Policy Distortions and Aggregate Productivity with Endogenous Establishment-Level Productivity

What accounts for differences in output per capita and total factor productivity (TFP) across countries? Empirical evidence points to resource misallocation across heterogeneous production units as an important factor. We study misallocation in a general equilibrium model of establishment productivity where the distribution of productivity is characterized in closed form and responds to the same policy distortions that create misallocation. In this framework, policy distortions not only misallocate resources across a given set of productive units (static effect), but also create disincentives for productivity improvement thereby altering the productivity distribution and equilibrium prices (dynamic effect), further lowering aggregate output and TFP. The dynamic effect is substantial contributing to a doubling of the static misallocation effect. Reducing the dispersion in distortions by 25 percentage points to the level of the U.S. benchmark economy implies an increasein relative aggregate output of 123 percent, where 54 percent arises from factor misallocation(static effect).