Evidence shows that Spanish regions differ significantly in their economic performance. Moreover, the process of regional convergence in labour productivity has practically stopped since 1985. If the drivers of productivity (investment, skills, innovation enterprise and competition) worked effectively, regional productivity would catch up. However, when regional market failures exist (in product, capital or labour markets), regional differences in performance regarding each of these drivers cannot fully explain regional productivity disparities. Because of the 1984 employment protection reform in Spain, there is evidence that the share of temporary contracts (with low severance pay) surged in the second half of the 1980s – staying above 30% since 1990 – in a clear regional divergence process, thus being far from EU standards (10% – 15%). In this context, the aim of this paper is to investigate the hypothesis that this surge in temporary contracts has a negative impact on regional productivity growth.. The estimations results of the empirical model in the NUTS 2 Spanish regions over the period 1987-2000 show that, in addition to under-investment in physical, human and technological capital, differences in regional economic performance would be explained by the negative effect on productivity of the conversion of permanent contracts into temporary contracts in very segmented regional markets.