Aggregate effects of firing costs with endogenous firm productivity growth

This article quantifies the aggregate effects of firing costs in a model of firm dynamics where firm-level productivity is determined by innovation. In the model, the productivity distribution is endogenous, and thus, potentially affected by policy changes, allowing the model to capture both the static (allocative efficiency) and dynamic effects (changes in the distribution of firms’ productivity) of firing costs. The model is calibrated to match key features of firms’ hiring and firing behavior using firm-level data from Spanish nonfinancial firms. I show that firing costs equivalent to 2.5 monthly wages produce a 4% loss in aggregate productivity relative to the frictionless economy. The aggregate productivity losses rise to more than 10% when firing costs are equivalent to 1 year’s wage. I show that a model with a standard AR(1) productivity process can only generate between 45 and 50% of these losses. Overall, the results suggest that ignoring the effects of frictions on the dynamics of firms’ productivity can substantially underestimate their effects.