Labor Market Rigidity and Employment: Firm-level Evidence

Abstract

We examine the effect of labor market rigidity on firms’ employment decisions in OECD countries using a rich firm-level panel dataset covering 164,048 firm-year observations. Exploiting intertemporal variation in country-level employment protection legislation (EPL), we document a trade-off. While stricter EPL reduces the output sensitivity of firms’ employment, it simultaneously lowers firms’ overall employment levels. Moreover, our evidence indicates that firms respond to increases in EPL by substituting labor with additional investment in net assets, particularly in labor-intensive industries. Overall, our findings suggest that the level of EPL materially affects firm behavior and that governments should carefully consider the associated trade-offs when designing labor market policies.