Do levy penalties boost disability hiring in SMEs? Evidence from a Japanese quota reform

• We study the effects of a levy-grant system for disability employment among SMEs. • A natural experiment of a recent policy change in Japan is conducted. • The policy change encourages SMEs to employ people with disabilities. • There is industry heterogeneity in the policy’s effects. Financial incentives can shape firms’ compliance with employment quotas, yet their effectiveness remains contested. This study examines whether Japan’s levy-grant system for disability employment promotes hiring in small and medium-sized enterprises. Using administrative data on statutory quota compliance, we exploit a 2015 reform—lowering the coverage threshold from firms with more than 200 to more than 100 employees—as a natural experiment. Difference-in-differences estimates, supplemented by regression discontinuity analysis, reveal heterogeneous effects by pre-reform compliance status. Firms already meeting the quota expanded disability employment in anticipation of the reform, thereby avoiding future levies, while non-compliant firms increased hiring only after coverage took effect. Near the 100-employee threshold, the policy raised the number of employees with disabilities by 0.2–0.3 persons, the employment rate by 0.2–0.3 percentage points, and the probability of employing at least one person with a disability by 12–15 percentage points. Effects weakened after about seven years, and no evidence was found that grants induced further hiring among compliant firms. Sectoral estimates show larger effects in manufacturing, consistent with accumulated know-how that lowers adaptation costs. These results suggest that levy penalties, rather than grants, drive early employment gains, particularly among firms previously out of compliance.