The Effect of Employment Protection Legislation andFinancial Market Imperfections on Investment:Evidence from a Firm-Level Panel of EU Countries

This paper analyzes the joint effect of EPL and financial market imperfections on investment,capital-labour substitution, labour productivity and job reallocation in a cross-countryframework. In the spirit of Rajan and Zingales (1998) and Ciccone and Papaioannou (2006),we exploit variation in the need for reallocation at the sectoral and aggregate level to assessthe average effect of EPL on firms’ policies. Then, exploiting firm-level information we study ifthe effect of EPL is stronger in firms with lower levels of internal resources. We find that, onaverage, EPL reduces investment per worker, capital per worker and value added per workerin high reallocation sectors relative to low reallocation sectors. The reduction in the capitallabourratio is less pronounced in firms with higher internal resources, suggesting thatfinancial constraints exacerbate the negative effects of EPL on capital deepening....