The impact of regulation on innovation

We present a framework that can be used to assess the equilibrium impact of regulation on endogenous innovation with heterogeneous firms. We implement this model using French firm-level panel data where there is a sharp increase in the burden of labor regulations on companies with 50 or more employees. Consistent with the model's qualitative predictions, we find a sharp fall in the fraction of innovating firms just to the left of the regulatory threshold. Furthermore, we find a sharp reduction in the positive innovation response of firms to exogenous demand shocks just below the regulatory threshold. Using the structure of our model we quantitatively estimate parameters and find that the regulation reduces aggregate equilibrium innovation (and growth) by 5.8% which translates into a consumption equivalent welfare loss of at least 2.3%, approximately doubling the static losses in the existing literature.