# **1. Introduction**

On paper, many countries have stringent regulations governing the hiring and firing of workers. For instance, there are almost 90 countries in which a firm is required to pay ten weeks or more of salary as severance pay when dismissing an employee for redundancy (World Bank, 2016). Such regulations are the subject of a growing body of research which, like research on other business regulation, is based largely on _de jure_ measures. However, survey data suggest that the enforcement of business regulations in low and middle income countries is often weak and uncertain (Hallward‐Driemeier and Pritchett, 2011). Is this poor enforcement related to weak enforcement capacity, and does it matter to how firms respond to regulations?

The Russian Federation’s labor code provides a good setting for examining this question. Its provisions governing hiring and layoffs are strict by international standards. While the labor code is the same countrywide, there is evidence that government capacity to enforce it varies across the regions of the Federation. For example, the number of labor inspectors per hundred thousand covered employees varies from a minimum of 11 to a maximum of 50 across regions. Similarly, the capacity of courts to handle labor disputes also varies across regions (Gimpelson et al., 2010; Gimpelson and Kapeliushnikov, 2008). In general, regulatory enforcement is weak in Russia; for example, its score in the World Justice Project’s 5 “Effective Regulatory Enforcement Index” is 0.5, while most high income countries have a score near 0.8.

In order to test if enforcement capacity matters to firm behavior, we draw on a fundamental theoretical prediction about the effect of regulations that raise the cost of hiring and firing workers. The prediction is that such rules should reduce employment adjustment in response to shocks, not only decreasing the number of layoffs during upturns, but also dampening hiring in upturns because of direct hiring costs and the potential cost of having to lay off newly‐hired workers in the future (Oi, 1962; Nickell, 1986; Hamermesh, 1993). The enforcement of such rules too matters here because the expected cost of labor adjustment depends on the firm’s assessment of the probability that the law will be enforced.

Our empirical strategy for testing this prediction is the following. We first identify episodes of upturns (surges) and downturns (slumps) in different manufacturing sectors (relative to their trend growth rates) from time series data on industry output. Using a large firm‐level panel data set that includes firms from 79 regions of the Russian Federation, we then test if firms’ employment adjustment during these episodes is smaller in regions with better capacity to enforce labor laws.

As expected, the regression results show that compared to normal years, the annual growth in firm revenue and employment is significantly higher during surges, and lower during slumps. But unlike revenue, the degree to which employment adjusts upwards during upswings and downwards during downswings is significantly smaller in regions with stronger enforcement capacity. This suggests that the extent to which employment protection laws dampen labor adjustment by firms depends on enforcement capacity.

> 5 World Justice Project data can be found at http://data.worldjusticeproject.org/#groups/AUT. The indices are based on surveys of households and experts across countries.

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