Do Countries Matter More in Determining the Relationship Between Employee Welfare and Financial Performance?

• Author: Chandrasekhar Krishnamurti,Kartick Gupta
• DOI: http://doi.org/10.1111/irfi.12231
• Published date: 01 June 2020
• Date: 01 June 2020

Do Countries Matter More in

Determining the Relationship

Between Employee Welfare and

Financial Performance?

KARTICK GUPTA AND CHANDRASEKHAR KRISHNAMURTI

Centre for Applied Financial Studies, University of South Australia, Adelaide,

South Australia, Australia

ABSTRACT

Extant literature suggests that employee-friendly practices influence corpo-

rate decision-making. Using a bargaining framework, we examine the role of

country-level determinants in influencing employee-friendly practices and

their impact on value creation. Utilizing a comprehensive sample of 25,483

firm-year observations from 56 countries, we find that firms domiciled in

countries with weak employment protection and regulations can potentially

benefit by voluntarily undertaking employee-friendly practices. Also, in

countries with flexible labor market conditions, firm value is enhanced by

undertaking employee-friendly practices. Furthermore, the importance of

employee-friendly practices in value creation is observed strongly in coun-

tries that provide better infrastructure, productivity, and incentives.

JEL Codes: G32; J24; J28

Accepted: 10 August 2018

I. INTRODUCTION

Firms such as Motley Fool, Optera, Carfax, and Alphabet Inc. provide liberal

facilities to their employees to maintain a satisfied workplace.

1

They claim that better treatment of their employees results in lower attri-

tion and higher productivity. Increasingly, firms are undertaking employee-

friendly activities to encourage employees to invest in firm-specific human capi-

tal

2

and to retain and attract human capital. The emerging literature on human

capital finds evidence consistent with the view that employee satisfaction is

positively correlated with stock returns (Edmans 2011). Human capital is

1 Source: http://www.abc.net.au/news/2016-11-30/the-new-way-to-raising-productivity-and-retai

ning/8081060

2 Cambridge dictionary defines human capital as, “employees, and all of the knowledge, skills,

experience, etc. that they have, which makes them valuable to a company or economy.”

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:2, 2020: pp. 415–450

DOI: 10.1111/irfi.12231

considered to be a key driver of a firm’s success and competitiveness (Faleye

and Trahan 2011).

The primary research question of this paper is whether a firm’s employee-

friendly practices have an impact on firm value. Our work is motivated by Zin-

gales (2000) and John et al. (2015) who posit that financial literature has paid

little attention to the relationship between employee-friendly practices and firm

performance. We argue that firm-level incentives to undertake employee-

friendly practices is also influenced by the country-level labor market regula-

tion, flexibility of labor markets, human capital infrastructure, and productivity

incentives. It is not clear if investing in employee satisfaction is always value

increasing for the firm. If it were so, then all firms would make this investment.

Organizational capital—defined as intangible capital that is embedded in key

talent—is movable across firms (Eisfeldt and Papanikolau 2013). When key tal-

ent has the option to move, firms have incentives to retain them through better

workplace treatment. The marketability of key talent may vary across countries,

making a case for cross-country examination.

This study extends the literature in several new directions. First, we extend

the work of Edmans (2011) and Edmans et al. (2014) which examine the rela-

tionship between employee satisfaction and abnormal stock returns using a

sample of US firms and an international sample composed of firms in 14 coun-

tries. They find that employee satisfaction is associated with positive abnormal

returns in countries with high market flexibility but not in those where it is

low. We extend prior work by examining a more comprehensive set of coun-

tries (56) and therefore contribute to the growing literature by documenting

the effect of country-level determinants on the impact of a firm’s employee-

friendly practices on its financial performance. A further distinction is that we

use Tobin’s Q as a proxy of financial performance, while Edmans (2011) and

Edmans et al. (2014) use abnormal stock returns. We construct our own firm-

level employee-friendly measure using individual employee practices and label

it as Employee Treatment Index (ETI). Our results indicate that undertaking

employee-friendly practices contributes positively to the firm’s value creation,

measured by Tobin’sQ.

Second, we use the bargaining framework to study the impact of country-

level employee protection on the relationship between employee treatment

and firm-level financial performance. Prior work such as Dasgupta and Sen-

gupta (1993) and Matsa (2010) have used a bargaining framework to explain a

firm’s capital structure decision in the context of bargaining with employees.

Simintzi et al. (2014) uses a cross-country setting to study the impact of

country-level labor market bargaining power on firm-level leverage. We extend

these studies by studying the association between employee treatment and

firm-level value creation. We argue that the level of employee treatment

depends on the bargaining power of labor. We categorize the bargaining power

of labor into two types. The first type which we label as “hard”bargaining

power arises when labor is protected by regulations and institutional support

from trade unions. Saint-Paul (2002) suggests that employees have a strong

© 2018 International Review of Finance Ltd. 2018416

International Review of Finance

bargaining power in countries that provide strong labor protection. In addition

to hard bargaining power, a second type of bargaining power which we label as

“soft”bargaining power may also be a significant determinant of employee

treatment. In flexible labor markets, soft bargaining power is created by the

threat of workers, especially those with a high degree of skills, leaving the firm.

Summing up, better treatment of employees by firms will likely result in

three possible outcomes. First, there will be no improvement in productivity

when the labor has hard bargaining power. The impact on firm value will be

negative since it will take real resources to improve employee treatment. The

second possibility is that employee treatment leads to better productivity, but

employees capture all the gains with none left for shareholders. Finally, there

may be situations in which employee treatment results in improved productiv-

ity and employees and shareholders share the gains from improvement. In this

situation, the value of the firm will increase, resulting in an increase in

Tobin’sQ.

3

When there is hard bargaining, the first or second situation is most

likely, resulting in no increase in firm value. When the third situation occurs—

which is most likely when labor has soft bargaining power, firm value and

therefore Tobin’s Q are likely to increase. We assume that increases in firm

value, arising from improvements in productivity, are captured entirely by

shareholders.

4

Third, we examine the role of three different aspects of country-level deter-

minants. The first aspect is related to a set of country-level regulations and pro-

tections, while the second set of country-level determinants reflects the

flexibility of labor market conditions. The last set of determinants relates to

country-level productivity and incentives. We posit that country-level “soft”

infrastructure is an integral part of the environment that sustains the soft bar-

gaining power of labor.

Fourth, we extend the literature by retesting prior findings in a new setting

using new data following the suggestion of Karolyi (2016), who finds that the

majority of the studies are biased toward the US market and advocates that it is

important to explore other markets where many of the previously documented

results may not be applicable. We take his call and address two issues: whether

unobservable country-level factors are driving the result; and whether the prior

results are robust to alternative modeling specifications or data sources. Finally, we

construct an alternate measure of employee treatment from the Asset4 database to

conduct our studies. Chatterji et al. (2014) note that Asset4 employee indicators

aremuchmorecomprehensivethanKinder, Lydenberg, Domini Research & Ana-

lytics (KLD), as the former has many more indicators of employee treatment.

We derive a set of testable hypotheses using the bargaining framework. If

labor is better protected, then they may have higher bargaining power relative

to managers and shareholders. Managers, then, will not be able to extract

3 Following prior literature, we use Tobin’s Q as a proxy of firm value changes.

4 We ignore any improvements in debt value due to lower risk arising from better treatment of

labor.

© 2018 International Review of Finance Ltd. 2018 417

Employee Welfare and Financial Performance