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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 studyif the 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 perworker in high reallocation sectors relative to low reallocation sectors. The reduction in thecapital-labour ratio is less pronounced in firms with higher internal resources, suggestingthat financial constraints exacerbate the negative effects of EPL on capital deepening.

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