Labor Protection, Tax Planning, and Capital Investment: Evidence from Small-Sized Enterprises

Abstract

This paper examines the effect of labor protection laws on tax planning and capital investment. Exploiting a major reform that introduced firing costs in Italy for firms with fewer than 15 employees but left firing costs unchanged for larger firms combined with matched employer-employee data, I show that the rise in firing costs led small firms to increase tax avoidance and capital investment relative to larger firms. Robustness and placebo tests suggest that the results are causal. Overall, the findings indicate that tax avoidance allows small firms to generate internal funds to substitute labor for capital when employment protection becomes stronger.

Keywords: labor protection, tax planning, tax avoidance, capital investment, small firms