Threshold effects and firm size: The case of firing costs

We study the role of employment protection legislation (EPL) in determining firm size distribution. In many countries the provisions of EPL are more stringent for firms above certain size thresholds. We construct a simple model that shows that the smooth relation between size and growth probability is broken in proximity of the thresholds at which EPL applies differentially. We use a comprehensive longitudinal dataset of all Italian firms, a country with an important threshold at 15 employees, to estimate the effects of EPL in terms of discouraging small firms from growing. We find that the probability of growing of firms in the proximity of the threshold is reduced by around 2%. We then construct a stochastic transition matrix for firm size that, together with the estimates, allows for a quantitative evaluation of the effects of EPL in the long run. Our results show that EPL does influence firm size distribution, but that its effects are quantitatively modest: average firm size would increase by less than 1% when removing the threshold effect. Our results suggest that EPL is unlikely to be a major determinant of cross-country differences in firm size.