Population growth, employment protection, and firm-level distortions

Declining population growth and firm-level input distortions are important real-world phenomena. In this paper, we develop a firm dynamics model to study how firing costs induce input distortions through the lens of growth of working-age population. We find that the negative impact of firing costs on aggregate productivity and output is amplified when the growth rate of working-age population declines. This is because slower growth of labor supply leads to fewer entering firms and more incumbents, which are more affected by firing costs. Using Japanese establishment-level data, we calibrate the model and conduct counterfactual analyses, showing that a decline in population growth has a quantitatively significant impact on firm entry and firm-level input distortions. Finally, we provide evidence using Japanese establishment-level census data to support the model’s key predictions.