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Abstract: In this paper I study the effect of employment protection rules on firm productivity using micro data on Swedish firms. A reform of the employment protection rules in 2001 made it possible for small firms to exempt two employees from the last-in-first-out rules. The reform targeted only firms with less than 11 employees, representing a natural experiment. I exploit this using a difference-in-differences framework to estimate the reform's effect on labor productivity. By using firm register data I am able to get a precise estimate of labor productivity for all firms in the economy. The results indicate that the reform increased labor productivity by 2.5 percent for the treatment group of small firms compared to the control group of larger firms. This is shown to be economically significant. The results appear to be driven by the smallest firms and firms that were downsizing. When restricting the sample to include only firms that were downsizing and firms that stayed within the group of treatment and control throughout the whole time period, the estimated increase in labor productivity reaches 6 percent. This effect is likely due to a combination of a decrease in moral hazard behavior and an increased possibility for small firms to retain or lay o personnel based on the worker's idiosyncratic productivity.

Keywords: employment protection; labor market regulations; labor productivity; last-in-first-out rules

JEL-codes: D22; J08; J32; J38; K31; O43

45 pages, First version: March 25, 2013. Revised: October 30, 2013.

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