Unleashing Innovation and Entrepreneurship: Ripple effects of employment protection reforms

This study investigates the effects of employment protection legislation (EPL) on entrepreneurship, firm dynamics, and economic growth in a general equilibrium model that incorporates endogenous Schumpeterian growth. The model implies that more stringent EPL encourages households to accumulate more firm-specific human capital, which raises the opportunity cost to start a business. Using Japanese firm- and household-level microdata to calibrate parameter values, the quantitative exercise reveals that EPL reform aimed at its elimination could stimulate entrepreneurship in the household sector, thus boosting economic growth through more creative destruction in the firm sector. A partial equilibrium model that disregards the general equilibrium effects can overestimate or underestimate the policy effects of the EPL reform on entrepreneurship and economic growth. Policies that directly support firm entries or incumbents' research-and-development investment have limited impacts on economic growth as long as stringent EPL exists.