The Cross-Section of Labor Leverage and Equity Returns

Donangelo, Andres; Gourio, François; Kehrig, Matthias; Palacios, Miguel

Working Paper

The Cross-Section of Labor Leverage and Equity Returns

Abstract: Using a standard production model, we demonstrate theoretically that, even if labor is fully flexible, it generates a form of operating leverage if (a) wages are smoother than productivity and (b) the capital-labor elasticity of substitution is strictly less than one. Our model supports using labor share?the ratio of labor expenses to value added?as a proxy for labor leverage. We show evidence for conditions (a) and (b), and we demonstrate the economic significance of labor leverage: High labor-share firms have operating profits that are more sensitive to shocks, and they have higher expected asset returns.

Keywords: Labor leverage; labor mobility; labor supply; wages; productivity;

JEL Classification: J20; J22; J24; J62;