has been receiving increasing attention in debates on competitiveness, technological dynamism, and Europe’s stagnant productivity.

Experimentation in technologically advanced sectors requires firms to frequently reorganize their workforce, terminate unsuccessful projects, and rapidly reallocate resources toward new activities. The argument underlying the cost-of-failure view is that European companies face heavy financial and legal penalties when they fail, increasing the cost of experimentation and thereby penalizing high-risk, high-reward projects.

A large academic literature has explored the relationship between market rigidities and innovation, productivity, and growth. Yet it remains difficult to identify the specific sources of these rigidities and assess their relative importance. This is an important gap, because effective policy design requires knowing not only whether the cost of failure matters, but also which frictions drive it, how large they are, and which firms and activities they affect most.

The main difficulty is that most existing empirical studies rely on aggregate indicators. As a result, correlations between innovation outcomes and proxies of restructuring costs may reflect other factors that are correlated with both. For instance, a widely used proxy is country-level indices of employment protection legislation (EPL). A negative correlation between EPL and innovation might lead policymakers to conclude that relaxing dismissal regulation would boost innovation in Europe.

Yet country-level EPL indices capture broad regulatory environments rather than the concrete constraints firms face when they restructure. Strict EPL may coexist with weaker business dynamism, more burdensome procedures for starting or scaling a firm, lower institutional quality, or broader differences in product, financial, and labor market regulation that are unrelated to dismissal rules.

Nor is there an a priori reason to assume that EPL is the only driver of restructuring costs or the key barrier to innovation. Instead, systematic evidence suggests that rule of law, corruption, government effectiveness, and the administrative burden placed on entrepreneurs when starting a business are at least as important for the development of high-tech sectors as dismissal regulation.

Moreover, parts of the literature—notably studies relying on more granular measures of dismissal regulation or more refined identification strategies—do not support the view that relaxing EPL would necessarily boost innovation in Europe.

Taken together, this evidence suggests that examining the cost-of-failure hypothesis requires more granular measures of the drivers of the cost of failure, and of restructuring costs in particular.

This paper makes a first step toward addressing this issue by introducing direct firm-level evidence on restructuring costs and innovation barriers through a new pilot survey conducted across four countries representing different labor market regimes: the United States, Denmark, Germany, and Italy.

The survey collects information on firms’ restructuring episodes, asking directly to quantify their economic value, decompose it into mandatory dismissal costs, voluntary employee-related expenditures, and non-employee restructuring expenses, as well as indicating the number of dismissed workers. Using the survey data, we express restructuring costs in monthly salary equivalents.

Compared with existing firm-level estimates, we find labor dismissal costs that are lower by roughly an order of magnitude, especially in countries with stricter EPL.

Monthly salary equivalents calculated from our survey become comparable to existing estimates only when we consider total restructuring costs, rather than employee-related costs alone, and also restrict the sample to restructuring plans in the top quartile of the restructuring cost distribution.

This pattern suggests that the existing estimates may not capture the typical cost of labor dismissal. Rather, they are likely to be more representative of the cumulative cost of large publicly listed firms and of unusually costly restructuring plans.

We also ask firms to rank the main barriers slowing their innovation activities. On average, fewer than 15% of firms in the sample identify restructuring costs as the dominant obstacle to innovation. Economic uncertainty, capital availability, and regulatory barriers unrelated to restructuring costs appear at least as important.

Among high-tech firms, the share identifying restructuring costs as the main barrier to innovation is almost three times larger than among other firms in traditional sectors. Yet we find no systematic differences across countries with different EPL regimes. Thus, while our evidence is consistent with the intuitive view that restructuring costs are an obstacle to radical innovation because of its high probability of failure, it also casts doubt on both the magnitude of these costs and the extent to which they are mainly driven by EPL.

To be clear, we do not deny that a high cost of failure in Europe can be a constraint on innovation. At the same time, our findings suggest caution toward the view that simply loosening dismissal regulation can solve or majorly ease the EU innovation problem.

The findings presented here are based on a sample of only 200 observations. While the small sample size prevents meaningful statistical inference, the results of our survey suggest that the relationship between restructuring costs—employment dismissal regulation in particular—and innovation decisions is neither as clear-cut nor as quantitatively significant as some narratives imply.

On the contrary, they underline the need for a larger representative survey to generate robust evidence on this important issue. Until such evidence is available, policymakers should proceed with caution and avoid pursuing labor-market reforms that impose clear costs on workers in exchange for uncertain innovation benefits.

IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.

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