Employment protection laws blamed for Europe’s lack of innovation

Europe’s strict employment protection rules may be holding back innovation, according to Marc Lemaître, head of the European Commission directorate for research and innovation. 

“The question is whether, in Europe, we have enough creative destruction,” Lemaître told an event jointly organised by the Commission and the OECD on November 17. He was referring to the theory that growth occurs when newer, more innovative technologies and business models oust older practices. 

“Lately, some people have pointed to the difficulty that Europe has in reallocating resources because of our employment protection laws that put the cost of restructuring at an extremely high level,” he went on. This high cost “might also be part of the explanation why Europe is shying away from disruptive innovation compared to other parts of the world.”

This theme was picked up two days later by Pascal Lamy, former director general of the World Trade Organisation and chair of the high-level panel that advised the Commission on the current Horizon Europe programme. Speaking at the European Business Summit on November 19, he pointed to the high costs of restructuring in case of failure as a barrier to disruptive innovation.

He cited recent research from Bocconi University that suggests employment protection laws are a “first order determinant” of disruptive innovation and explain a major part of the technology gap between the US and Europe.

Researchers Yann Coatanlem and Oliver Coste found average restructuring costs in the US to be equivalent to seven months of salary per employee, compared with 31 months in Germany, 38 months in France and 52 months in Italy. Switzerland and Denmark emerged as European outliers, at 2.5 and 3.3 months respectively.

Focusing on the tech and biotech sectors, the authors found a strong negative correlation between restructuring costs and business R&D intensity.

“These numbers tell us why we have much less appetite for jumping into the unknown,” Lamy said. He suggested this could be addressed in the Commission’s upcoming proposal to simplify company creation across the EU, known as the 28th regime.

The Bocconi researchers recommend that other European countries adopt the Danish “flexicurity” model combining labour market flexibility with strong social protections, including generous unemployment benefits and retraining programmes. 

They suggest reforming employment protection law only for top earners, for instance the top 10%, which they argue would unlock innovation while preserving the European social model. “The employees targeted by large restructuring plans in innovative companies are typically highly qualified, highly paid and rarely unemployed,” they write.

However, the link between employment protection and innovation is not black and white. Previous studies have concluded that laws protecting employees against unfair dismissal can spur innovation.

A global issue

Europe is not the only region facing these challenges. Productivity growth has slowed in economies around the world over the past 30 years.

OECD research shows that the defining feature of the slowdown in productivity growth is the widening gap between leading firms and the least productive firms, Jerry Sheehan, the OECD’s director for science, technology and innovation, said during the November 17 event.

“This trend is particularly concerning, because it indicates declining innovation activity and declining levels of technology diffusion among the least productive firms,” he said.

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Several other indicators point to a weakening of creative destruction in more advanced economies, including increased market concentration, and a decline in firm entry rates, the employment share of young firms and employment churn.

“When fewer new firms enter markets, and incumbent firms face less competitive pressures, the diffusion of innovation weakens, resource reallocation slows and productivity gains fail to spread across the wider economy,” Sheehan said.

However, policymakers can take action to strengthen innovation, improve the diffusion of technology and reinforce competition, he said.

Boosting private R&D should be a key priority. The EU spends less than 2.3% of its GDP on R&D, far below its target of 3% and the US at almost 3.5%. This discrepancy primarily reflects lower levels of private spending, as rates of public investment are similar in both regions.

Cohesion still applies

Lemaître also addressed the tension in research policy between funding only excellent projects, wherever they are located, and a desire to achieve geographical balance, ensuring that smaller countries aren’t left behind.

He suggested that these latter goals, reflecting the EU’s broader cohesion policy, remain central to the Commission’s thinking. “Our duty is also to ensure that innovation and opportunity extend beyond a handful of star firms or privileged regions,” he said. Innovation should drive a “stronger, more inclusive and more sustainable economy that benefits all parts of society,” he added.