Using a country-industry panel dataset (EUKLEMS) we uncover a robust empirical regularity,namely that high-risk innovative sectors are relatively smaller in countries with strictemployment protection legislation (EPL). To understand the mechanism, we develop a twosectormatching model where firms endogenously choose between a safe technology withknown productivity and a risky technology with productivity subject to sizeable shocks. StrictEPL makes the risky technology relatively less attractive because it is more costly to shedworkers upon receiving a low productivity draw. We calibrate the model using a variety ofaggregate, industry and micro-level data sources. We then simulate the model to reflect boththe observed differences across countries in EPL and the observed increase since the mid-1990s in the variance of firm performance associated with the adoption of information andcommunication technology. The simulations produce a differential response to the arrival ofrisky technology between low- and high-EPL countries that coincides with the findings in thedata. The described mechanism can explain a considerable portion of the slowdown inproductivity in the EU relative to the US since 1995....
