Committing to Grow: Employment Targets and Firm Dynamics

We study the firm-level and aggregate effects of government-imposed employment targets. We develop a dynamic general equilibrium model with heterogeneous firms and endogenous productivity growth in which penalties for below-target hiring generate a polarization mechanism: low-productivity firms exit, while others expand employment beyond efficient levels, and firms invest in productivity to avoid future penalties. We test and confirm the model’s firm level predictions using unique contractual data on more than 18,000 employment commitments from the East German privatization, exploiting quasi-random variation in the assignment of privatizers to firms. Quantitatively, employment targets reduce unemployment and raise welfare in the short run, but these effects fade as distorted labor allocations and weakened investment incentives slow aggregate productivity growth, leaving no lasting welfare gains. We also evaluate how alternative designs for employment-protection (e.g., the choice between mandates and subsidies, the structure of targets) impact misallocation and the resulting short- and long-run outcomes.