Employment Protection Legislation and the Size of Firms

The existing literature ignores the fact that in most European countries the
strictness of Employment Protection Legislation (EPL) varies across the firm size
distribution. In Italy firms are obliged to rehire an unfairly dismissed worker only
if they employ more than 15 employees. Theoretically, the paper solves a
baseline model of EPL with threshold effects, and shows that firms close to the
threshold are characterized by an increase in inaction and by a reluctance to
grow. Empirically, the paper estimates transition probability matrices on firm
level employment using a longitudinal data set based on Italian Social Security
(INPS) records, and finds two results. First, firms close to the 15 employees
threshold experience an increase in persistence of 1.5 percent with respect to a
baseline statistical model. Second, firms with 15 employees are more likely to
move backward than upward. Finally, the paper tests the effect of a 1990 reform
which tightened the regulation on individual dismissal only for small firms. It
finds that the persistence of small firms relative to large firms increased
significantly. Overall, these threshold effects are significant and robust, but
quantitatively small.