Labor Supply and Firm Capital Structure

We exploit the setting of China’s land titling program that released labor from farm activities as a quasi-natural experiment to examine how private and publicly traded firms respond to an abrupt increase in labor supply. We find that, while private firms reduce their leverage after the reform, public firms increase theirs. The difference between public and private firms is driven by the interplay between labor market frictions and financial flexibility in capital structure decisions. The entitlement of property rights stimulates labor supply, reducing labor costs and alleviating labor market friction. This, in turn, can reduce firms’ indirect costs of financial distress and increase their leverage. However, firms also choose to lower their leverage to maintain financial flexibility and attract workers in the local labor market. The former effect is more pronounced in public firms, while the latter effect is more prominent in private firms.