Published on Development Impact

What is the empirical evidence for the different arguments for and against government support for firms in developing countries?

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In my recent post on the impact evaluation evidence (or lack thereof) around green technology innovation and adoption for firms in developing countries, I mentioned that it was part of a broader talk I was giving on firm-level support in a webinar organized by the World Bank’s Markets, Competition, and Technology unit (video of the talk for World Bank internal users). I had several requests to summarize some of the main points of the talk into a blogpost, so here goes.

Should governments be directly helping some firms?

In my discussions with operational staff at the World Bank and policymakers in developing countries, I have come across several people who are incredibly skeptical about any form of direct support to firms, or mention of industrial policy. There is perhaps a sense that a lot of the old efforts around industrial policy in Africa and Latin America were not very successful, and concerns about undermining competition, coupled with a few that instead all we need to do is get regulatory and macro policy right, and pursue policies that benefit all firms indirectly (such as financial sector reform) rather than specific firms directly.

There are definitely valid concerns here, so it is worth noting three types of responses.

The first is a theoretical response. As Dani Rodrik has argued,  “the market failures which industrial policies target – in markets for credit, labor, products and knowledge have long been at the core of what development economics study”. In addition to these market failures, externalities arising from pollution and the underpricing of carbon emissions provide further justification for green industrial policy actions. Moreover, governments may wish to support these policies because of the externalities involved in job creation, or, following the strategic management literature, because improving skills and firm capabilities critical for innovation and productivity, and government has direct interest in this for increasing overall economic performance.

Second, the more practical answer is a positive one. Governments are pursuing and are going to pursue these types of policies, and so the key question is then not whether they should be doing them, but how can they do them well. World Bank projects contain many such policy instruments, including business training programs, management improvement programs, matching grants, subsidized loans, incubation and accelerator programs, investment readiness programs, innovation adoption subsidies and credits, and various green technology initiatives. Moreover, it is not just in developing countries that such policies have been used -  Michela Giorcelli has a nice set of papers showing the long-run positive impacts of government support to improving management in SMEs historically in the U.S., Europe, and Japan, the EU spends billions on programs such as smart specialization and state aid, and the recent Inflation Reduction Act in the U.S. has $400 billion in subsidies for solar, wind, electric vehicles and other green activities – leading John Van Reenen to note that industrial policy has gone from being “the policy that should not be named” to being “back in a big way”.

Saying that there are valid reasons why this should be done, and saying it is being done is all well and good, but the question is what evidence do we have on how it is working in practice, and on many of the concerns people may have? Here is my condensed empirical response

Concern 1: Targeting/Additionality

There are two types of concern often raised here. First, the refrain that “governments can’t pick winners”, with the resulting concern that the firms that end up being supported will turn out to be failures. Second, that even if governments end up picking growing firms, they just end up subsidizing them to do what they were going to do anyway, and do not induce new activities (often referred to as a lack of additionality).

What do we see?

It’s true that it is hard to pick winners (as this work on a Nigerian business plan competition shows), but governments typically don’t need to. It can be enough to either i) be able to figure out the losers – that is, it may be easier to know which firms to definitely not support because of no growth prospects; or ii) support firms in stages and have information revealed along the way. Moreover, some failures are desirable – we want firms to be supporting a portfolio of risky activities, in which it is likely that not all will succeed – which is part of the reason the market won’t support them.

In terms of additionality, we do have quite a bit of evidence that there often is additionality – when you have a government program that subsidizes or helps firms to do more of X, they do indeed do more of X. Some examples include:

·       Credit: in a directed lending program in India, targeted firms do expand borrowing and use it to increase production; offering a new loan product in China got firms to borrow more and increase sales.

·       Management consulting: firms provided with management consulting in Colombia use more consulting hours, improve their management practices, and increase employment.

·       Innovation grants for firm-industry collaboration: firms receiving these grants in Poland do more science-industry collaboration on the project they apply under, and increase patenting.

·       Matching grants: Firms in Yemen receiving matching grants for innovation double their rate of product innovation.

