This paper analyzes a labor market, where firms offer workers incentive contracts and make decisions about irreversible capital investments. The state authority regulates the institutional framework by choosing the level of unemployment benefits and the workers' bargaining power. Our results suggest that unemployment benefits reduce workers' incentives to exert effort, thereby decreasing capital investments by the firm, and thus, output. The workers' bargaining power, in contrast, has ambiguous effects, as it raises the workers' share of the quasi-rent. On that account, it increases effort incentives, but reduces capital investment. We find that overall welfare is maximized by reducing the unemployment benefits and setting a positive bargaining power of labor.