Theory predicts that mandated employment protection may reduce productivity by distorting production choices. We use the adoption of wrongful‐discharge protection by state courts in the US from 1970 to 1999 to evaluate the empirical link between dismissal costs and productivity. Drawing on establishment‐level data from the Census Bureau, our estimates suggest that wrongful‐discharge protection reduces employment flows and firm entry rates. Moreover, plants engage in capital deepening and experience a decline in total factor productivity, indicative of altered production techniques. Evidence of strong contemporaneous growth in employment, however, leads us to view our findings as suggestive but tentative.
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