We study the role of employment protection legislation (EPL) in explaining the relative small average size of Italian firms. We construct a simple model that shows that the smooth relation between size and growth probability is disturbed in proximity of the thresholds at which EPL applies differentially. We use a comprehensive dataset of all Italian firms between 1986 and 1998 to estimate the effects of EPL in terms of discouraging small firms from growing. We then construct a stochastic

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... ion matrix for firm size that, together with the estimates, allows for a quantitative evaluation of the effects of EPL in the long run. Our results show that EPL does influence firm size distribution, but that its effects are quantitatively modest: average firm size would increase by less than 1% when removing the threshold effect. In terms of policy, these findings suggest that changes in EPL are not likely to have a large impact on the propensity of small firms to grow JEL classification numbers: J65, D21, L11 seminar participants at the Bank of Italy and participants at the Research Conference on Microeconomic Analysis of Labor Reallocation (Kalamazoo, Michigan, August 2003) for useful comments and suggestions. We also thanks the Italian Social Security Service (INPS) for supplying us with their firm-level data. We are responsible for any mistake. The views expressed here are our own and do not necessarily reflect those