the income level of a country, the greater the likelihood that firms find labor regulations to be an obstacle to their business, other things being equal. This may be due to the fact that more developed countries have more stringent regulations on labor or that enforcement improves with economic development. We go back to this issue below when we introduce formal regulations in the equation.

In the second set of specifications (columns 5 to 8) in Table 3, we also include controls for firm performance: innovation (whether the firm is upgrading its production line or its products) and expansion of employment. Consistently with theory, firms that are innovating are more likely to report that labor regulations are a significant source of constraint. Most of the time, innovation involves the adoption of new technologies that require new skills and labor regulations, by raising the costs of adjusting the workforce, may make it more difficult or costly to do so. The results are not significantly changed when controlling for potential endogeneity of this variable (Table A1 in Annex 3). Not surprisingly, firms that increased the number of full-time staff are found, other things being equal, to be less concerned by labor regulations than others. The perception about labor regulation and the decision to change the workforce are obviously correlated. We use the change in employment to characterize the general performance of the firm (whether it is expanding or downsizing) and, to reduce the obvious endogeneity problem, we use the lagged values of the employment change. Moreover, results in Tables 3 and 4 show that all other coefficients are robust to the inclusion of this variable.

In Table 4 we turn to the effects of formal regulations on employers’ perceptions. We use the same basic controls discussed above and add our EPL indicators in levels and in interactions with firm size and changes in employment. The main result is that even controlling for firm characteristics, income per capita and geographical location of the countries, _de jure_ regulations are consistent with employers’ perceptions: firms facing stricter EPL are less likely than others to report that labor regulations are not an obstacle to their business, and are more likely to report that regulations are a major obstacle to their operation (columns 1, 2, 5, and 6). We should note here that the effect of countries’ income level does not disappear (results not shown in Table 4): firms in countries with higher income level are more likely to report that labor regulations are a constraint, even controlling for the strictness of actual _de jure_ labor regulations.

As stressed above, the link between actual regulations and perceptions of regulations is likely to be influenced by firm’s characteristics and behavior. This is analyzed by allowing the coefficients of EPL to vary depending on firm size (columns 3, 4, 7 and 8). While all firms perceive regulations more constraining in countries with strict EPL, in both the WBES and especially in the ICS data, medium-sized firms are more severely affected (the coefficients on medium-size firms are significantly larger in absolute value than coefficients for small and large firms). This is consistent with the hypothesis of a “forgotten middle” (e.g. Scarpetta _et al._ , 2002; Batra et al., 2003). Small firms are often exempted from certain aspects of labor regulations (Boeri and Jimeno, 2003). In many countries where enforcement of regulations is limited, small firms do not comply, remaining invisible to regulators and inspectors. For large firms, hiring and firing costs 21