"This paper uses data from Spanish manufacturing firms to analyze the effect of a labor market reform on firms' innovation, growth and exporting. The reform provided additional flexibility to firms with less than 50 employees by enabling them to hire workers on a permanent basis with an extended trial period, and thus effectively reducing their firing costs. Exploiting this natural experiment in a difference-in-differences framework, we find that the reform increased the product innovations of the affected firms. We also provide evidence that the reform induced upgrading of product quality and enabled firms to grow faster and to enter new markets. The effects are concentrated in industries where flexible adjustment to unexpected shocks is likely to be important like industries with high R&D intensity and high levels of volatility. Our results suggest that a reduction of employment protection legislation (EPL) increases innovation in firms operating in environments that require high flexibility to produce because the reduction of EPL decreases labor adjustment costs."

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