02 May 2013

By Professor Simon Deakin

Under the government's current proposals for employment law reform, employees will be able to give up rights concerning unfair dismissal, redundancy pay, flexible working and time off for training in return for receiving shares in the company that employs them, gains on which will be exempt from capital gains tax.

It is right for the government to be encouraging worker ownership in companies; there is abundant evidence suggesting this improves labour productivity. What is completely unnecessary and counterproductive is to link this to the loss of employment protection rights.

Since the early 1970s, under laws initially introduced by a Conservative government, an employee with a minimum period of continuous service (currently two years) is protected against unfair dismissal. This means that if their employer wishes to terminate their employment, they must come up with a good reason, in principle, for doing so, such as misconduct, lack of capability or redundancy. The employer must also show that it has complied with certain procedures, including allowing the employee to put their case in a formal hearing. These laws do not confer a job for life and in no way permit "featherbedding". On the contrary, they give employers ample scope to incentivise and motivate employees. Nor do they prevent firms making workers redundant when there is a downturn in business. Their aim is to ensure that the workplace operates according to certain basic principles of fairness, which most of us could subscribe to: decisions on a matter as important as employment should not be made in an arbitrary fashion.

Although fairness is the main goal of these laws, they also have economic effects. They encourage workers to make a more serious commitment to the firm and to invest their time, effort and loyalty in it. Second, they provide firms with a strong incentive to treat the skills of their workers as a resource to be developed, rather than an asset to be disposed of at will. Employment protection laws encourage a virtuous cycle of investment in the knowledge and processes that are increasingly recognised as essential to economic success, particularly in high-technology sectors.

One of the government's aims in bringing forward this proposal is to encourage the kind of high-tech start ups associated with Silicon Valley in California. Silicon Valley is often said to have a "high velocity" labour market, in which employees move around from one firm to another, thereby promoting the circulation of knowledge. Employers, on the other hand, benefit from the flexibility that goes with having a skilled and mobile workforce. It is often assumed that the right of firms to hire and fire "at will" is critical to this type of flexibility. There is a major problem with this assumption, which is that it is simply not borne out by the facts.

The Californian law on dismissal is actually at the stricter end of the spectrum of US laws on employment. The principle that an employer can dismiss at will – that is, without good cause and on minimal, if any notice – has been qualified by the Californian courts, which require employers to demonstrate that they have acted in good faith when terminating a worker's employment. This principle is not so far removed from the notions of fairness that underpin British unfair dismissal law. The scope of the exceptions to employment at will have waxed and waned over the years, and it is possible to analyse the consequences of this for productivity and innovation. We know from econometric research that there is a correlation between tighter dismissal laws and innovation in California, as measured by increased number of patents and citations to patents. Not just that; as the law imposed constraints on the employer's power to dismiss, the number of small-firm start ups went up, as did the numbers employed in high-tech firms.

British dismissal law, like Californian, has varied over time, creating a similar "natural experiment" for research. The identical effect is also observed: stronger employment laws are correlated with innovation as measured by patents and citations to patents.

The intuition here is clear, and it is backed up by empirical research: when the law limits the right to dismiss, it enhances the confidence of workers that their efforts and knowledge will not be expropriated by the employer. The law can help to create an environment in which firms and workers make mutual investments in new technologies and processes, to the benefit of both sides.

Employment law plays another critical role in supporting technology-based innovation in US firms. In California, so-called "restrictive covenants" that prevent an employee resigning to set up his or her own firm or to work for a competitor are void. Californian courts refuse to enforce such clauses, on the grounds that they are a fetter on competition. This, rather than flexible dismissal laws, is the source of the much-vaunted "high-velocity labour market" of Silicon Valley. How does the UK compare? Under English contract law, contrary to the Californian practice, restrictive covenants are enforced by the courts almost as a matter of routine. We know this matters. When the state of Michigan changed its employment laws to make restrictive covenants enforceable, it saw a decrease in employee mobility.

So if the British government wants to do something to encourage innovation through employment law reform, there are two things it could do. The first would be to strengthen laws that promote fairness in the workplace. The second would be to take a closer look at judicial enforcement of restrictive covenants. There is clear evidence that these contract clauses restrict employee mobility and depress innovation.

Compared with these changes, which empirical evidence suggest would have a tangible effect, the proposed reforms are at best an irrelevance. At worst, they will set back innovation in British high-tech firms.

Originally published in the Financial Times

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