Firing the Wrong Workers: Financing Constraints and Labor Misallocation

This paper studies the effect of financing constraints on firms’ firing decisions. When firing a worker, firms consider wages, current and expected productivity as well as firing and hiring costs. Financing constraints may distort this inter-temporal trade-off leading to suboptimal firing decisions. Using matched employer-employee from the Swedish population between 1990 and 2010, we show that financially constrained firms fire the wrong type of workers, such as workers with steeper productivity profiles or lower firing costs, relative to unconstrained firms. Our study reveals a new misallocation effect of financial frictions that operates within firms across different types of workers. Our empirical setup allows us to estimate differential effects for different types of workers within a firm-year. Moreover, we propose a RDD identifying financing constraints as well as the use of shocks to employment based on exchange rate shocks to trade.