The effects of employment protection legislation and financial market imperfections on investment: evidence from a firm-level panel of EU countries

Exploiting information from a panel of European firms we study the joint effect of EPL and financial market imperfections on investment, capital-labour substitution, labour productivity and job reallocation. We find that EPL reduces investment per worker, capital per worker and value added per worker in high reallocation sectors relative to low reallocation sectors, while increasing the average frequency at which firms adjust their capital stock. The reduction in capital per worker and value added per worker is less pronounced in financially sound firms. Also, the propensity to invest appears to increase only in firms that are likely to be financially unconstrained. Overall, poor access to credit markets seems to exacerbate the negative effects of EPL on capital deepening and productivity.