Recent advances in international trade theory indicate that trade liberalization can have a positive impact on a country’s average productivity as freer trade induces resources to flow from less to more efficient firms. In this paper I argue that labor market regulations obstruct the ability of an economy to allocate resources to more efficient firms, thus limiting the impact of trade liberalization on average productivity. To that end, I first develop a model of heterogeneous firms that incorporates labor regulation. I show that although freer trade raises long-run average productivity, regulation slows down the pace at which the more productive firms (exporters) expand, as well as the pace at which the less productive firms (non-exporters) contract, following trade liberalization. As a result, there is a protracted period in which the economy exhibits lower productivity than the longrun free-trade equilibrium would imply. I then test the predictions of the analytical model against a large firm-level international database. I show that exporting firms grow more than 1.5 percentage points faster in industries where trade is liberalized. Importantly, I also find that exporters grow almost 4 percentage points more rapidly after trade liberalization in countries with less burdensome labor market regulations.