Policy Distortions and Aggregate Productivity with Endogenous Establishment-Level Productivity

What accounts for income per capita and total factor productivity (TFP) differences across countries? We study resource misallocation across heterogeneous production units in a general equilibrium model where establishment productivity and size are affected by policy distortions. We solve the model in closed form and show that the effect of policy distortions on aggregate productivity is substantially magnified when the distribution of (relative) establishment sizes is constant across economies as supported by some empirical evidence. In this case, more distorted economies feature higher establishment lifespan, amplifying the negative effect of distortions on establishment productivity growth. Policy distortions in this environment substantially reduce aggregate productivity, an effect that is 2.8-fold larger than the model with unrestricted relative size distribution.