Policy Distortions and Aggregate Productivity with Endogenous Establishment-Level Productivity1

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 hinges crucially on the size distribution of establishments approximately satisfying Zipf’s law, an empirical phenomenon that can be interpreted to imply that misallocation is low or that the establishments’ lifespan is long, or both. More distorted economies feature higher establishment lifespan which amplifies the negative effect of distortions on productivity and establishment growth. Policy distortions substantially reduce aggregate TFP, an effect that is 2.8-fold larger than in the model with unrestricted size distribution and 6.9-fold larger with perfectly correlated distortions