Using a country-industry panel dataset (EUKLEMS), we find that in
countries with strict employment protection legislation (EPL) or other
indicators of high exit costs, high-risk innovative sectors have
relatively low employment shares. We develop a two-sector model with a
risky sector subject to sizeable productivity shocks and a safe sector
with stable productivity. Absent exit costs, the risky sector is
relatively attractive because the option to shed workers or exit bounds
the downward risk. EPL makes exit more costly and therefore reduces the
attractiveness of the risky sector. Exit costs have similar effects. A
calibrated version of the model produces the same relationship between
risk and sector size found in the data. We find that the described
mechanism is a good candidate for explaining a considerable portion of
the slowdown in productivity in the EU relative to the US since 1995.