Concern 2: Political capture

The concern here is whether governments can withstand lobbying from powerful firms to capture the rents from these policies, and whether politicians will use these instruments to enrich themselves or their families and networks.

This is certainly a concern in many of the countries the World Bank works in. In an attempts to evaluate matching grant programs in six African countries, we did find that political economy or capture reasons were often a proximate cause of low take-up of these programs. This was often tied to red tape and bureaucracy – by making it very complicated for firms to apply and participate in these programs, only connected firms could access the programs. In one country I worked in, the Chamber of Commerce ended up effectively writing the regulations for the program in a way that only its members would be eligible to apply. So making programs simply to apply to and transparent is key – and when programs are oversubscribed, random selection not only provides a way for rigorous evaluation, but also helps provide a guard against political selectivity.

This is where there is a role for a third party organization to help set the rules, monitor, and oversee implementation. In the EU, the European Commission sets rules on the use of state aid that help prevent individual countries and politicians doling them out to their favorites. Having the World Bank or donors like FCDO/DFID hire staff for and oversee a project implementation unit and help write the eligibility conditions for programs can help a lot here.

Concern 3: Impacts on market competition

A first concern here is that helping some firms may just simply lead them to stealing the business of the firms not supported, without growing the overall market.

·       For business training/management consulting/firm innovation programs that help firms figure out how to do something new and innovate, this concern seems less of an issue. For example, in a Kenya business training program implemented with market-level randomizations, I found that women who received training were able to introduce new products and sales in the market as a whole expanded, with untrained women not being hurt. In the Nigeria business plan competition mentioned above, it seems also that the grants helped firms to introduce new products into underdeveloped markets.

·       In contrast, if the policy just increases financing without helping innovation, crowd-out is more likely to occur. In the China loan example mentioned before, almost all of the gains to firms with loans came at the expense of lost sales for firms in the same industries in these markets who did not get loans. Consumers did still benefit.

·       A nice example comes from the market for private education in Pakistan. When only one school in the village received a grant, it increased capacity but not quality. But when all schools got grants and so had to compete with one another, they increase quality – and children’s test scores improve.

The takeaway here is to support innovation and firm growth in underdeveloped markets, but to also try to support many firms so there is competition, rather than just a handful.

The second concern that comes up is whether subsidies for firms to use training or business consulting end up undercutting the market for business service provision. Empirically this may not be the case, because there are a lot of information frictions in the market for service provision. As Petar Sotjic, director of the UK Business Support Policy in charge of its Manufacturing Advisory Service (MAS) notes “SMEs do not always know what they do not know, and they do not know how useful business expertise can be. And even when the SME manufacturer knows it has a problem, it does not always know how to procure the right solution. After they have worked with MAS, they understand . . . the value of external expertise in general, so when they have to pay the full rate in the future, they now know what to look for and have greater confidence in approaching the market”.

This is what we see empirically in a World Bank project that subsidized firms using HR consultants, accounting firms, and marketing firms in Nigeria. Most SMEs did not know of the existence of most of the providers, found it hard to tell good from bad providers, and were reluctant to trust them. After using the subsidy, we find a year later they are more likely to go back to the market and spend their own funds to buy more of these services – that is, these initial subsidies can build market demand.

So the benefits can outweigh the costs, but there is a lot of uncertainty and a need for more prospective impact evaluation

The webinar also featured a talk from Nicole Robins of Oxera, discussing the EU’s State Aid approach in which governments wanting to support individual firms have to provide an ex-ante assessment that aims to demonstrate that the project is likely to bring benefits, have additionality, and use the least distortionary instrument and amount of financing possible – and then ex post evaluations are sometimes done to see what happened. This process seems like it can be very helpful in thinking through the likely causal chain and in selecting the appropriate instrument – but innovation is an inherently risky activity and counterfactuals are hard – so building prospective impact evaluations into these projects that help measure these impacts and allow adjustments along the way is needed. This is particularly the case for some of the underexplored areas of government support, such as the green agenda discussed in my last post.


David McKenzie

Lead Economist, Development Research Group, World Bank

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